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Conflicting Views on Pay Consultant Conflicts

By Melissa Klein Aguilar — May 28, 2008

hief executives and their boards have been on the hot seat for quite a while over soaring levels of executive compensation. Now, thanks to details emerging this spring from corporate proxy statements, they have more company: the compensation consultants who help design those pay plans.

RELATED RESOURCES Study: Effect of Comp Consultants on CEO Pay (March 2008) Text of House Report on Comp Consultants (December 2007) Related Coverage In Europe, CEO Pay Gets Complicated (May 20, 2008) SEC Speaks on Options Expensing (Jan. 8, 2008) Media Exposure Drives Up CEO Pay (Dec. 4, 2007) Clawback Policies for CEO Pay Rising Swiftly (Oct. 16, 2007) Golden Parachutes Still Open for Business (Sept. 11, 2007) An Outside Job: External CEO Hires Paid More (May 1, 2007) Expensing Rule Drives Stock Awards (March 27, 2007) Under Fire, Golden Parachutes May Get Cut (Nov. 28, 2006) CEO Pay May Not Jump, But Scrutiny Will (Oct. 24, 2006)

Pay consultants are under a fierce spotlight this year, with studies published, Congressional hearings held, and letters written to regulators—all probing exactly what role consultants play in setting executive compensation and how much information companies disclose about the type and volume of work the consultants do.

Carter

Observers say much of the increased scrutiny stems from new rules for compensation disclosure that went into effect last year. Investors had long been curious about pay consultants, “but because companies weren’t required to disclose any information related to consultants … it was difficult to answer those questions,” says Mary Ellen Carter, a business professor at the University of Pennsylvania’s Wharton School.

The new disclosure rules broke that bottleneck, specifically with the advent of the Compensation Discussion & Analysis section in the proxy statement. The CD&A requires companies to disclose the name of any compensation consultant used by the board’s compensation committee in setting executive pay.

That disclosure, in turn, has led to new concerns about the independence of pay consultants. Institutional investors want to know whether pay consultants used by the board are also employed by the company directly, which could be a conflict of interest. Earlier this month, a coalition of institutional investors sent a letter to the Securities and Exchange Commission urging the agency to expand the disclosures it requires companies to make in the proxies.

Washington lawmakers have also taken a keen interest in the role consultants play. Last December, the House Committee on Oversight and Government Reform held a hearing on how consultants help determine the pay packages of top executives at large public companies. A committee report studying Fortune 250 companies found that those with the highest conflicts of interest with their consultants (measured by other work the consultants did for the company) offered higher executive compensation packages.

The House report concluded that a pay consultant’s conflict of interest with a company correlates to higher CEO compensation at the company.

Conflicting Evidence

Carter, however, conducted her own study earlier this spring and reached the opposite conclusion. Her report, “The Role and Effect of Compensation Consultants on CEO Pay,” concluded that the potential conflict of interest between companies and consultants is not a primary driver of excessive CEO pay—a conclusion that even surprised Carter herself.

“We expected we’d find evidence that the consultant conflict of interests were leading to higher pay,” Carter says. “We were surprised that we were unable to find any such evidence.”

Carter’s study examined disclosures from 880 companies in the S&P 1500 for fiscal 2006; 86 percent of those companies retained a compensation consultant that year. The report did find that compensation was somewhat higher among companies that hired pay consultants, Carter and her co-authors wrote that they could not find “widespread evidence of more lucrative CEO pay packages for clients of conflicted consultants, despite anecdotal evidence to the contrary.” Indeed, Carter’s study didn’t even find evidence that pay consultants lead companies to focus less on pay-for-performance, another belief popular among critics of CEO pay.

PAY CONSULTANTS Below is an excerpt from the recent study, “The Role and Effect of Compensation Consultants on CEO Pay.” Utilizing new SEC rules requiring companies to disclose their use of a compensation consultant, we find that 86 percent of 880 firms with December 2006 fiscal year ends from the S&P 1500 retain a compensation consultant, suggesting that the use of consultants are widespread. We examine the relation between the presence of a compensation consultant and the level and form of CEO pay. Specifically, we consider the level of salary, bonus, equity, and total annual compensation, as well as the pay-performance sensitivity of each form of compensation. We find evidence that clients of compensation consultants pay their CEOs more than other firms after controlling for economic determinants of pay. This finding generally holds after controlling for the endogenous choice of whether the firm retains a consultant. When we examine differences in the pay-performance sensitivity between the two groups of firms, we find no evidence that clients of consultants have lower sensitivities than firms without compensation consultants. These results are robust across a number of alternative specifications. Our findings suggest that CEOs of firms that use compensation consultants obtain economic rents in the form of higher compensation. However, due to econometric issues associated with selection models and the lack of a clear underlying theory guiding the selection of a consultant, we hesitate to rely solely on this analysis to form any conclusions … Using multiple proxies for whether the consultant is less independent, we find some, but not widespread evidence that such consultants are associated with greater rent extraction by CEOs. Overall, we do not find compelling evidence that the controversy and accusations regarding the use of potentially conflicted compensation consultants are warranted. Source Study: Effect of Comp Consultants on CEO Pay (March 2008).

She and her co-authors point out that the House report didn’t control for various factors that could affect CEO compensation, such as the size of the company or its future growth prospects. On the other hand, they admit that the House report uses data about the actual fees companies paid their consultants and what sort of services those consultants provided; Carter’s report did not have access to that information.

“Whether we would get the same results if we had their data is a question we can’t answer,” she says. “We tried three different proxies and every which way to show that potential conflicts of interest led to differences in pay, and we were unable to find it.”

James McRitchie, publisher of governance Website CorpGov.net, says Carter’s findings do not surprise him at all. “I would agree entirely,” he says. “Potential conflicts of interest do not explain why top executives now pull down 10 percent of corporate profits.” McRitchie dismisses conflicts of interest among pay consultants as a “small” factor leading to bloated CEO pay, “among many other factors that loom much larger.”

Fried

Jesse Fried, a law professor at the University of California at Berkeley, says the findings “are consistent with compensation consultants being used to justify higher pay. The compensation consultants are willing to play this role whether or not they have other ties with the firm.”

Fried contends that consultants play a relatively minor role in determining actual pay levels. “Their main job is to help justify the pay that the CEO and board agree to.” Even if boards only employ consultants with no other relationship to the company, Fried says, “Boards would still overpay CEOs, because they have an incentive to avoid confronting CEOs and it’s not their money.”

Hodgson

Still, Paul Hodgson, senior researcher at the Corporate Library, says a single academic study “isn’t necessarily conclusive.” Rather than looking at averages among a large group, Hodgson says he prefers to comb through the details of how consultants advise individual companies and decide on a case-by-case basis whether there’s a “good or bad influence.”

“Consultants can be part of the problem, but they can also be part of the solution,” says Hodgson. “You can’t tar them all with the same brush.”

Hodgson says investors’ current fears about conflicts among consultants may be traced back to concerns about audit firms providing consulting services to auditing clients in the late 1990s. Those concerns eventually led to the prohibition of certain non-audit services by firms to their audit clients.

“In large part because of our experience with the accounting profession, there are concerns that the same kind of thing might be happening with compensation consultancies,” he says. Hodgson says such fears are overblown.

“I don’t think we’ll have to do the same thing for compensation consultants that we did with audit firms,” he says. While it’s best to remove the possibility of any conflict of interest, Hodgson says, “I have yet to be convinced entirely that the conflicts of interest are real in every case.”

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