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Introspection, Overdue in the Compensation Committee
by Joseph Semo, Esq.

About a year ago, Spring 2007, I noted that members of the Board of Directors' Compensation Committee would need to evaluate their independence and the independence of the advisors on whom they rely.1 I cautioned: "[The effort to assure independence of its advisors] will require many Committees to reach out to additional advisors to add assurance that a prudent process is being followed. To find advisors of sufficient independence, the Compensation Committee will have to look beyond the large multi-state law firms traditionally used and find advisors prepared to forego the representation of the corporation generally." Directors with whom I have spoken since publishing that article have uniformly agreed that the process of the Compensation Committee would benefit by engaging independent consultants and by introducing an independent attorney to the process, recognizing that an attorney by nature would aid questioning of the consultant's guidance and would add a filter that would improve the decision making process. These same directors, however, all noted that the use of counsel as a regular resource for the Compensation Committee was not common practice and that their committee was not a pioneer. It is time to re-think the conduct of business at the Compensation Committee. It is time to embrace change before becoming tomorrow's featured story in your newspaper's business section.

For those who might be quick to dismiss my suggestion, consider the following realities of 2008:

At the end of January 2008, Congressman Henry A. Waxman, Chairman of the Oversight and Government Reform Committee of the House of Representatives, sent inquiries to the Compensation Committee chairs of each of the Fortune 250 companies to provide information about their executive compensation consultants and how they are utilized in setting executive pay.2

During December 2007, the Majority Staff of the House Oversight Committee released its study of conflicts of interest among compensation consultants.3 As a result, this year began with the need for the Compensation Committee to consider these astounding findings:

Compensation consultant conflicts of interest are pervasive. In 2006, at least 113 of the Fortune 250 companies received executive pay advice from consultants that were providing other services to the company.

The fees earned by compensation consultants for providing other services often far exceed those earned for advising on executive compensation. In 2006, the consultants providing both executive compensation advice and other services to Fortune 250 companies were paid almost 11 times more for providing other services than they were paid for providing executive compensation advice. On average, the companies paid these consultants over $2.3 million for other services and less than $220,000 for executive compensation advice.

Some compensation consultants received over $10 million in 2006 to provide other services. One Fortune 250 company paid a compensation consultant over $11 million for other services in 2006, over 70 times more than the company paid the consultant for executive compensation services. Another Fortune 250 company also paid a compensation consultant over $11 million for other services, over 50 times more than it paid the consultant for executive compensation advice.

Many Fortune 250 companies do not disclose their compensation consultants' conflicts of interest. In 2006, over two-thirds of the Fortune 250 companies that hired compensation consultants with conflicts of interest did not disclose the conflicts in their SEC filings. In 30 instances, the companies informed shareholders that the compensation consultants were "independent" when in fact they were being paid to provide other services to the company.

There appears to be a correlation between the extent of a consultant's conflict of interest and the level of CEO pay.
In 2006, the median CEO salary of the Fortune 250 companies that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use conflicted consultants. Over the period between 2002 and 2006, the Fortune 250 companies that hired compensation consultants with the largest conflicts increased CEO pay over twice as fast as the companies that did not use conflicted consultants.

The investigation also uncovered evidence that some Fortune 250 companies may not be disclosing the identity of all consultants hired to provide executive compensation advice. Securities and Exchange Commission rules require publicly traded companies to disclose "any role of compensation consultants" in determining executive pay and to identify all such consultants, whether they advise management or the board. The information obtained by the Committee from the compensation consultants indicates that in 2006, almost 100 Fortune 250 companies used executive compensation consultants that they did not disclose. In some cases, the companies paid hundreds of thousands of dollars to undisclosed consultants for executive compensation services. One explanation for these discrepancies may be that the compensation consultants used a different definition of executive compensation services in reporting to the Committee than the companies used in their SEC filings.

(Emphasis supplied).

How does your Compensation Committee explain its chain to past practice in light of the scrutiny these findings bring to each Compensation Committee? How does your Compensation Committee explain its failure to engage truly independent advisors to guide the procedural prudence of the process they follow and a continuing failure to document the careful discharge of their obligations? While the focus may be on the Fortune 250, these concerns trickle down (perhaps, pour down) to all companies (indeed, both for profit and not-for-profit) as best practices in corporate governance is demanded by corporate stakeholders. I respectfully suggest that it is time to take action.

1. Transition to Independent Consultants; Form an Advisory Team

The letter from Congressman Waxman being read by the chairs of the Compensation Committees of the Fortune 250 basically is asking two questions: (1) are you being advised by independent consultants with respect to executive compensation matters, and (2) are you accurately disclosing the nature of those advising the Compensation Committee to shareholders? Responding to these questions is going to be embarrassing to those serving on the board's Compensation Committee, who on the whole are experienced businessmen and, having to confront the reality that they are taking guidance from advisors who operate under substantial conflicts of interest, will wince at this scrutiny. Even in those cases (likely to be most cases) where the director and the consultant believe that each has acted in good faith to their obligations, both will recognize that perception has overtaken this conversation.

The issue for directors serving on the Compensation Committee is to develop a plan to transition to independent advisers. This may mean a period of utilizing multiple consultants to assure transition of institutional knowledge and history.

In addition to changing players, the directors should consider whether their Compensation Committee is structured to reach best decisions. A prudent team approach would include utilizing attorneys and accountants in the deliberation of compensation matters.

Independent counsel will improve decision making. By training, counsel will question presentations of other professionals bringing to the fore information for the directors to consider in addition to, not in place of, the probing questions of directors. Moreover, among the professionals the Compensation Committee will use, only counsel are subject to strict Codes of Professional Conduct requiring faithful service to their client.

Together, a team of advisors consisting of an attorney, an accountant, and a compensation consultant will work best to assure that the Compensation Committee understands the ramifications of its actions, as any change of one element of compensation will likely affect other compensation programs including the qualified and non-qualified arrangements.4

2. Ask Advisors to Disclose All Services Performed For the Company

Directors must insist on accountability of advisors. The directors must ask advisors to disclose all other services performed for the company, its affiliates, its partners, and other organizations that the board deems to be related to management. This would include disclosures of cross-referral patterns. For example, if the directors request a referral to an "independent" advisor from a conflicted source (such as the corporation's outside counsel), the director's should understand the extent to which the two firms refer matters between them. Failure of an advisor to provide such disclosure must be a ground for immediately discharge.

3. Organize the Committee's Work to Assure Procedural Prudence

The directors must create a system that assures the prudent consideration of its areas of responsibility. At a minimum this requires attention to the process of considering matters: (1) are materials provided in writing; (2) are materials circulated sufficiently in advance for committee members to study the issues, frame questions, and allow time for responses to questions to be prepared; and (3) are minutes prepared and circulated promptly following the meeting while memories of discussions remain fresh.

4. Stay Focused On Major Responsibilities

While consideration of good governance practices is being driven by the public scrutiny being given to the work of the Compensation Committee and the disclosure of the cost of traditional ways of doing business, the committee must stay focused on the key role it plays in doing the work of the Board. The Committee must be always mindful of succession issues and have contingency plans available for promoting and recruiting talented managers when they are needed. A manager may be lost in literally a heartbeat. While a Compensation Committee may not be expected to have an offer letter for a successor in its work file, it must be constantly vigilant of the need to act quickly should a key manager be unable to continue service.

5. Focus on Continuing Education

A significant reason for a Compensation Committee to engage a mix of independent consultants is to assure continuing learning of the legal and regulatory environment in which they must confront business decisions. The Committee should require each professional to keep it abreast of developments in each of their respective disciplines. This process serves two purposes: the Board is kept abreast of developments and to the extent that the advisers fail to bring developments to their attention, the Committee will be able to consider whether the adviser is serving the purpose for which engaged.

6. Be Always Accountable

If the work of the Committee is organized for procedural prudence, the Compensation Committee will not panic should stakeholders request an accounting for the Committee's work. Better decisions will follow from a well organized Committee. By insisting that advisors report directly to the Committee, the Committee will avoid being unable to explain what has occurred on its watch.


Stakeholder oversight of the work of the Compensation Committee is, and is likely to remain, an ongoing reality. Members of the Compensation Committee should listen and consider the adequacy of its current practices and seize the opportunity to adopt better practices. It is time to take ownership of the Committee's work and to assure the Committee has its resources in place to discharge its responsibilities.


Notes
1 "New Requirements Now Effective for the Board Compensation Committee," Corporate Board Member Magazine Web Site, April 10, 2007.
2 Press Release, Committee On Oversight and Government Reform, Congress of the United States, Oversight Committee Requests Executive Compensation Information From Fortune 250 Companies (January 31, 2008).
3 Majority Staff of the House of Representatives Committee on Oversight and Government Reform, Report on Executive Pay: Conflicts of Interest Among Compensation Consultants (December 2007).
4 Accountants also are positioned to make valuable contributions by projecting how compensation decisions should affect the corporation's financial statements. However, the use of an accountant from the Company's internal audit staff is likely to make sense as familiarity with the company's practices and the independence of the other advisers should adequately aid the Committee in its work.


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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