Corporate Governance

Regime Change and the SEC's Corporate Governance Agenda: #5 Compensation Consultant Disclosure

By J. Robert Brown

There are few more pressing areas of regulatory concern these days than executive compensation.  The SEC systematically amended the disclosure requirements in Item 402 back in 2006.  The result has been far greater emphasis on the process for determining compensation and greater sunlight cast on assorted perqs including club memberships and personal use of corporate aircraft.

The one area where the disclosure requirements fall short, however, is with respect to compensation consultants.  The consultants are commonly used to meet state law fiduciary duty requirements by allowing the board (or the compensation committee) to claim it was informed.  Yet the consultants may not always meet these requirements.  Shareholders, however, have no way of knowing given the weak disclosure regime for compensation consultants.  

The SEC requires only minimal disclosure about compensation consultants. Under Item 407(e), companies must disclose the role of the compensation consultant:

• in determining or recommending the amount or form of executive and director compensation,
• identify such consultants and state whether such consultants are engaged directly by the compensation committee or any other person; and
• describe the nature and scope of their assignment, and the material elements of the instructions or directions given to the consultants with respect to the performance of their duties under the engagement.

The provision, however, does not address conflict of interests. There is no obligation to disclose other services provided by the consultants. There is no requirement to disclose the method used to select the consultant, including the CEO's role in the process. Indeed, in adopting the requirement, the SEC deleted a requirement that would have required companies to identify "the executive officers of the company that the compensation consultants contacted in carrying out their assignment." Exchange Act Release No. 54302A (August 29, 2006). This requirement would have at least put into the public domain information about the CEO's contacts with the consultant.

This is not an academic concern. Shearman and Sterling conducts periodic surveys of corporate governance practices among the 100 largest companies that have shares traded on an exchange.  One of the surveys tracks director and executive compensation trends.  The report noted concern with the independence of compensation consultants. 

• The concern arises from the fact that many compensation consultants work for diversified human resources consulting firms that have developed strong ties to management by providing other non-compensation-related services to their corporate clients, including actuarial services, information technology services, risk management and insurance underwriting, health and welfare services, tax and legal advice and outsourcing.  The fees earned for these service are often significantly higher than the fees earned for executive compensation consulting services provided to the compensation committee.

The issue has been examined by the Congressional Oversight Committee.  The report published in December 2007 concluded the following:

• Compensation consultant conflicts of interest are pervasive. In 2006, at least 113 of the Fortune 250 companies received executive pay advice from consultants that were providing other services to the company.
• The fees earned by compensation consultants for providing other services often far exceed those earned for advising on executive compensation.
• Some compensation consultants received over $10 million in 2006 to provide other services. One Fortune 250 company paid a compensation consultant over $11 million for other services in 2006, over 70 times more than the company paid the consultant for executive compensation services.
• Many Fortune 250 companies do not disclose their compensation consultants’ conflicts of interest. In 2006, over two-thirds of the Fortune 250 companies that hired compensation consultants with conflicts of interest did not disclose the conflicts in their SEC filings. 
• There appears to be a correlation between the extent of a consultant’s conflict of interest and the level of CEO pay. In 2006, the median CEO salary of the Fortune 250 companies that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use conflicted consultants. Over the period between 2002 and 2006, the Fortune 250 companies that hired compensation consultants with the largest conflicts increased CEO pay over twice as fast as the companies that did not use conflicted consultants.

The Sherman and Sterling report noted that only a small number of companies have adopted a policy requiring compensation consultant independence, including Wachovia Corporation, The Procter & Gamble Company, Pfizer Inc., Sprint Nextel Corporation, The Home Depot, Inc. and Verizon Communications Inc.

In other instances, the compensation consultants appear to act more as agents for executive officers than the board and shareholders.  For posts on the subject, go here and here.  Yet the existing disclosure requirements do not pick up the interaction between the consultants and the CEO.

The Division of Corporation Finance should be instructed to begin working on rule proposals that would amend Item 407(e) and expand the disclosure surrounding the use of compensation consultants, including conflicts of interest that might exist.

Full post as published by The Race to the Bottom on January 06, 2009 (boomark / email).