Revealing relationships

Investors are concerned executive pay firms have a conflict of interest in representing both management and the board and are pushing companies to come clean about their arrangements. They suspect consultants might not be giving unbiased views on management compensation for fear of losing out on other lucrative consulting contracts with companies. ‘We don’t know if pay is being compromised but we do feel there are some areas where conflicts of interest could arise,’ says Louis Malizia, corporate affairs coordinator for the International Brotherhood of Teamsters, which is pushing for disclosure in this area.

Around 25 companies became the target of a shareholder campaign to drive disclosure of business relationships with compensation advisors last October. A group of investors representing $849.5 billion in assets sent a letter to top S&P 500 companies asking them to reveal their arrangements with pay consultants and whether they have a formal policy to guarantee independence for these advisors. Eighteen companies have now responded with many volunteering the name of their consultant and the nature of their business ties. ConocoPhillips, Pfizer, ExxonMobil, Cisco, Wachovia, Goldman Sachs, GE and Home Depot are among those that have complied with investors’ requests.

‘We have gotten a variety of responses and now feel comfortable that the processes by which some companies are selecting and managing compensation consultants are appropriate,’ says Damon Silvers, associate general counsel at the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO), the union that has submitted proposals on this topic to several companies. ‘We have also heard from companies that have said that the human resources director hires the consultant and we find that response insufficient.’

Rooting out conflicts

The ultimate aim of this campaign is to root out any potential conflicts for pay consultants that work for both management and the compensation committee. ‘We are trying to bring to light these potential conflicts the same way we did with auditors,’ says Malazia. AT&T’s continued use of CCA Strategies for compensation consulting after it was bought out by JP Morgan represents a potential conflict because JP Morgan provides other services for the telecom, Malazia adds. ‘We want to know if there is a bright line of independence and what the board considers when a consultant is bought out by a company that already provides other services.’ 

GE was first out of the gates in publicly revealing its arrangement with compensation consultant Frederic Cook in December. Its disclosure shows a fairly limited use of these services with GE participating in Cook’s long-term incentive survey and purchasing market intelligence on broader pay trends for its human resource department. The disclosure came after discussions with the AFL-CIO that then dropped its shareholder proposal on this topic. ‘Our CEO doesn’t believe compensation consultants should be used,’ comments Peter O’Toole, spokesman for GE. ‘We have a fairly modest engagement with our consultant.’

The AFL-CIO also dropped its proposal at Home Depot after the company explained it already has a policy that prohibits pay consultants from doing other work for management. The policy has been around for a while but the company just recently formalized it by adding it to company governance guidelines and posting it online. ‘A policy like the one we’ve created is, in our view, an element of best practice as it helps ensure independence, avoid conflicts and, consequently, results in objective and impartial advice,’ says Frank Fernandez, executive vice president, secretary and general counsel at Home Depot. In its upcoming proxy, the hardware retailer will also identify its consultant as Towers Perrin and discuss its role in making executive compensation recommendations.

Verizon is taking a different approach in letting shareholders vote on whether it should reveal other work done by consultants that have advised its board on executive pay. The communications company came under examination for potential conflicts of interest last year when the New York Times revealed its consultant Hewitt Associates was also working on various other projects for Verizon. It has since changed consultants to Pearl Meyer & Partners and plans to reveal more on its past relationships. ‘We will make appropriate disclosures about the identity and services of former consultants in our upcoming proxy,’ comments Bob Varettoni, a Verizon spokesperson.

A complex industry

The influence of pay consultants has grown significantly in the last five years with compensation committees demanding more assistance throughout the year. ‘It used to be management would retain the compensation consultant and today it’s more likely that the compensation committee chair will hire the consultant,’ says Peter Lupo, managing director of Pearl Meyer’s New York office. ‘The other trend is that companies might decide to have separate consultants advise the board and the management.’ This practice hasn’t really taken off, however, with most US companies still using one advisor for all services, Lupo adds.

With auditing firms, it became apparent that much of their revenues were coming from consulting contracts, calling into question the objectivity of audit work. But the compensation consulting industry is more complex, with small and large firms offering different types of services.

For large firms like Towers Perrin, Mercer Human Resource Consulting and Hewitt Associates, board advisory services on executive pay is often a fraction of the work they do for management. So a company might pay $150,000 for executive compensation consulting versus $3 million for broader consulting work on employee salaries and benefits. Smaller firms like Frederic Cook and Pearl Meyer tend to specialize in board advisory services. Along with advising the compensation committee, these firms might provide specific survey or market intelligence services to the board but do not regularly engage in work for management.

‘Where we are retained by board compensation committees, we generally have signed consulting agreements saying we will not do other work for the company without the knowledge and consent of the compensation committee chair,’ says George Paulin, CEO of Frederic Cook. The proxy statements of Pfizer, Procter & Gamble and Hewlett-Packard describe such arrangements, adds Paulin, who serves as the independent advisor to the compensation committees of these companies.

Firms that often work for both management and the board say they haven’t seen pay advice compromised. ‘Oftentimes, the consultant working with the committee will have little or no contact with other parts of the organization that is providing other services for the company,’ says Mark Borges, a Mercer principal. ‘You hear anecdotal talk about conflicts of interest but I haven’t heard of any situation where the consultant has offered non-objective advice.’

The big question

The million dollar question is: Will disclosure guarantee unbiased pay advice and better align pay to performance? Investors are betting yes. In focusing on the largest 25 companies in the S&P 500, they are trying to underline the need for compensation committee advisors to operate independently of management. ‘Right now we are just getting a first glimpse of what is happening in corporate America and it will take real outreach to get this disclosure and then work towards true independence for compensation consultants,’ says Malazia. ‘The ultimate aim is to have the pay practices correct and, like a lot of things in governance, disclosure goes a long way to establishing best practice,’ adds the AFL-CIO’s Silvers.

Other experts are less convinced. ‘Compensation consultants don’t set the pay level; they just provide the information and then the board sets it,’ points out David Larcker, a compensation expert with Stanford Graduate School of Business. ‘A lot of this pressure for disclosure stems from the belief that we perform a function similar to the auditors’ role but that is somewhat misplaced because our role is strictly advisory,’ agrees Borges.

In getting companies to disclose details about their relationship with pay consultants, there is a risk of executive pay increasing. ‘You might see companies firing the consultant that pays less,’ says Larcker. ‘This might push pay levels higher as some companies see what others are doing and adjust their pay scale accordingly,’ agrees Lupo.

Either way, this issue is expected to heat up this proxy season and compensation committees will have to decide whether to reveal more about their relationships with outside consultants. This will undoubtedly influence the evolution of the compensation consulting industry and could see companies adopt formal policies to safeguard advisors’ independence. For now, investors would be satisfied with seeing companies talk about their relationships in the proxy. As Malazia says, ‘this would carry a lot of weight with shareholders because that is something internal controls has to verify.’