Remuneration consultants brought in to advise on executive pay need to be kept under tight control by corporate compensation committees to ensure that they remain independent of management and give objective, neutral advice.
The controversial role of remuneration consultants in the U.S. has come under the microscope in a soon-to-be-released report by The Conference Board which argues that, at a minimum, the compensation committee must control all aspects of the committee-consultant relationship, including the scope of work, oversight and monitoring, and, if necessary, the dismissal of the consultants.
The report, " Dealing in Good Faith: The Evolving Role of the Compensation Committee and its Relations with Consultants", focuses on the vexed question of whether remuneration consultants acting for a company's compensation committee should also perform services for its management.
Remuneration consultants have come under fire on both sides of the Atlantic, particularly from institutional investors, for selling their services to chief executives based on their ability to push up pay.
But according to the report's authors, Dr Carolyn Kay Brancato and Alan A. Rudnick, compensation committees – not executives – should retain and control the terms of the relationship with any outside consultants whom they hire.
"There is, however, much discussion about whether consultants who provide advice to the compensation committee can also provide advice and sometimes other services directly to management," Carolyn Kay Brancato added.
On the one hand, she said, separate advisors for boards and management better ensures that consultants are independent of management and therefore can provide objective advice.
On the other hand, while companies want to avoid "dueling consultants," eliminate duplicative and wasteful work, and achieve continuity in approach, they also need to ensuring that boards fulfil their fiduciary duties to act independently and in good faith when making their decisions.
Only under certain very limited and specifically prescribed circumstances, the report argues, should a consultant do other work for the company. However this must be overseen and monitored by the committee.
But despite claims by consultants that many U.S. corporations have taken such recommendations on board, median total compensation for the CEOs of S&P 500 companies still grew by 30 per cent in 2004 to $6m, double the 15 per cent rise in 2003.
A key message of the Conference Board's report is that consultant's role and scope should also be clearly articulated and monitored by the compensation committee with the same oversight processes that the board and its committees employ in other areas.
In other words, the report says, "each compensation committee should, based on the application of governance principles to its needs, determine the practice best suited to the requirements of its company and board, based in good faith on all information reasonably available to it and decided solely in the company's best interests."
The report describes several scenarios faced by compensation committees and discusses what committees need to do to ensure that they have met their fiduciary duties when choosing a consultant:
In setting top executive compensation, if the committee chooses a compensation consultant who has not worked with management and will work only for the committee, this is the ideal situation and presents the least problem for directors.
If the committee chooses the consultant, but management wants to have the consultant perform additional services, this can be done under certain very limited circumstances if the committee assures itself that the consultant's work for management will not impair its independent judgment in doing its work for the committee.
The most problematic scenario is when the committee chooses the company's historic consultant who performs work both for the committee and management, making it difficult for the committee to assure itself that the comp consultant is not more loyal to management than to the committee.
Among the report's key recommendations are that the compensation committee should be composed entirely of independent directors; it should have primary responsibility for ensuring that the company's executive compensation programs are fair and appropriate to attract, retain and motivate management while ensuring that compensation is reasonable in view of company economics and the relevant practices of comparable companies. It should also have full control over retaining and overseeing the scope of work of any compensation consultants hired to advise it.
"The guiding fiduciary principles that directors must follow are the ones they must employ for all their actions," Carolyn Kay Brancato said.
"Directors must act consistent with their duties of care, loyalty, and good faith. Subjecting complex choices which must be made by compensation committees to these standards will serve directors, management, and shareholders well."