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Independent Adviser: Lose the Illusion
by Joseph Semo, Esq.

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Directors who believe that lip service of the directors' concern for independence from management will placate shareholders will be in for a serious surprise. In recent weeks, board members who serve on compensation committees have been struggling with their duty to review management's compensation discussion and analysis and to provide their assessment to the full board and shareholders. In our post Sarbanes-Oxley world, these directors are beginning to recognize the need for incorporating best practices into their committee work.

One hallmark of best practice for a compensation committee is assuring the independence of directors serving this important function. Moreover, these directors can only safeguard their independence by using independent advisers. While this value proposition is easily stated, some board committees are struggling with breaking ties to firms that otherwise advise the corporation's management. By failing to embrace independent advisers, these committees are simply adding fuel to the suspicion of shareholders that these directors do not have their best interests at heart.

Background
Shareholder and public interest on matters related to executive compensation is at an all-time high. As an example, five out of 15 shareholder resolutions advanced for consideration at the 2007 annual meeting of shareholders of Exxon Mobil relate to executive compensation. As annual reports are released, each disclosure of senior management's compensation and the value of their severance and retirement packages bring increased criticism of the past work of compensation committees. When directors fail to aggressively analyze the compensation package of senior management, they face the ire of shareholders and stakeholders, who may challenge their re-election to the board.

Report Card Risk
Members of a board of directors, generally, and of compensation committees of boards, specifically, are under the microscope of corporate governance monitors. Shareholders readily are armed with the evaluations being published by these organizations to challenge the actions of directors. For example, consider these reports offered in March and April of this year by The Corporate Library:

  1. Analyst Alert: 2007 Proxy Season Insights #3: Did the CEO Receive a Bonus Last Year?;
  2. Research Report: The Corporate Library's Preliminary CEO Pay Survey;
  3. Analyst Alert: 2007 Proxy Season Insights #2: A Little Nest Egg For Your Retirement, and
  4. Analyst Alert: 2007 Proxy Season Insights #1: Executive Perks: Have Shareholders Been Paying All Along And Just Didn't Know About It?

Based upon the research on actions taken by particular directors, shareholders are focusing their discontent. They are monitoring and criticizing any track record of permitting over-compensation of senior executives.

The Verizon Contest
The record of director votes on executive compensation also is being used as fodder for stakeholders to attack the re-election of directors. The Wall Street Journal recently reported on the effort of labor to challenge the re-election of directors who provided for the reward of executives at Verizon even as the company was seeking wage concessions from rank-and-file workers. The record of director candidates for not challenging management compensation of directors has simply provided another ground to challenge the company's effort to control wage expenses, generally.

The Verizon contest also focused upon the issue of shareholder advisory votes on executive compensation. These resolutions cannot be dismissed as they are obtaining support from state and union pension funds, as well as mainstream investment firms. The final tally of the shareholders' vote on this issue at Verizon counted a slight majority (50.18%) of votes in favor of having the company seek such a shareholder advisory vote. This successful shareholder resolution was preceded by similar action at Blockbuster Inc. Significant support for such action also was reported for votes cast at Merck & Co. (49.2%) and at AT&T Inc. (43.8%).

These shareholder actions bring home a strong message: unless the compensation committee documents good reason for its action, it will face public criticism from shareholders who are organized to impose accountability. Moreover, those serving on the compensation committee now have the additional burden of dealing with the politics of this situation. The Wall Street Journal reported that a representative of the American Federation of State, County and Municipal Employees (who influence the vote of roughly 4% of the company's stock through the various pension funds representing their members) has already warned that the members of the compensation committee will be held directly accountable if they do not implement an advisory vote. In this environment, the compensation committee must focus on its internal operations to withstand the public challenges that will come.

Time Warner
Corporations appear to understand the indicia of independence required for a board member to be identified as independent. The annual reports recently published suggest that most have made the required inquiry of the relationships between directors and their families with the corporation and third parties that deal with the corporation. Many compensation committees also appear to understand that independent directors can only maintain the mantra of independence by relying upon independent advisers - advisers who do not otherwise work for the corporation. But some corporations do not get the message.

Time Warner Inc. recently released its annual report and informed shareholders that its compensation committee has engaged a well-regarded consultant as its independent adviser. The report explained that its compensation committee hired the individual and not the firm in which he is a principal and through this engagement assured independence of the committee's adviser. It is respectfully suggested that the committee is myopic and that the corporation, which already has been evaluated as having poor governance practices, will continue to earn its low rating.

Time Warner's annual report explained that the compensation committee has hired the adviser: (1) to provide competitive market compensation data for executive positions; (2) to conduct analyses related to proposed executive contracts, and (3) to review equity compensation. According to the report, this adviser received compensation of roughly $260,000 in the most recent year and $150,000 in the previous year. So far, there is nothing surprising in this part of the report.

But how does the compensation committee conclude that it secured independent advice when:

  1. The adviser is a member of the firm that provides the company with consulting services regarding human resources;
  2. The adviser is managing principal of the consulting firm that provides consulting services to the company;
  3. The aggregate fees of the consulting firm (of which the adviser is managing principal) for the two prior years were $2 million and $3 million (more than ten times the amount of fees paid by the committee).

The corporation asserts that it has obtained an independent adviser because:

  1. The committee had hired the adviser and not the consulting firm;
  2. The adviser reports directly to the committee;
  3. The adviser meets with the committee outside of the presence of management;
  4. The adviser does not meet with management outside meetings with committee members;
  5. Other members of the consulting firm that work with the advisers do not work with other members of the consulting firm that service the corporation, and
  6. The adviser is not the client relationship manager for the consulting firm of the corporation's account.

An ethics degree is not required to understand that an adviser whose firm is receiving millions of dollars for corporate work is going to have a very difficult time - in the real world - of going against senior management's compensation. One can readily suspect that the shareholder community will not be impressed with the compensation committee's claim of reliance upon "independent" advice in these circumstances. One can guess how an "advisory" vote would turn out. It is no surprise that this company faces - and most likely will continue to face - shareholder resolutions to give the shareholders greater opportunity to voice their (dis)approval of compensation practices and opposition to directors who fail to be diligent.

Finding Best Practices
The Wall Street Journal, May 14, 2007, reported on the efforts of boards to avoid conflicts of interest and quoted a researcher stating the obvious, "[T]here are enough compensation consultants to go around that there doesn't need to be even the hint of a conflict of interest." Now is the time for compensation committees to restructure themselves to adopt prudent processes for discharging their duties to oversee executive compensation. Best practices will begin with recruiting independent consultants and independent counsel to structure prudent process and record diligent evaluation of the compensation questions which the committee must address, understanding that the committee's work will now be more public.

Congressional Interest
On May 8, 2007, U.S. Rep. Henry A. Waxman (D-Ca.), Chair of the Committee on Oversight and Government Reform, addressed letters to several of the nation's largest consulting firms seeking the following information:

For each of the largest 250 companies measured by revenue please provide the following information for the time period from Jan. 1, 2002, through Dec. 31, 2006:

  1. Identify each company for which your firm provided both executive
    compensation consulting services as well as other types of services [including companies even if such services were not provided for the same year];
  2. For each company identified in response to request no. 1,
    a. Describe the nature of the executive compensation consulting services provided by your company;
    b. Provide the total revenues received annually for providing executive compensation consulting services;
    c. Describe the nature of all other services (other than executive compensation consulting services) provided by your company, and
    d. Provide the total revenues received annually for providing these other services.

Chairman Waxman requested replies by May 29, 2007. All firms except one - the firm used by Time Warner - responded. The Oversight Committee, on or about June 29, 2007, after failed attempts to obtain a response issued a subpoena from the lone hold-out. It will be no surprise to see conduct like that shown by Time Warner's consultant to be pictured on the bulls-eye of Congressional criticism.

Conclusion
Time Warner's annual report and its explanation of what constitutes an "independent advisor" stands as a classic example of delusional interpretation. What can explain the failure of Time Warner's board to recognize what jumps out of its own report? Does its compensation committee really need to have its judgment singled out in Congressional hearings for question? Does a corporation really need to spend its assets responding to these criticisms?

There is no lack of capable advisers to choose from. Does Time Warner and its directors who approved this annual report seriously expect the reader to believe that if presented with the opportunity of choosing between the representation of the compensation committee or his firm (of which he is managing principal) continuing to provide services to the corporation, that the adviser would choose the assignment paying less than ten percent of the consulting services provided by his firm? Unless one answers this question yes, most observers have recognized that notwithstanding the most frequent review of the consultants assignments for the corporation, the Time Warner compensation committee will never convince the public that it is obtaining independent advice.

Board members who serve on compensation committees should reflect carefully on the scrutiny given to their work. It may not be business as usual to engage independent advisors. Nonetheless, directors will have an easier time developing working relationships with independent advisers than being held as examples of poor judgment by corporate governance monitors and the fodder of congressional inquiries.

Notes
1The five resolutions proposed: (1) that there be a shareholder advisory vote on executive compensation; (2) that any decision with respect to the compensation of the president or chief executive officer of the company be approved by at least two-thirds of the independent directors; (3) that the board review executive compensation and report on how the compensation package of the CEO compares to that of the lowest paid U.S. workers, analyze the pay gap between the executives and low paid workers in the U.S., report on whether top executive compensation is excessive, and whether sizable layoffs should result in an adjustment of executive pay; (4) that a $500,000 limit on executive compensation for the top five persons named in Management be imposed; and (5) that a by-law provision be adopted to facilitate the recovery of incentive compensation later determined to have not been properly earned (such as a result of restatement of earnings).


Joseph Semo, Esq.
Mr. Semo provides comprehensive guidance on compensation arrangements in addition to a general business practice. Representative engagements include:

EXECUTIVE COMPENSATION
Counseling on executive compensation arrangements.

Evaluation of deferred compensation arrangements under Internal Revenue Code §409A.

EMPLOYEE BENEFIT PROGRAMS
Representation of plan sponsors and plan fiduciaries in all aspects of employee benefits including plan design (pension, welfare, and non-qualified compensation plans), compliance issues (tax and labor), multi-employer plan representation, institutional investment issues (e.g. security lending agreements, investment management agreements, and third-party administration contracts), prohibited transaction exemptions, multiple employer welfare plan issues, and provider contracts.

INTERNAL INVESTIGATIONS
Conduct internal investigation of corporate stock transactions to determine whether distributions of stock and other equity interests to employees were executed consistent with terms of agreement with venture capital investors.

Since 1984, Mr. Semo has been a member of the City of Annapolis Police and Fire Retirement Plan Commission and serves as its Chairman. During that time, the investments of the retirement plan moved from guaranteed insurance contracts to a fully diversified investment program.

Mr. Semo received his undergraduate degree from the Wharton School of the University of Pennsylvania and his law degree from George Washington University. He is a member of the bar of the District of Columbia, Maryland, Virginia and Wisconsin. He is admitted to numerous federal district courts, Circuit Courts and the United States Supreme Court. Mr. Semo received an honorable discharge from the U.S. Army Reserve, achieving the rank of Captain, Quartermaster Corps.


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