In the latest of our conversations with compliance and governance executives, we catch up with Patrick McGurn, head of U.S. corporate governance trends for RiskMetrics Group. Readers can also visit our archive of Q&A interviews.

DETAILS

McGurn

Patrick McGurn provides special counsel to RiskMetrics Group’s ISS Governance Services unit. Considered by industry constituents to be one of the leading experts on corporate governance issues, he is active on the nationwide speaking circuit and plays an integral role in policy development.

Prior to joining RiskMetrics Group, McGurn was director of the Corporate Governance Service at the Investor Responsibility Research Center (IRRC), a not-for-profit firm that provides governance research to investors. He also served as a private attorney, a congressional staff member and a department head at the Republican National Committee.

COMPANY BASICS

Company

RiskMetrics Group, Inc.

Headquarters

New York, NY

Employees

1,123

Industry

Risk Management

’06 Revenue

$101.2 million

Related Coverage

Executive Pay Tops Investors’ Priorities (Feb. 12, 2008)

RiskMetrics Compensation-Related Policies (Dec. 4, 2007)

RiskMetrics’ Disclosure Best Practices (Oct. 23, 2007)

Describe the criteria RiskMetrics will consider when recommending whether to vote for or against a pay package. What will you be looking for?

Most of the changes we put in place for 2008 reflect what we gleaned from last year’s enhanced executive compensation and the CD&As.

One of the specific grounds for potential no votes was poor disclosure in and of itself. We wanted to give companies that first year as a trial … because the disclosure rules were new. We’ve tried to identify companies where we thought there were problems last year.

We’ll take another look at them in 2008. If they’ve raised their game, if they’ve improved their disclosures sufficiently, they’ll go on their merry way. But if we see companies that still aren’t being fully transparent and are not meeting either the letter or the spirit of the SEC rules, then we’re more likely to take action against them in the form of withhold or against recommendations on members of the comp committee or the full board of directors.

As far as withhold votes, or against votes for compensation committee members, will there be more leniency?

We have to wait until the disclosures come out before we can grade them out. So it’s not a pre-emptive strike. All we’re saying is we noticed these deficiencies in 2007; let’s wait and see if the company addresses these concerns. Some of the concerns were exactly the same ones the SEC pointed out in their 350-company review …

We’re very unlikely to say companies have picked the wrong performance measure. We’re much more likely to question where they’ve set the bar. To us, that’s much more important as far as evaluating the performance of the comp committee. We’re going to say: “You either didn’t tell us where the hurdle was, so we’ve got no way of judging how accountable you’re going to make people,” or “You didn’t provide us with enough to figure out how difficult it was even if you didn’t give us the actual number.” I think that’s going to be a major flashpoint issue this proxy season, given the amount of pushback that people are giving in some of their correspondence with the SEC.

Looking at poor disclosure practices, are performance targets going to be the number-one area of focus?

By far. The targeting this year for the pay for performance proposals and the letter writing campaigns directly flows from last year’s disclosure. If those resolutions make it to the ballot, they’re likely to get heightened levels of voting support.

What other things are you considering when judging pay packages?

We obviously don’t like things like pay-for-failure and excessive severance provisions. That’s not anything new. We tend to define excessive as being above the traditional 2.99 times annual compensation spelled out in the excise tax regulations. We’re still looking at all of the same things we looked at last year. The additions on our list this year were driven by the numbers that we encountered [in the 2007 disclosures]. Before, we weren’t getting a really great idea about the size of severance packages and the overall size of the SERP [supplemental executive retirement plan]. We may see more instances where those particular issues come into play.

What kind of balance should there be between fixed pay and performance-based pay?

We only tend to address that issue when we think there’s a pay-for-performance disconnect. In other words, when we’ve identified the company as underperforming its peers over a mid- and longer- range cycle. Then we’ll start looking in detail at the level of linkage between pay and performance of the plans. What we tend to dictate under our guidelines in those situations is that you have a substantial portion—typically somewhere around half of all grants of equity awards received—be performance based. We don’t necessarily provide guidance as to what sort of awards they should be. From our perspective, plain vanilla stock options and time-lapse restricted stock aren’t per se performance based. There has to be some performance vesting provision or performance tie.

How will you gauge boards’ responsiveness to shareholder concerns, about compensation or other complaints?

As we’ve gotten more into the process of looking into the performance of compensation committees, we’ve had a dialogue both with comp committee members, especially the chairs, and often, their independent consultants. It’s been very informative. Often, you learn one of two things: there’s nothing really there; there are no signs of intelligent design behind the program and there’s very little downside baked into their compensation programs. In other instances, it’s very complex. There may be a good “why” behind an issue. You’ve got this severance package, why do you have it in place? Why is it as large as it is? We end up asking that second and third why a lot. You designed it like this, why? Why these type and size of awards? If you get to the third why and the answers to the questions start to dissemble, you start getting worried. They can defend the individual pieces of the package on a stand-alone basis but they can’t defend the package as a whole.

The CD&A is a longer-term problem. It really is going to require a change in mindset by many companies, and frankly a greater degree of self-awareness than perhaps some of them are willing to exercise today.

That’s why we’re starting to come up with new tools. One of them focuses directly on peer group selection and tries to analyze that in a much more systematic fashion. We’ll be issuing some more information on that in the coming weeks. We’re also starting to take a look at the risk component of pay. Are we encouraging CEOs, via the pay packages we’re providing, to swing for the fences, knowing if they hit a home run they’re going to be extraordinarily rich and if they strike out, as long as they don’t lose their job, there’s very little downside risk built into their plans?

Given all the publicity and concern about executive pay, do you expect companies to put up much of a fight over it? Or on any other issue this season?

Pay for performance is the big one. We put out a best practices report this year, and other groups have as well. People can go online and pull up somebody else’s form and use that. So I think we’ll start seeing the formatting of the disclosures becoming somewhat more homogeneous around those best-practice models. Over time, I think a lot of the structural problems with the disclosures will disappear.

The CD&A [Compensation Discussion & Analysis] is a longer-term problem. It really is going to require a change in mindset by many companies, and frankly a greater degree of self-awareness than perhaps some of them are willing to exercise today. It’s going to force them to look back and say, “Was there intelligent design behind our programs or did they just grow over time? Were they driven largely by accounting and tax considerations and the need to attract talent and really to not create any sort of coherent program of linking pay to performance?”

Is it going to be a repeat of what happened with the MD&A where it took years for the SEC to get the importance of it into people’s heads?

Ultimately, it took enforcement actions. I guess it’s our expectation that the SEC will go after a couple of companies and force them to refile the material and potentially force them to postpone a meeting as a result. While that’s not going to be great for shareholders of those companies because of the additional time and expense involved, it’s going to put the fear of consequences into those companies, and I think that will lead to a quantum leap in the disclosure practices.

What other best pay practices do you see going out the door?

I think five years from now, you’ll look at large market-cap companies and there won’t be a perquisite left among them. The one that’s going to go out kicking and screaming is what I call PUCA, or “personal use of corporate aircraft.” I think even it will go out of favor, or at least executives will have to pay a market rate for their time using corporate aircraft, if they’re required to do so for security purposes. The opening salvo in that battle is the one this year against gross-ups. Gross-ups, on their face, are a very offensive concept. The excise tax issue does complicate the gross-up issue. But suffice it to say, the status quo is unacceptable. I think it’s going to continue to be an issue that attracts attention.

Use of executive contracts is coming up for the first time via shareholder proposals this year. People are focusing more on contracts as the root cause of many of the problems like pay for failure and excessive severance payouts. Going forward, boards aren’t going to be able to get away with simply saying, “Everybody else does it so we do it too.” The million-dollar question for many companies this year is, can you really make a rational argument as to why you’re keeping some of these components of compensation? For example, why are you making contracts when half the CEOs in the industry don’t have one?

SERPs are another area being thrown into the public eye for the first time in a significant fashion. We’re going to see shareholder proposals and more attention focused on that topic. I think a lot of the abuses in that area will dry up over time. The primary thing is the ‘dog year’ issue of executives getting accredited for extra years of service to boost pension payouts. That’s part of a larger issue—the move way from DB [defined benefit] plans toward DC [defined contribution] plans for rank-and-file workers and the differential treatment that executives often get. I think that’s going to get Congress in the game. And if we have that proverbial blue state sweep in November, I would not be surprised to see hard caps on SERPS and other deferred compensation arrangements going forward.

Now that RiskMetrics is a public company providing advice to companies while also trying to please Wall Street, how will you address conflicts of interest?

What we have now is a new report card on that front. We’ve always said that the best enforcement mechanism we had was the fact that this was a process that was transparent to our clients. Ultimately, they could always question us if they thought we were pulling our finger off the scale or putting it on. Now, as a public company, we get a report card every day in the marketplace. To the extent that concerns are voiced by our shareholders, we are going to be responsive to those concerns. It gives us one more layer of accountability built into the process.

Thanks, Pat.