External Advisors

Under Dodd-Frank and the listing standards for the NYSE and NASDAQ, compensation committees are empowered to hire external advisors to assist them in managing their responsibilities. The legislation requires companies to provide funding for the committee to pay an external advisor if the committee decides to use one. Annually, the committee is required to conduct a review of the candidate’s independence (if they use a consultant).

Why Use a Compensation Consultant?

It is a testament to the complexity surrounding the issue of executive compensation that the overwhelming majority of compensation committees use a consultant. On the surface, the decision on how much to pay a company’s senior executives may seem simple enough. However, there are multiple advantages to including a consultant as part of the process:

• Third-Party Independence: If management is left alone to develop recommended compensation levels and design, their self-interest would encourage them to propose relatively high compensation levels and low performance standards. The use of a third-party advisor helps to ensure that the information used as the basis for establishing recommended pay levels and performance standards does not have a bias in favor of management. Since consultants are engaged by the committee, their incentives tend to be more closely aligned with those of the committee members.
• Experienced Advisory: Experienced consultants have worked with hundreds of clients over their careers and can therefore advise on many situations that might be new to individual compensation committees. A strong consultant will have learned from past experiences and can share that knowledge with committee members to provide assurance when making decisions.
• Competitive Information: Through past client exposure and firm resources, consultants can provide detailed information on competitive practices to the committee. While competitive data should not be the primary basis for committee decision-making, it is a valuable input and can provide comfort to committee members that the designs they are implementing do not deviate from common market approaches. In the words of Jill Kanin-Lovers, the consultant “needs to keep you smart.”
• Technical Expertise: The design of executive compensation programs requires knowledge across multiple disciplines, including tax, accounting, SEC disclosure rules, and insider trading. In addition, it is critical to have an understanding of the financial drivers of business success. While compensation committee members may excel in their understanding of business strategy and financial performance, it is unlikely that they will have adequate technical knowledge to navigate the intricacies of executive compensation design on their own.
• External Cover: The reality of the business world today is that there is no shortage of external scrutiny of corporate decision-making. The recently adopted “Say on Pay” proposals have served as the basis for shareholder lawsuits, and executive compensation has long been a popular topic for the business press. The use of a consultant allows the committee to demonstrate to external critics that they tried to “cover all bases” in developing the compensation program. In the event of a lawsuit, if the committee has used a consultant, they can point to their independent, third-party advice as an input into their decision-making.

Typical Consulting Arrangements

The nature of the arrangement and the level of workload required factor into how much a consultant will be paid. In our experience, an annual consulting engagement with a compensation committee could cost as little as $50,000 if the role of the consultant is geared towards simply reviewing and commenting on data and recommendations developed by management (and/or its consultant) with occasional meeting attendance. In other cases, the consultant reports to the committee but works with management to develop recommendations. In these cases, fees can range from $100,000–$500,000 depending on the complexity of the company’s compensation programs and decision-making processes. Similar to law firms, most consulting firms will charge clients based on the hours required to complete the work according to an hourly billing rate. Consultants will generally provide an estimate of fees for the year associated with anticipated work steps.

Consultant Independence

Over the past 5–10 years, committees have become more concerned about the independence of their consultants. In the past, compensation consultants were often engaged by management and would be brought in to discuss management recommendations with the compensation committee. As external scrutiny of executive compensation increased, there was a push to make sure that the consultant reported directly to the compensation committee — rather than to management — to reduce the risk that the consultant would feel obliged to support management recommendations in order to remain engaged by the company.

Throughout the 1990s and into the 2000s, most executive compensation consulting arrangements were with large, multi-service human resources consulting firms (e.g., Towers Watson, which was created by the merger of Towers Perrin and Watson Wyatt, Hewitt, and Mercer). Over time, shareholder advisory firms, certain institutional investors, and the press raised concerns about potential conflicts of interest for these firms. They posed the question, “Would the compensation consultant with annual fees of $150,000 really be willing to confront management on executive compensation if it put annual pension benefit consulting fees of $3–$5 million at risk?” The presumptive answer was that this was indeed a conflict. As a result, over the past 5–10 years, many large companies have transitioned from using multi-service consulting firms to working with boutique consulting firms that only provide executive compensation consulting advice.

Concerns about consultant independence culminated in the Dodd-Frank legislation, which requires committees to consider the following six independence factors when engaging a consultant:

Criteria	Assessment
Does the consulting firm receive any revenue from XYZ Company for services other than executive compensation consulting?
What is the percent of revenue estimated fees represent as a percent of the consulting firm’s annual revenue?
Does the consultant have any personal relationships with members of the board of directors or executive officers at XYZ Company?
Does the consultant have any business relationships with members of the board of directors or executive officers at XYZ Company?
Does the consultant directly own any shares in XYZ Company?
Does the consulting firm have a written policy for managing conflicts of interests?

The committee is not required to hire an independent consultant. If the committee does determine that a conflict of interest exists for the consultant and still decides to proceed, the company must disclose how the conflict was addressed. However, to avoid the perception of a conflict of interest, it is likely that most compensation committees will avoid working with consultants who give concerning responses to any of the six questions.

Single-Consultant vs. Dual-Consultant Model

Two compensation consulting models have developed that are commonly seen in the market: 1) a single consultant reporting to the committee chair and working for the committee and with management; and 2) two consultants, one directly engaged by the committee and one working directly for management.

Single-Consultant Model: In this structure, a single consulting firm addresses all executive compensation consulting needs. The consultant works with the human resources team, as appropriate, to ensure that the compensation committee chair approves of any services performed.

Dual-Consultant Model: In this structure, there are two consultants. The first, the consultant to the committee, typically holds responsibilities that include attending committee meetings, reviewing proposals prepared by management, benchmarking senior executive compensation, providing an overview of market trends, working with the committee chair to ensure good governance, and considering shareholder optics and best practices. The second, the consultant to management, works closely with the human resources (HR) team and management to design incentive programs, benchmark the executive compensation levels for positions below the most senior executives, assist with executive compensation disclosure, and address the company’s other data needs.

There is significant variation within the market in terms of the division of responsibilities between the two consultants. The table below provides a detailed breakdown of the work steps typically allocated to each consultant.

Consultant to the Committee

Consultant to Management

Advise on compensation philosophy and overall positioning for senior executives Review recommendations on peer groups Prepare proxy data for CEO and possibly for other named executive officers (NEOs) Advise on amount and mix of pay for CEO and prepare alternatives for review by chair and/or committee Review management’s recommendations on compensation for other executives in advance of committee meeting and advise on appropriateness of recommended amount and mix of pay Review management’s recommendations on design of annual and long-term incentive plans Provide an assessment of covered executive pay vs. company performance Review executive pay tally sheets Review proxy statement disclosure (specifically CD&A) on behalf of the committee Advise on market trends related to executive compensation Advise on relationship between executive compensation and risk Review and recommend board of directors’ compensation Attend compensation committee meetings and executive sessions as requested

Propose appropriate compensation philosophy tied to related business and talent objectives Recommend peer groups based on business and talent competitors Prepare proxy and survey data for executives, excluding CEO Support HR in crafting pay recommendations for covered executives and senior management, excluding the CEO Support HR in developing proposals on design of annual and long-term incentive plans Prepare executive pay tally sheets, if requested Advise HR on amount and mix of pay for executives below the covered executive level Research executive compensation issues for HR Support HR/legal as necessary in drafting the proxy statement Advise on non-executive compensation issues Conduct risk review on compensation program

The dual-consultant model is relatively new and has mainly been adopted by the largest companies with the greatest concerns about the perception of conflict of interest. For most companies, it is viewed as duplicative to have two consultants work on the topic of executive compensation.

The table below summarizes key advantages of each model:

Single-Compensation Consultant	Dual-Compensation Consultants
Avoids concerns over “dueling consultants”	Typically management’s consultant has limited interaction with the committee
Easier to manage limited resources because one firm is less expensive than two	Management would normally work with its consultant but actually present the material at committee meetings
Given the rise of boutique firms, avoids the perception of a conflict of interest	In this case, committee’s consultant can develop more into an “auditor” role rather than a partner
One consultant can develop a more holistic view of the company, its strategy, goals, and culture, since it interacts with all parties (the compensation committee, senior management, HR, and other support functions)	Reduces possible perception of a conflict, provided the committee’s consultant does not provide other services to the company

What to Look for in a Consultant

Most consultants that you interview will have adequate experience to provide you with the technical advice that you require and will come from a firm with significant resources to provide required market data. Your final selection will therefore come down to your views of how the consultant will interact with the committee and management. The table on the following page provides an example of the information typically required by a request for proposal for an executive compensation consultant.

Topic Area and Description/Rationale	Information Typically Requested
Company Experience Allows the committee to gain an understanding of the consulting firm’s experience, philosophy, and resources	Brief overview of the firm Description of consultant’s background and experience as it relates to the work being requested Current list of clients and industry experience Description of the firm’s thought leadership Experience in designing annual and long-term incentive compensation programs
Consulting Team Provides the committee with information on the potential consulting team to understand the depth of experience of the team	For each member of the consulting team, provide: Name Anticipated role Years of experience List of current clients Biography
References Gives the company and committee an opportunity to learn about the consultant from previous clients	Provide three compensation committee chair references with the following information: Company for which the individual is the committee chair Contact information: company (current or former, if retired), contact name, address, email, and phone number Summary of scope of work Length of relationship
Potential Conflict of Interest Alerts the committee to any potential conflicts of interest prior to engaging a consultant	Highlight any potential conflicts of interest that could result from this engagement including the SEC factors Provide the firm’s conflict of interest policy
Pricing	Provide total anticipated consulting fees for completion of the work steps outlined in this request for proposal

General positive aspects in a consultant will include the following:

• Willingness to speak up when consultant is uncomfortable with decisions the committee is making or management is recommending
• Creativity in helping the committee consider solutions to difficult challenges
• Preparedness in advance of meetings sufficient to address issues efficiently and anticipate committee questions
• Flexibility to think “on the fly” as new issues surface during meetings
• Ability to engage different points of view while maintaining objectivity
• Proactive in keeping the committee chair aware of emerging issues between meetings
• Effectiveness in facilitating decision-making

Similar to the compensation committee chair, while part of the role of the consultant is to provide information and expertise, it is also to facilitate decision-making and bridge the gap between differing points of view. In order to fulfill this role well, the consultant needs to be trusted by the committee members and management, and should be able to relate to their concerns. Directors we spoke to indicated that one of the key challenges for a consultant is balancing the relationship between the committee and management. For example, Peter Haje said, “An open and candid relationship between the consultant and people in the company is critical, and it has not worked well when there was a poor relationship between management and the consultant.” Consultants who fail to recognize the importance of an effective working relationship with management may find that their relationship with management quickly becomes adversarial. On the other hand, if the consultant is perceived as being “too close” to management, the committee may come to question whether or not the consultant is providing objective, independent advice.

Much like management and directors, consultants will generally be most effective if they always keep in mind that their ultimate clients are the company’s shareholders, and that all three key parties (management, the board, and the consultants) should be acting in their interest. As part of the committee’s annual process, they should incorporate an evaluation of the effectiveness of the relationship with the consultant.

Sample Compensation Consultant Evaluation

Rating Scale: 1 = Well Below Expectations;
2 = Below Expectations; 3 = Meets Expectations;
4 = Exceeds Expectations; 5 = Far Exceeds Expectations

Evaluation Statement	Rating / Comments
Overall, how would you rate the consultant’s relationship with the committee?
Did the consultant respond to your requests, questions, and concerns effectively, and did they do so in a timely manner? Were there any problems and, if so, in what way?
Did the consultant communicate effectively during the engagement? Did the consultant listen and ask effective questions? How would you rate the usefulness and quality of the consultant’s input? In what ways could the consultant improve?
Does the committee feel the consultant made appropriate use of market data? Did the data meet the needs of the situation?
Does the consultant have a strong understanding of your business, short- and long-term issues, compensation philosophy, and programs? Were recommendations presented with the business context in mind?
Did the consultant provide the committee with proper context for their recommendations? Were recommendations presented to include governance, regulatory, and shareholder perspectives?
Were the work and recommendations presented effectively? What can be improved?
Did the consultant interact with management (on the committee’s behalf) effectively? Should any revisions be made to how interactions occur going forward?

Legal Advisors

In many cases, the compensation committee does not view it as necessary to have an independent legal advisor reporting directly to the committee. Instead, the committee often relies on the company’s internal legal staff and management’s external counsel to provide the committee with legal advice. However, there are certain situations where it is critical for the compensation committee to have its own advisors, and some committees have determined that it is worthwhile to retain a legal advisor to attend all committee meetings and serve as a sounding board between meetings.

Additionally, there are times when the compensation committee needs to work on confidential projects and does not want to share information with the management team. In particular, when recruiting a new CEO or determining compensation arrangements for a departing CEO, it is critical to obtain external legal advice to ensure objectivity.