New Best Practices For Comp Committee

Serving on a board’s compensation committee is no easy task these days—and it probably won’t be ever again.

Once upon a time, comp committees could take their cues from consultants they hired or even the executives they oversaw. Today, however, corporate pay practices are under enormous scrutiny from regulators, investors, lawmakers, and the media. That means a new level of accountability for committee members and an emerging new set of best practices to satisfy those expectations.

“The main thing that’s changed in recent years is that committees are more aware of their responsibilities and are asking for more information,” says Danielle Benderly, of counsel at the law firm Perkins Coie. “They’re not just accepting recommendations from a compensation consultant and management.”

Brancato

Carolyn Kay Brancato, director emeritus of the Directors’ Institute at The Conference Board and chief executive of the Riverside Group, agrees. Each committee will conduct its duties in its own way, she says, but “by and large, compensation committees are more hands-on than they were 10 years ago … They have to understand what’s going on, as opposed to just rubber stamping things.”

The renewed attention to compensation practices first started with passage of the Sarbanes-Oxley Act in 2002, but took a huge step forward this year with the Securities and Exchange Commission’s overhaul of disclosure rules for executive pay. While the new rules don’t change the committee’s role or responsibilities, there’s far more disclosure about how pay is set. That has led committees to examine their practices closely.

“If the committee had their house in order and is happy having those details divulged, there isn’t anything to do,” says Paula Todd, managing principal at compensation consulting firm Towers Perrin. “But I think it’s like most people when they have a party at their house. They clean, they rearrange things, they make some changes. Some committees may have had more housework to do than others.”

Under pressure from activists, committees are also far more focused on tying pay to performance. In fact, many institutional investors and proxy voting firms have published their own guidelines for comp committees (see box below, left). “Ten years ago, compensation was in a little black box off to the side and that was all the compensation committee did,” Brancato says. “But compensation ought to be linked with the company’s overall strategy and performance.”

Similarly, Benderly says while tying pay to performance isn’t required under any rules, “It’s common sense.”

“The board is looking at the company’s overall business plan and the incentive and compensation package builds on that,” she says. “They ought to be tied at least in part to the same metrics.”

Due Diligence In Committee Duties

Benderly

Benderly has one big caution for compensation committees: don’t act by written consent and communication alone. “They should meet and there should be appropriate formality around those meetings,” she says. Indeed, while it may seem obvious, experts stress the need for compensation committees to get any materials or information they need well in advance of meetings, and allow themselves time to deliberate.

SUMMARY

The excerpt below is from the Council of Institutional Investors' policy on Executive Compensation, "Role of Compensation Committee":

Structure

Committee composition: All members of the compensation committee should be independent. Committee membership should rotate periodically among the board’s independent directors. Members should be or take responsibility to become knowledgeable about compensation and related issues. They should exercise due diligence and independent judgment in carrying out their committee responsibilities. They should represent diverse backgrounds and professional experiences.

Responsibilities

Executive pay philosophy: The compensation philosophy should be clearly disclosed to shareowners in annual proxy statements. In developing, approving and monitoring the executive pay philosophy, the compensation committee should consider the full range of pay components, including structure of programs, desired mix of cash and equity awards, goals for distribution of awards throughout the company, how executive pay relates to the pay of other employees, use of employment contracts, and policy regarding dilution. Best practices would include shareowner approval of the compensation philosophy.

Oversight: The compensation committee should vigorously oversee all aspects of executive compensation for a group composed of the CEO and other highly paid executives, as required by law, and any other highly paid employees, including executives of subsidiaries, special purpose entities and other affiliates, as determined by the compensation committee. The committee should ensure that the structure of employee compensation throughout the company is fair, non-discriminatory and forward-looking, and that it motivates, recruits and retains a workforce capable of meeting the company’s strategic objectives. To perform its oversight duties, the committee should approve, comply with and fully disclose a charter detailing its responsibilities.

Pay for performance: Compensation of the executive oversight group should be driven predominantly by performance. The compensation committee should establish performance measures for executive compensation that are agreed to ahead of time and publicly disclosed. Performance measures applicable to all performance-based awards (including annual and long-term incentive compensation) should reward superior performance—based predominantly on total stock return measures and key operational measures—at minimum reasonable cost and should reflect downside risk.

Annual approval and review: Each year, the compensation committee should review performance of individuals in the oversight group and approve any bonus, severance, equity-based award or extraordinary payment made to them. The committee should understand all components of executive compensation and annually review total compensation potentially payable to the oversight group under all possible scenarios, including death/disability, retirement, voluntary termination, termination with and without cause and changes of control. The committee should also ensure that the structure of pay at different levels (CEO and others in the oversight group, other executives and non-executive employees) is fair and appropriate in the context of broader company policies and goals and fully justified and explained.

Committee accountability: In addition to attending all annual and special shareowner meetings, committee members should be available to respond directly to questions about executive compensation; the chair of the committee should take the lead. In addition, the committee should regularly report on its activities to the independent directors of the board, who should review and ratify committee decisions. Committee members should take an active role in preparing the compensation committee report contained in the annual proxy materials, and be responsible for the contents of that report.

Outside advice: The compensation committee should retain and fire outside experts, including consultants, legal advisors and any other advisors when it deems appropriate, including when negotiating contracts with executives. Compensation advisors should be independent of the company, its executives and directors and should report solely to the committee. Use of outside compensation consulting firms retained by the compensation committee should be disclosed, along with the compensation committee’s assessment of the advisors’ independence and a description of other business performed for the company.

Source

Role of Compensation Committee (Council of Institutional Investors)

Some committees hold pre-meetings with the committee chairman and management or the compensation consultant to vet significant issues in advance of committee meetings, Todd says. “Big issues should be teed up at least a meeting in advance of when they need to be decided, so the committee has time to discuss it, digest any proposal, and reflect on it,” Todd says.

Benderly recommends that a securities lawyer who is well-versed in the SEC disclosure requirements be present at every committee meeting or any board meeting where compensation is discussed—and detailed minutes of every meeting are essential.

“Almost everything has a potential disclosure item trigger, either Form 8-K or proxy,” she says. “Counsel should be present to keep the committee informed about the potential disclosure ramifications of what they’re doing.”

Another still-evolving issue for compensation committees is equity compensation. Because of the options backdating scandal that exploded last year, companies are re-examining their practices and policies around granting stock options or restricted stock awards. Still, experts say, companies aren’t all taking the same approach and not all committees are making changes.

“Some will look and say their processes are fine,” Benderly says. “Others are making changes to when or how they grant options or how they document option grants.”

The options scandals have also led boards at least to revisit, if not revise, the issue of delegated authority for granting options. “Some companies are moving away from delegated authority while others are moving toward it,” Benderly says. For example, companies might use delegated authority for approving new hire grants.

“As long as it’s exercised and documented appropriately, there’s nothing wrong with delegated authority,” she says. “But the parameters need to be clear. There has to be reporting back to the committee so the committee is still overseeing the process.”

Consultants And Other Practices

The rise of compensation consultants is another evolving question for compensation committees. A large number of companies use pay consultants (see related story above, right), which has prompted the idea of hiring two consultants: one for the committee and another for management.

“We’re finding that the issue of whom the consultant reports to is critical,” Brancato says. “In order to carry out its fiduciary duty, the compensation committee should have its own separate, independent consultant to consult on top executive compensation.”

Brancato likens the situation to how an audit firm is prohibited from providing certain other services, such as consulting on IT systems, to audit clients. Executive compensation should be set by the board with the help of a consultant who is hired by the board, she says. “All other compensation should be set by management with a separate consultant, but not duplicating the same work.”

Benderly and Todd, however, say most companies have yet to embrace the two-consultant model. A common practice, Benderly says, is for the committee to hire a consultant when none had been used before, or to hire the same consultant but simply have him report to the committee rather than management. “Just because management hires the consultant doesn’t mean they’re not doing a good job,” she says.

Todd

Todd says the two-consultant model “isn’t that customary.” Typically, she says, one consultant reports to the committee and the committee may authorize him to do other work with management. In some cases, the committee may say the consultant and the firm can’t do any other work for the company.

A clearer practice has emerged around the use of tally sheets to present one plain, bottom-line number for an executive’s total compensation—a number now required by the new SEC disclosure rules. Tally sheets are seen as an excellent tool to disclose that number and were already gaining popularity after the fiasco of Dick Grasso, former chief executive of the New York Stock Exchange, received more than $130 million in compensation when he left his job. That eye-popping payout was exactly the sort of “holy cow” moment tally sheets are intended to prevent.

Among nearly 500 directors surveyed last year by Towers Perrin and Corporate Board Member magazine, 62 percent reported that their companies use tally sheets, and another 28 percent planned to do so. “The notion of looking at all elements of pay in a holistic way has become much more routine,” Todd says. “They’re now characterized as a best practice.”

“While not everyone is using them yet, everyone is at least talking about them,” Benderly says. At a minimum, she suggests, a tally sheet should include all of the information that’s required in the Summary Compensation Table in the proxy statement.

Like so many other pieces of data, tally sheets and consultant work feed into the committee’s ultimate responsibility: “to have all of the information they need to understand what’s being proposed,” Benderly says.

“The committee’s job is oversight,” she continues. “Management or a consultant brings the committee proposals. They question them and poke holes in them. If they don’t think something works, they have to ask for something else, or ask for more information.”