The Comp Committee Takes Its Turn on the Barbie
from September/October 2008
by Steven Flax
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When you interview directors who are members of compensation committees—while the company’s communications honcho is present, that is—they’ll tell you that they’re carrying on conscientiously, doing their due diligence, and loving the challenge. But an anecdote recounted recently by Paul Hodgson, senior research associate at the Corporate Library, a shareholder watchdog and research firm, suggests that the reality is a little harsher.
While attending a compensation seminar in Boston, Hodgson had tea between sessions with a director and fellow participant. The setting, a former private gentlemen’s club with heavy drapes and large leather armchairs suitable for the backsides of those endowed with corporate clout, gave the impression that the people inside were shielded from the tumult and insistent imperatives of the business world outside.
The director knew better. He had no intention of ever handing a CEO a blank check, but now his position had become onerous in ways he hadn’t expected, he told Hodgson. He complained about how time-consuming it was to oversee the production of the far more detailed compensation disclosures mandated by the 400-plus pages of new Securities and Exchange Commission regulations. He found particularly irritating the way the committee’s lawyers were trying to take control of the “compensation discussion and analysis” section that the SEC requires in the company’s proxy. The director wanted the wording to be in lay English and shareholder-friendly. The lawyers wanted it to be legalistic. The director saw all too clearly that where regulatory compliance was concerned, his stylistic preferences counted for almost nothing.
Like it or not, he and many other compensation committee members at lots of companies have had to leave the shelter of their clubby enclaves. The pressures on them now, says Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, are “much more serious and severe.” They must deal with the glare of public scrutiny and the demanding expectations of shareholders and activists. For compensation committee members at some public companies, shareholders have lately taken on the aspect of an antagonistic and suddenly aggressive ex-spouse—one bringing congressmen, regulators, and the media to the fray.
General managers of big-league sports teams are used to being second-guessed by fans about how much they spend for free agents. And they’re spending the team’s own money. Compensation committee members are spending the shareholders’ money. That inflates the investors’ expectations and their sense of entitlement, and also ratchets up the directors’ awareness of their accountability. They have become more sensitive than ever about what will eventually have to be disclosed. “I don’t see the risk diminishing unless the level of scrutiny diminishes,” Paul Hodgson says, “and I don’t see that happening anytime soon.”
In boardrooms across the country, comfy pedestals are being pulled out from under those who have perched upon them. It’s been just a few years since the egregiously excessive pay or severance packages awarded to CEOs at Home Depot and Walt Disney Co., among others, provoked shareholder outrage and widespread public disgust. That thrust compensation committee members into the spotlight, and there they’ve stayed.
“There has been an outcry, and it has been recognized by directors,” says Raymond Troubh, 82, a former investment banker at Lazard Freres, a former governor of the American Stock Exchange, the National Association of Corporate Directors’ 2003 Director of the Year, and a member of four boards, including Triarc, a holding company with interests in restaurants and other businesses. Troubh has had a number of conversations with directors about the insecurities they’re feeling. “You have a general undercurrent of dissatisfaction going on,” he says. “The plates under the earth are moving. There hasn’t been an earthquake yet, but you can hear the rumblings.”
As a result, the worklife of compensation committee members has changed dramatically. The time many invest in developing pay packages and the like now averages some 250 hours a year, double what it was a decade ago. Comp committees have become far more deliberate in their decision-making. Some are hiring their own lawyers and, significantly, their own compensation consultants rather than relying on those who work for the company, which has been the norm. And they’re grilling these experts harder about the recommendations they receive. They’re also keeping a tighter grip on packages for new CEOs—something that translates to a greater willingness to hire from within, a well-known cost-saver.
Compensation committee members are now more keenly aware that at any moment they could be in the gunsights not only of some shareholder, judge, or self-appointed watchdog, but also of their fellow directors. According to David Swinford, CEO of Pearl Meyer & Partners, a New York City-based compensation consulting firm that helps comp committees put pay proposals together, boards are demanding more of these committees. “Increasingly they’re insisting that comp committees justify their pay recommendations,” he says. Time was when the meetings at which the chairman of the committee presented his or her report on pay proposals tended to be pretty perfunctory. There might be a question or two, but the recommendation was generally accepted without rigorous or extensive scrutiny. Now those executive sessions are more exacting. Boards are putting pressure on the committee members to explain how and why they’ve come up with certain compensation proposals— proposals that could become the subject of external debate or perhaps litigation. “We have to convince them of our recommendations,” says Swinford, “and they have to be able to convince
the board.”
Like making sausage, the process can at times be unappetizing to witness or participate in. “After the passage of the Sarbanes-Oxley law, it was the audit committee you didn’t want to be on,” says Roger Kenny, president of Boardroom Consultants in New York City, a firm that recruits directors and does board assessments. “Now it’s the compensation committee.”
Adding to the challenge facing board recruiters, shareholder activist outfits such as ISS Governance Services, a unit of RiskMetrics Group in New York City, have pushed the principle that no full-time senior executive should sit on more than two boards. That has forced some capable directors off compensation committees. Among them: Mackey McDonald, 61. Last year he served as CEO and later also chairman of VF Corp., an apparel company (Nautica, North Face, and Wrangler, among other brands), and sat on the boards of Hershey, Wachovia, and Tyco International, where he chaired the compensation committee. Even though he was to step down as VF Corp.’s CEO in January 2008, the proxy advisory firm Institutional Shareholder Services challenged his reelection to the Tyco board, and he opted not to run again. As Dennis Carey, a senior partner in the Scottsdale, Arizona, office of recruitment firm Korn/Ferry International, puts it, “He was boarded up.”
Carey suggests that limiting the number of boards an executive can serve on should be done on a case-by-case basis. “I appreciate and understand the basic rationale,” he says. “Some of the shareholder activists, such as Calpers, have been very responsible, very reasonable. But others have drawn a line in the sand a little too rigidly. This too-rigid insistence on the rule is squeezing an already dwindling supply of terrific people.”
It may be, however, that demands on directors’ time are a bigger deterrent to committee service than outside pressures. Michael S. Melbinger, a partner in the Chicago office of the law firm Winston & Strawn who specializes in executive compensation, says meetings of compensation committees have become more numerous and more formal. There used to be perhaps two a year; now there are four or five a year, and sometimes one a month. “Before, we were advising compensation committees on fiduciary duties generally and facilitating the process,” he says. “Now every meeting has an agenda and scrupulously kept minutes.” In addition, committee members have to go through all manner of briefing material before each meeting—sometimes a single 10-page report, sometimes three inches of paperwork. Often, says Melbinger, there are multiple documents, PowerPoint presentations, and legal papers for review. It all takes a lot of time and effort. Just as the rules governing compensation committees are changing, so too are the demographics of many of these committees (and indeed of boards themselves, as the preceding cover story makes clear). Sarbanes-Oxley dictated that audit committees include sophisticated financial experts; similarly, the changing expertise required of comp committee members has encouraged the recruitment of people with a background in human resources. “HR executives have experience with compensation systems, succession planning, and performance metrics,” says Korn/Ferry’s Dennis Carey. His recruits include Dan Phelan, 58, senior vice president of HR at GlaxoSmithKline, who serves on the compensation committee at Tyco Electronics, a spin-off from Tyco International with 2007 sales of $13.5 billion, and Laurie Siegel, 52, Tyco International’s head of HR, who joined the compensation committee at Embarq, a $6.4 billion spin-off from Sprint Nextel.
Yet even experienced HR executives like Siegel say that compensation committee members must become much better informed and more sophisticated in making compensation assessments and managing the consultants who advise them. “The requirement for technical understanding and expertise has gone up,” she says. “We review a lot more performance data. Developing compensation packages sounds much simpler than it is. It’s not just a matter of correlating two factors; it’s a more complex exercise.”
Companies now may have three different forms of long-term incentives, typically options, restricted shares, and performance shares. Options are increasingly used, in combination with performance plans and restricted stock, to align top executives’ performance with shareholders’ interests, says Siegel. Compensation committees are more commonly using restricted stock to promote the retention of top executives, and they’re having to decide whether to make new performance plans absolute or relative. “We don’t want to give executives a free ride because the stock market is booming,” Siegel says, “but we don’t want to penalize them excessively if we’re in a down market.” Because of these considerations, structuring the mix of incentives takes finesse.
The general view that CEOs are way overpaid is a huge issue for compensation committee members. “They feel more exposed, in public opinion as well as a court of law,” says attorney Stephen Fackler, a co-chair of the executive-compensation group in the Palo Alto, California, office of Gibson Dunn & Crutcher. “So there’s far greater sensitivity to what will eventually be disclosed.” Committee members depend on consultants to ensure that they stay up-to-date with what their peers are doing at other companies and to help them design pay packages. They’re also second-guessing more, aware that the paydays they put together may be challenged and that they themselves may be vulnerable to shareholder backlash. “We get caught up with the big outliers,” says Dennis Carey, “companies that have overshot the runway with their egregious compensation packages.”
Comp committees are wary of the chance that CEOs and other top executives might exploit various perks. According to Fackler, there are now more restrictions on the personal use of corporate aircraft, for example. “Perk packages are sometimes changed to eliminate disclosure in the proxy,” he says. Directors are also paying more attention to the severance benefits they hand out, as well as supplemental retirement benefits.
Another area of sensitivity is granting what are called golden-parachute excise-tax gross-ups. At its simplest, this comes into play when a CEO, say, collects a big payout triggered by a merger that costs him his job, and receives reimbursement for the taxes he pays on the part of the golden parachute that’s “excessive.” (According to the tax code, excessive severance is defined as equal to three or more times the average annual compensation the executive received over his or her last five years of employment.) While not all compensation committees have done away with such make-whole payments, their use is often being constrained or eliminated.
Because of the vulnerability they’re feeling, comp committee members have overreacted at times. For instance, Roger Kenny, president of recruiter Boardroom Consultants in New York City, cites the chairman of one compensation committee who wanted to scrutinize the pay packages of the top 150 executives at the company. The rest of the board rebelled. “It was too much into the weeds,” says Kenny. The committee chairman agreed not to stand for reelection.
The spotlight on the amounts compensation committee members must pay to attract talented outsiders is making them more inclined lately to hire from within. They don’t want to be criticized for not doing two key jobs: grooming an internal successor to the CEO and, more broadly, ensuring that the company has developed bench strength. “They’re becoming more willing to say, ‘Let’s go with an insider rather than pay the buyout package of Mr. Wonderful,’” Kenny says.
Another sign that compensation committees’ work has gotten more complex and vulnerable is the creation of a niche publishing industry to serve them. One example is Melbinger’s Compensation Blog at compensationstandards.com, put out (usually) twice a week since 2005 by Chicago attorney Mike Melbinger. He discusses executive-compensation trends, the IRS code, and seminal legal cases. Another blogger, Mark Borges, who’s a principal at Compensia, an executive-comp management consulting company in San Francisco’s Bay Area, is even more specialized. His Borges Compensation Disclosure Blog, which can be accessed through the same site, is devoted to advising directors and managers on how to handle the more extensive disclosures required by the 2006 SEC proxy-disclosure regulations.
Melbinger has seen firsthand how beleaguered some comp committee members are. “These guys are on the firing line,” he says. “The public’s resentment never trickled down to the compensation committee before. Now compensation committee members’ names are published in the newspapers, and they’re criticized in Congress. I bet half the financial world knows who served on the compensation committee of the New York Stock Exchange [when it authorized the notorious $185 million pay package for then-chairman Richard Grasso, who became a symbol of Wall Street greed].” Melbinger, whose site gets 3,000 hits per month, notes the increased pressure on compensation committee members to possess more arcane expertise. Section 162(m) of the tax code, for example, allows companies to deduct no more than $1 million of compensation for each of their five highest-paid executives. “In the past, many comp guys wouldn’t have known about this section,” he says. “Even some prominent lawyers wouldn’t have known about it. But these comp guys know about it now.” They’d better.
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