compensation reform: Motivating Integrity

“One of the great, as-yet-unsolved problems today is executive compensation and how it is determined” – SEC Chairman William Donaldson, 2004. How do insurers measure up?

Independent advisory firm Executive Risk Consulting, which specializes in executive compensation and board effectiveness issues, has gathered the views of Canada’s foremost thought leaders in executive compensation, and specifically their views on what changes are required. The goal was to identify reform that offered the most promising means of better governance around executive compensation.

To begin with, the issues behind compensation plans are complex, and largely based on financial matters and analysis. Regulators in Canada require that “financially literate individuals” sit on the audit committee, but they have not yet realized that you also need them on the compensation committee. Ideally, regulators should require that the compensation committee consist entirely of professionals with sophisticated compensation backgrounds. Unfortunately, there are only a handful of highly experienced compensation consultants in Canada, and when you address the issue of independence (as discussed below), the

number drops by more than half. A Compensation committee needs to take full control of the

compensation process and be entirely composed of independent directors experienced in compensation and financial matters. If experience is not available on the board, then outside counsel should be brought in.

INDEPENDENT EXPERIENCE

The issue of a consultant’s independence has come under the magnifying glass of New York’s attorney general Eliot Spitzer. And, Harvard Business School professor Michael Jensen recently commented via research that “many of the largest human resource consulting firms such as Hay, Hewitt, Towers Perrin,

Mercer, and Watson Wyatt receive fees from their actuarial or employee pay practices that are orders of magnitude larger than the fees charged by their executive pay practices. These prospects for cross-selling other services dramatically increase the conflicts of interest faced by the compensation consultants. It is not

realistic to expect a management compensation consultant to aggressively argue against overpaying a CEO who the consultant knows is going to rule on hiring to perform a vastly more lucrative actuarial or rank and file consulting contract.”

Our research showed that people expect that regulators, just as they did with accounting firms a few years ago after Arthur Andersen’s and Enron’s collapse, will soon force many of these large human resource (HR) integrated consulting firms to eliminate their non-core consulting services. Since these firms receive revenue by offering a wide range of services – technology outsourcing, pension consulting, investment consulting, etc. (and of course, executive compensation consulting), conflicts were visualized as potentially widespread and the issue of independence was questioned.

THE “RATCHETS”

Recent legal cases around executive compensation (e.g. Disney, NYSE), raise the question as to why only directors are being held liable. The executive compensation industry has received some negative attention from such governance advocates as Claude Lamoureux, president of Ontario Teachers’ Pension Plan. I believe he is correct in saying there are some less than competent compensation advisors in the marketplace, which he refers to their firms as “Ratchet, Ratchet and Ratchet”. However, there are also advisors who are highly effective, independent and keep shareholders’ interests at hand.

In my career as a compensation consultant, I have had numerous debates with others in my field as to whether an independent consultant should provide clients with specific recommendations. In my opinion, a consultant cannot add value without doing so. Others, however, purposely shy away from making direct recommendations because they create potential liability risks for consultants and their employers. I ask, as should the directors relying on a consultant’s expertise, why should consultants not be on the hook for their recommendations?

Further, we need to look beyond just the compensation consulting industry. There are other players involved in the compensation decision-making process. For example, some tax professionals, executive recruiters, lawyers, and accountants are involved at times and have an impact on compensation design issues or pay levels.

CHECKED BALANCES

Annual compensation audits and fairness opinions regulate the process. Although I am not usually a believer in regulating companies to conduct specific due diligence (or follow specific processes), I do think regulation can be valuable in situations that can have a significant financial impact on shareholder value

(and where the risks can be avoided). There are many examples of how poorly designed compensation plans can cost shareholders billions of dollars (e.g. Enron) – a detailed audit can assist in resolving this problem.

Last year, Canadian securities regulators imposed new rules for audit committees. For example, “Multilateral Instrument 52-108” requires public companies to have their financial statements and internal controls audited annually. It surprises me that no matter how many accounting scandals are discovered, regulators and investors have yet come to the realization that it is the company’s compensation plans that are driving the accounting practices at most organizations and can be the main cause of these scandals.

Regulators should impose companies to undertake detailed reviews of their compensation plans and have professionals provide written, publicly disclosed fairness opinions for which they, not just the board, are accountable. An annual audit needs to cover more than compensation to simply provide competitive compensation data and an overview of trends. An annual audit and fairness opinion should include:

* A well developed and communicated compensation philosophy reflecting a company’s vision and corporate governance principles;

* A detailed “pay-for-performance” analysis using relevant peer group and performance measures;

* Use of a wide array of independent, credible and defensible compensation data.

* A review of how compensation costs are accrued by management in the income statement;

* An analysis of the company’s compensation liabilities on the balance-sheet (as maintained by management), and whether this accurately reflects the company’s future payment obligations;

* An analysis of the company’s short and long-term incentive plan(s), specifically potential design issues, funding rates, annual “burn rates”, dilution levels, derivative contracts, share ownership requirements, details on pay mix, and the overall cost to shareholders;

* Review and disclosure of specific details relating to the design of pension arrangements,

executive indebtedness, benefits and perquisites;

* Commentary on the employment terms of the top five executives’ employment agreements, such as termination payout provisions;

* Recommendations on the top five executives pay levels for the fiscal year and a discussion as to why these levels are being recommended; and

* The compensation consultant should disclose its identity and sign-off on reviews in the proxy circular in the same way auditors, actuaries and investment bankers are required. If the compensation consultant’s firm earns revenue from other services provided to the company, the details thereof should be disclosed to shareholders.

This spring, the Ontario Securities Commission will be finalizing National Policy 58-201 that outlines governance standards for public companies. In addition, effective this September, the Ontario Teachers’ Pension Plan Board will add to its proxy guidelines a need for companies to “retain well-known and reputable consultants, and have the identity of the consultants and the nature of compensation paid to them disclosed”.

These are all good steps but I see them having minimal impact on the systemic issues that exist today. At the end of the day, these are only voluntary guidelines that deal with a few issues. Some people will argue that guidelines coupled with shareholder pressure will have an impact, but in an area as complex as executive compensation where experience in law, statistics, surveys, accounting, corporate finance, governance, taxation and competitive marketplace is required, more regulated processes, as we have for auditors, actuaries and investment bankers, will be required. The reforms proposed here may well offer the most promising route for improving executive compensation and corporate governance we have seen to date.