The Advisors' Blog

– Frank Glassner, Compensation Design Group

A few weeks ago, Financial Week magazine reported that the Congressional crackdown on executive compensation consultants with conflicts of interest has rapidly changed the industry landscape.

Many of the country’s largest companies are now rushing to hire independent consulting firms that specialize exclusively in executive compensation, instead of retaining large consulting firms that provide other, often far more lucrative, consulting services, such as human resources, actuarial, healthcare, pension and benefits plan administration, in addition to dispensing advice on executive pay. Many of those firms provide insurance products to, and receive commissions from, the very companies to whom they are providing compensation consulting services. Some are even owned by the insurance companies themselves.

The extent of the change is stark. According to a recent Equilar analysis of Fortune 1000 proxy filings, 39% of compensation committees now rely on independent consultants for advice on executive pay, compared with barely 30% in 2007. The remaining compensation consulting arrangements are with “full-service” firms.

Similarly, many other corporations are disclosing lengthy details concerning their relationships with their existing compensation consultants, in hopes of quashing concerns about possible conflicts of interest that sometimes arise when a consulting firm provides multiple types of consulting services outside the executive pay arena.

These changes are taking place at a time when both presidential candidates, lawmakers, and shareholder activists have been trumpeting the potential of very real conflicts to arise if an executive compensation consultant’s firm performs non-related work for the same client.

Congressional Interest

Indeed, the Congressional Committee on Oversight and Government Reform, under the leadership of Rep. Henry Waxman (D-Calif.), released a highly critical report at the end of 2007, revealing that 113 of Fortune 250 companies retained “conflicted consultants”—consultants that received, for example, $200,000 to provide advice on executive pay, and yet more than $2 million to provide consulting services in other areas. In the Committee’s well publicized hearings last December, Rep. Waxman declared, “In effect, the consultants are being asked to evaluate the worth of the executives who hire them, and then pay their consulting firms millions of dollars”. The system is intrinsically flawed.

The Committee found that:

– Human resources consulting firm conflicts of interest are pervasive;

– The fees earned by human resources consulting firms for providing services other than executive compensation consulting services (e.g., benefits, pension actuarial, healthcare, insurance, etc.) often far exceed those earned for advising on executive compensation;

– Some human resources consulting firms received over $11 million dollars in 2006 to provide services other than executive compensation consulting – in some cases, 50 to 70 times more than the client company paid the human resources consulting firm for executive pay consulting; and

– Most of the companies scrutinized by the Committee did not disclose their human resources consulting firm’s conflicts of interest.

According to the Committee, there appears to be a direct correlation between the extent of the human resources consulting firm’s conflict of interest and the level of CEO pay within the client company.

It is no wonder many companies are going above and beyond to avoid even the hint of such a conflict. Financial Week reported that corporations such as Safeway and Verizon, for instance, have changed their compensation consultants to independent firms over the past year, pointed out Paul Hodgson, senior research associate at the Corporate Library. “It’s a clear-cut way to send a message that you’re intent on being conflict-free,” Mr. Hodgson said. “It’s an easy solution to something that could be a potentially sticky problem.”

“It’s an emerging trend to use an independent adviser in this role,” said Melissa Plaisance, senior vice president of finance and investor relations at Safeway, which generated more than $42 billion in revenue last year. “We felt it was just an additional step in maintaining a strong governance program.”

The Trend in Practice

Because of this, independent executive compensation consulting firms will continue to be in greater demand for their services. For instance, Pfizer, whose board has used an independent compensation consultant since 2003, goes so far as to name its consultant as a specific adviser in its proxy—while also itemizing each of the 14 responsibilities he is charged with in his role, as well as the specific projects he worked on for the company last year.

Pfizer also volunteered to disclose the fees paid to their executive pay consultant for these services. In 2007, the pharmaceutical company paid $150,901 for consulting with its board on executive compensation issues, plus a fee of less than $5,000 for an executive compensation survey.

Pfizer is hardly alone in deciding to disclose information about fees paid to executive compensation consultants. While only a small portion of companies actually offer this level of disclosure— only about 3% of companies revealed these fees in their proxies earlier this year—that’s triple the percentage of companies that did so in their 2007 proxy filings, according to the Equilar proxy analysis. (The average fee for these services was $161,691 last year, a 33% increase from the average fee of $121,183 one year prior.)

Such disclosures appear to be even more detailed if a human resources consulting firm also provides other advisory services to a company. Consider Time Warner, which in its proxy filing earlier this year offered a seven-paragraph, 700-plus word description of the role of its compensation consultant, Towers Perrin, which it attempted to characterize as “independent”. The company notes that its compensation committee has used the firm as its independent executive compensation consultant since 2002, outlines the work it did for the committee in 2007, and also reveals the fees Time Warner paid for Towers Perrin executive compensation consulting services: $250,368 in 2007 and $263,885 in 2006.

However, in the same section of the proxy, Time Warner notes that Towers Perrin also provides the company with consulting and actuarial services for its retirement plans, as well as consulting on its health and welfare programs for employees, and consulting on human resources systems. For these services, Time Warner disclosed that it paid Towers Perrin roughly $2 million in aggregate fees for each of the last two years. None of these fees, however, impact the compensation advice Towers Perrin provides to Time Warner, it states in the proxy, adding that the team of compensation consultants do not work on any other consulting assignments for the company, and, they attempt to explain, that their own pay has nothing to do with any of these other arrangements.

Our Views

Compensation Design Group has always supported the Committee’s conflict of interest views on human resources consulting firms that really do have entangled business relationships.

We also believe that public company shareholders and board members deserve higher standards of disclosure to verify the independence of the executive compensation advice that their companies receive from their consulting firms. This disclosure will assist in curing the terribly negative views that shareholders, employees, the media, and the American public have on executive pay.

The Securities and Exchange Commission will likely require further disclosure on compensation consultant independence. Current SEC rules do not require tabular disclosure of fees for services provided by human resources consulting firms. This only fuels the flames of public perception as well that the executive compensation consulting profession is not helping with, and perhaps even exacerbating problems with executive pay.

Diversified human resources consulting firms, often owned by insurance providers or public companies themselves, in fact have significant economic incentives to provide ancillary services, frequently far more financially lucrative than the executive compensation consulting services they provide. The executive compensation consultants of these firms do, however, have the ear of the board and senior management. That coupled with cross selling of ancillary services, along with the realization of significant fees, creates a recipe for the disaster of independence and objectivity.