The Advisors' Blog

Selection of appropriate peer companies is one of the most important decisions that a compensation committee makes. If the peer group is flawed, then the competitive analysis is likely to be flawed as well, and the rest of the decisions made by the committee are suspect as a result.

By way of example, the recent Congressional hearing into severance pay practices at several high-profile financial firms uncovered some interesting information about the conversations between the compensation committee of Countrywide Financial Corporation and various consultants regarding the construction of the company’s peer group. At one point during the process, there was a suggestion to eliminate three smaller banks from the peer group (SunTrust Banks, BB&T Corporation, and Fifth Third Bancorp) and replace them with Bank of America Corporation, Merrill Lynch, and Goldman Sachs. When looked on the basis of assets, the three smaller banks were in fact modestly smaller, with assets ranging from 60% to 100% of the assets of Countrywide.

On the other hand, the three suggested replacements ranged from about 4-7 times Countrywide in asset size. In terms of market capitalization, all three of the smaller banks were very close to Countrywide in terms of market capitalization at the time, while the market capitalization of the suggested replacements ranged from 3 to 9 times Countrywide. And the pay practices were quite different as well—CEO total compensation at the three replacement companies at the time averaged more than $25 million, while CEO total compensation at the three banks that were to be excluded from the analysis averaged about $3.5 million.

It seems possible that the modified group was chosen based on the pay practices for the CEO as opposed to factors such as industry segment, size, performance, market capitalization, etc. However, peer group suggestions such as those made in this case are often justified on the basis of statements like “we need to be able to compete with these kinds of companies for the world-class talent necessary to drive our business forward.” While these statements are true in the abstract, the new approach to disclosure makes it even easier to pick a group that is biased toward high payers. Any CEO—even those that do not set out intentionally to bias the peer group—may have information about each company’s pay practices in their head as they define the appropriate group with the consultant and the compensation committee. When discussing two companies that are similar, arguing for the one with higher pay might be too tempting to avoid.

– Jim Woodrum