When the Enron, Worldcom, Tyco and related corporate scandals surfaced a few years ago, the immediate attention was on financial irregularities and their intended watchdogs: audit committees. Legislation, regulation and investor scorecarding have focused on the independence of audit committees and the assignment of specific responsibilities to those committees. However, simmering in the background before and throughout this period were concerns about executive compensation and the role of compensation committees in setting it.
These concerns ranged from views that executive compensation was getting too high (both on an absolute basis and relative to the compensation of other employees in the organization) through fears that executive compensation arrangements had been designed to include irresistible incentives that were contributing factors to some of the major scandals. As audit committee issues have been dealt with on a crisis basis, attention is being shifted to the role and the functioning of compensation committees.
Problems with compensation committees derive from a lack of understanding of the role of the compensation committee, appointment to the committee of the wrong people and processes that are not up to the task. The discussion below draws on my personal experience as a director; however, having spoken with many other directors, I believe that my experience is not unusual.
Historically, compensation committees tended to operate on an unmandated basis (that is, without a written mandate defining the role of the committee, differentiating the role of the committee from that of the board generally, or differentiating the role of the committee and board from that of management). Meetings were often unplanned and disorganized, consisting of the CEO (perhaps supplemented by the CFO) appearing to table for immediate decision recommendations on bonuses for the past year (including management's views on the level of achievement of any stipulated performance targets), proposed salaries for the ensuing year and option recommendations. Directors were not appointed to compensation committees on the basis of distinctive skills or interests. Rather, they tended to be directors who could be relied on by management to be both sympathetic to management's compensation requests, and non-confrontational. There was limited outside involvement, in the sense of providing benchmarks against which compensation for the executives in question could be measured: if compensation consultants were involved, they were selected and engaged by management. The compensation committee tended to have only the experience of individual directors as a counterbalance to management and consultant recommendations.
Some observers have traced the origin of what they regard as executive compensation excess to U.S. Securities and Exchange Commission requirements that public companies publish the salaries of their top five executives. This gave rise to the consulting business of benchmarking, providing the data against which executives of a particular company could be compared with other executives. The benchmarking studies usually divided comparables into quartiles, or low, medium and high ranges. It would be the rare compensation committee or board of directors that would want to regard its executives as other than high-performance onesÃ³no one would like to admit that they hired a CEO who is not up the median of comparablesÃ³with the resulting upward spiral being entirely predictable.
Independently, perceived abuses relating to stock option grants (including their number, vesting, repricing and accounting treatment) have focused attention on compensation committees. It is these committees that grant, or at least recommend to the board, the grant of stock options; accordingly, interest in stock option abuse translates into interest in compensation committees.
Compensation committees are at the cutting edge of the point at which the concept of independent functioning of the board bites. To the extent that those interested in corporate governance focus on independence as a criterion in good governance, there can be no better place for it than as it relates to the compensation of management (and the directors themselves), by directors who are perceived to be independent or otherwise. And if the focus is on process, compensation issues (as noted below) are prime candidates for clear and transparent processes.
Compensation Committee Role and Mandate
As is the case with boards generally, the starting place for a compensation committee that does its job well is to have the right people who know their role. Traditionally, companies were not obligated to have compensation committees, and it was open to the board as a whole to perform compensation committee duties. As a practical matter, most boards do now constitute compensation committees, and the need for and nature of these committees are gradually becoming mandatory. Legislation or regulation in many jurisdictions requires that a compensation committee be established and maintained, and that the majority of members be "independent." Independent in this context has not been taken to the highest level at which it is used occasionally (for instance, in the Nasdaq audit committee rules, which would regard as not independent a director who, or whose firm, receives any benefit, however small, from the company, beyond director's fees) and, despite the majority test, it is clearly a best practice for the compensation committee to be made up entirely of independent directors.
While audit committee reforms have dealt specifically with the skills and experience required of audit committee members (mandating financial literacy or expertise), compensation committee reforms have not included comparable requirements. However, the job to be done is distinctive, and knowledge of and experience in compensation and human resources issues, as well as in investor sentiment toward particular sorts of compensation arrangements, can be helpful. Other skills that may be available in board members can be useful to the tasks that compensation committees undertake.
Like any organization, the committee should be chosen to include members who are interested and who will devote the time necessary to do the job well. The committee should include as many expert and generalist skill-sets as can be mustered within the context of a small (typically three-person) committee that must function in a collegial fashion, but often firmly vis-Ã -vis management.
It is important that the committee understand what it is expected to do. The best way to establish this is for the board of directors to develop a written mandate that describes the committee's responsibilities. The mandate is typically substantially broader than simply dealing with establishing senior management compensation levels, and indeed, it is far easier to address senior management compensation within the context of board responsibility for human resources issues generally. Accordingly, a typical committee mandate might specify the following duties.
CEO and senior management:
establish, monitor, review and revise, at least annually, performance guidelines for the CEO and guidance for the development of corporate strategy;
assist the board in assessing and evaluating the CEO's performance;
review and recommend the CEO's compensation, including salary, incentives, benefits and other perquisites;
on the recommendation of the CEO, approve the appointment of, and annual compensation plans for, each member of senior management, including salary, incentives, benefits and other perquisites;
regularly establish, review and monitor succession plans (including emergency succession plans) for all key management personnel (including the chair of the board and the CEO);
recommend to the board from time to time the amount, determination and payment of remuneration to be paid by the corporation to directors in light of time commitment, fees paid by comparable companies and responsibilities; and
report on executive compensation as required in public disclosure documents.
Corporate human resources:
review, approve and monitor, on a regular (and at least annual) basis, the corporation's compensation and benefits programs, developed by management;
review and approve, with senior management, annual corporate-wide compensation guidelines, including for the development and administration of executive short-term bonus plans;
review with management on a regular basis to satisfy itself that the corporation's human resources policies comply with applicable laws and regulations;
review management's recommendations regarding hirings, firings, transfers and promotions of senior officers and related severance packages;
review and monitor the overall employment environment of the corporation; and
consider any other human resources issues that it considers appropriate or that may be referred to it by the board.
Long-term incentive plans:
establish, review and monitor the terms of long-term incentive plans;
act as the board committee responsible for administering the corporation's stock option, stock purchase or other long-term performance (DSU, PSAP, etc.) plans;
review and approve awards under compensation plans;
review and approve any incentives to be granted outside ongoing plans; and
consult with management regularly to satisfy itself that compensation plans are meeting their intended objectives and comply with applicable laws, regulations and best practices.
Recommend updates to the committee's mandate (typically on an annual basis).
Advise on procedural matters:
advise on the number of members of the committee (usually three), restrictions on membership (for instance, to prohibit related directors from being members of the compensation committee), the role of the chair (both generally and in terms of having appropriate power to act between committee meetings), meeting procedures, quorums, appointment of a secretary, the creation and circulation of minutes (to the committee and to the board generally) and similar matters.
Compensation Committee Procedures
If the committee is to perform its job in a responsible manner, suitable procedures must be developed and implemented. While ultimate responsibility for these matters resides with the committee itself, the corporate secretary is typically central in driving the operational features.
For instance, meetings of the committee should be scheduled well in advance, having regard to known deadlines. The company will typically have a budget-setting process for which compensation levels are an important input. There is usually a particular time of year when corporate bonuses are discussed and when option issues are considered. Regulatory requirements for compensation committee reporting and other processes or requirements may also drive the need for committee activity. As many of these requirements are known well in advance, there is no excuse for not scheduling committee meetings so that committee members will have ample time for preparation and a likely ability to attend all meetings.
The agenda for committee meetings should be set well in advance, by consultation between the committee chair and the corporate secretary. Suitable materials (adequate, but not overwhelming) should be prepared and available to committee members in such a way that they should be expected to have read and absorbed them. Committee meeting time can then be used to discuss and decide on issues, rather than spent on the transmission of background data.
To ensure the independence of the committee, it is important that management not have any automatic right to attend committee meetings. However, equally, it is necessary that the committee have access to management as required. Accordingly, a best practice is to include in the committee's mandate the right to require members of management to attend when requested by the committee.
While it is desirable that the committee operate on an independent basis, it is important to remember that it is the role of management to manage the business, and the role of the board (and therefore its delegate, the committee) to oversee that managementÃ³only. Accordingly, recommendations on matters such as compensation policies, bonus arrangements and targets, appropriate long-term plans and the like should typically be generated by management in the first instance. This is not to suggest that the processbetween management and the committee is not dynamic, but it is not the committee's place to design suitable arrangements. On the other hand, the committee may well take the lead, with the assistance of the corporate secretary, in matters relating to its mandate, procedures and priorities. Good working relationships between the committee chair, the board chair, the CEO and the corporate secretary are important in ensuring leadership by the appropriate person on a topic-by-topic basis.
Distinctive issues arise with respect to the CEO's compensation. In this case, it is less appropriate for management to initiate proposals, and more appropriate for the committee to do so. However, in a company in which suitable levels of trust and confidence exist both among senior management and between management and the board/committee, the process can be dynamic, in terms of reports from compensation consultants, tentative proposals being developed by the committee, discussions with the CEO, and discussions with other members of senior management, all proceeding to an acceptable result.
The trust required to achieve results of this sort is needed more generally between management and the committee. In particular, the committee should work to establish good working relations with the corporate secretary and with human resources personnel, whose leadership and support are required in developing the committee's agenda, providing relevant background, and internal corporate and market information.
It should be clear that the committee is entitled to engage consultants as required. There has been much concern about the role of compensation consultants, particularly when, as was the case historically, they were engaged by management. It would hardly be surprising that concerns were raised about a propensity of management to select compensation consultants who might be biased in favour of more generous arrangements and whose next engagement might depend on delivering on that likelihood. Similarly, while it might be appropriate for the committee to rely on legal advice provided by the corporate secretary or the company's outside counsel, situations can arise in which it is preferable for the committee to engage counsel that is acting clearly and solely on behalf of the committee. (The term "engagement" here goes beyond hiring, to include compensation and the mandate of consultants engaged by the committee.)
It is sometimes necessary to clarify that management should seek its own consultants. For instance, on executive compensation matters, the committee and its counsel (who may be the corporate secretary, the company's usual outside counsel or counsel engaged independently by the committee) are not acting on behalf of management, and there should be no confusion about this fact.
The compensation committee occupies an increasingly important place in corporate communications. It is now mandatoryÂ—or virtually soÂ—for compensation committees to issue broadly disseminated reports on executive compensation. The basis of compensation decisions, and the process through which these were reached, are now quite transparent and are the object of scrutiny by investor representatives. A carefully considered and expressed compensation committee report can be a plus in these reviews: a report that is boilerplate inserted by counsel without review by the committee can be a serious negative.
An effective committee will also assist management by being the first line to receive messages that exist within compensation decisions ("her bonus arrangements suggest she is more important than that person, who would disagree") and in shaping the timing and nature of communications, both internally and externally. This can be done in substance ("we do not mind a bonus opportunity of this magnitude, but it would be better if it were demonstrably tied to objective results that support corporate objectives or visible shareholder value, and paid after those results are available") and in form (in terms of the ways in which and times at which various compensation decisions are communicated).
A Word on Executive Compensation
The topic of suitable executive compensation, as a substantive matter, is beyond the scope of this paper. But certain themes, apparent in committee activity in the recent past, are noteworthy.
First, compensation committees are acting on a more independent and informed basis. They tend to engage compensation consultants on their own, to take longer in reviewing the recommendations of these consultants (and from management itself), and to bring questioning attitudes to the exercise. The result tends to be more refined compensation arrangements that include bases (marked to comparable market numbers), short-term bonuses (that can be tied to demonstrable achievements, personal and/or corporate) and thoughtful, long-term incentive arrangements.
The use of options, as the long-term incentive arrangement, has come under pressure of late, less for the (effective and, in many cases, mandatory) need to expense the cost of options through the income statement, than for escalating criticisms that options create inappropriate short-term stock promotion incentives, and that options do not in fact align the interests of optionees and shareholders (since the former have upside exposure only). From management's point of view, options have become less appealing because they have failed to pay off for a cohort of disappointed executives who accepted them in the late nineties in anticipation of a continued steep rise in stock prices.
Today, all sides tend to feel more comfortable with arrangements that have likely value in all scenarios (even if less upside leverage on a runaway stock). For instance, there is increased use of restricted stock (grants of shares that vest over time and/or on the basis of performance), performance share units (basically stock-based bonus arrangements) and other equity-based incentives, that will (if earned) always pay off to some extent (unlike underwater vested options). The earning and/or value of these incentives is being tied increasingly to performance, rather than to time-based vesting. For instance, the number of shares "earned" under an LTIP, or the value of performance share units, can be affected by corporate or share price performance metrics. As well, and in a further attempt both to align the interests of management with those of shareholders and to reduce short-term stock price incentives, long-term incentives increasingly include elements that require recipients to actually hold the stock, or its value, for longer terms (as opposed to being able to exercise options as soon as they vest, sell the underlying stock, and pocket immediate gains, irrespective of longer-term corporate, or stock, performance).
There is also a trend, in the development of increasingly sophisticated metrics, to examine corporate (and hence executives') performance on a relative basis (compared to some peer group or index), as opposed to simple gain in the abstract (as for instance, a higher stock price that may reflect no more than a generally rising stock market).
The Way Forward
Compensation committees have heard the call of those interested in corporate governance. They are taking their responsibilities more seriously. Committee (and chair) compensation is increasing correspondingly (and more frequently involving long-term incentives there, as well as at the executive compensation level). These are all appropriate developments that will help to ensure that compensation committees make the corporate governance contributions that they should.
Barry J. Reiter (firstname.lastname@example.org) is a partner in the Toronto office of Torys LLP. His practice focuses on corporate development and finance of new-economy companies. Mr. Reiter is the chair of Torys' technology group and a member of its executive committee.