Pay Pals Face Fresh Fire Concerning Conflicts; Congress May Seek SEC Action

By Jeff Nash

Dec. 11, 2007

A scathing congressional report alleging widespread conflicts of interest among executive compensation consultants may lead to regulatory action that would force companies to disclose all the fees paid to such consultants for pay-package advice and other services.

    What’s more, some consultants say expanded disclosure could force multi-service firms to split or sell off their compensation businesses—or at least inspire partners to leave and launch their own boutique consultancies for corporate boards that want independent executive compensation advice.

    The report, commissioned for California Rep. Henry Waxman, the Democratic chairman of the House Committee on Oversight and Government Reform, found that roughly half of Fortune 250 companies used compensation consultants that were also providing much more lucrative services—such as employee benefits administration, human resources management and actuarial services—to these major clients at the same time.

    While current Securities and Exchange Commission rules don’t require companies to reveal the fees paid for these various services, many panelists at a congressional hearing on the issue in Washington last week—including both shareholder advocates and compensation consultants—agreed that more disclosure is needed. A staffer on the oversight committee confirmed that an e-mail has been sent to the SEC to suggest a follow-up meeting on the issue, but the staffer says nothing has been scheduled yet. An SEC spokesman declined to comment.

    Such added disclosure could lead to a full-blown restructuring of the industry, not unlike what happened to the auditing industry after conflicts of interest were exposed in the late 1990s. At that time, leading auditing firms like KPMG and PricewaterhouseCoopers sold off their consulting practices, notes Joseph Rich, chairman of Pearl Meyer & Partners, a compensation consultant working only for board clients.

    “The full-service firms must be having conversations about possibly selling off their executive compensation businesses,” he says.

    The impetus for any upheaval is Waxman’s report, based on a seven-month investigation by his staff of the 250 largest publicly traded companies.

    The consulting firms asked to supply data were Frederic W. Cook & Co., Hewitt Associates, Mercer, the human resources consulting unit of Marsh & McLennan, Pearl Meyer, Towers Perrin and Watson Wyatt. Hewitt, Mercer, Towers Perrin and Watson Wyatt are full-service firms that can be hired by both boards and management; Cook, like Pearl Meyer, specializes in board-only work.

    The report’s findings included:

  • At 113 companies that use consultants with what the Waxman committee called conflicts of interest, the consultants on average received $200,000 to advise the company about CEO pay, and more than $2.3 million to provide other services.

  • More than two-thirds of Fortune 250 companies don’t disclose their compensation consultants’ conflicts of interest. In 30 cases, the report claimed, companies say their compensation consultants were “independent” when they were actually being paid for other services. For example, in its SEC filing, MetLife said its compensation consultant was independent even though it paid the consultant more than $7 million to provide other services.

  • There appears to be a link between the level of CEO compensation and the level of a consultant’s conflicts of interest. For example, the median CEO salary of the Fortune 250 companies that hired the consultants with what congressional researchers deemed the most conflicts of interest was 67 percent higher than the median salary of companies that did not use “conflicted consultants.”

    Some hearing participants took issue with that apparent link. Rep. Tom Davis, R-Virginia, the ranking Republican member, said the theory that “pliant and corrupt consultants, working both sides of the fiduciary street, take huge fees from management, then recommend unreasonably high compensation for those same managers” is an “interesting theory, one steeped in anti-corporate populism. … But there’s little proof it’s true.”

    Indeed not all members of Waxman’s committee agreed with the findings, or that there was any need for the special hearing in the first place. Rep. Lynn Westmoreland, R-Georgia, complained it was another step “on our march to socialism,” while Rep. Mark Souder, R-Indiana, said the hearing was “one of the most appalling and embarrassing hearings we’ve ever had.”

    James Reda, an independent consultant in New York who spoke at the hearing, told Financial Week that he recommends the SEC require companies to disclose all fees paid to consulting firms on their annual proxy statements. “If that happens, I could see Hewitt or Towers Perrin spinning off their executive compensation practices,” he said, “or consultants from those firms leaving to start their own businesses.”

    But Donald Lowman, managing director of Towers Perrin, called such speculation “wishful thinking,” and pointed out that any analogy to the audit industry was flawed. “We’re not the auditing profession, we don’t have ‘standards,’ companies are not required to use us, and they’re certainly not required to follow our advice,” he said. “We’re certainly not having those conversations.”

    Lowman says his firm will continue with business as usual, which includes “understanding and managing and mitigating conflicts. And where there are conflicts that would in any way influence our judgment, we won’t accept the work. That’s something that’s not understood [out there]. We do walk away.”

    He also discounted congressional charges of cross-selling at the full-service firm. The Waxman report included as an example of egregiousness a job posting by Towers Perrin that called for “minimum revenue generation from all sources (i.e., not just executive compensation services) of $750,000.” Lowman says that based on the sales figure, the ad was for a junior-level position.

    Such a position, he explained, would not interact directly with a compensation committee or CEO, but would work with middle management. (A similar Mercer ad cited by the committee was also for a non-CEO compensation position, explained company spokesman Charles Salmans.)

    At Watson Wyatt, compensation practice director Ira Kay also downplayed any need to spin off his unit.

    “We have sufficient safeguards to prevent conflicts of interest,” he said. “I don’t know anything about other work we may be doing at a company for which I provide executive compensation services.”

    Kay also said his firm could handle more disclosure: “We have a flexible business model and are prepared to do our business whatever comes our way.”

    Shareholder groups and governance watchdogs have targeted compensation consultants in recent years for what they believe to be their contribution to the dramatic increase in executive pay, too often without a coincident rise in shareholder value. In 1980, chief executives in the U.S. were paid 40 times the average worker’s pay; last year, the average Fortune 250 CEO earned more than 600 times the average worker’s pay, according to a report by the Institute for Policy Studies and United for a Fair Economy that was cited by the Waxman committee.

    Companies may already be moving toward using only independent pay consultants, regardless of any future regulation. Wachovia, Procter & Gamble, Pfizer, Cisco, Lockheed Martin and Verizon, for instance, have written policies prohibiting compensation companies from performing work for the management side of the company.

    “It’s one of those things directors never thought to ask about [before],” says Suzanne Hopgood, a director at DHB Industries and Acadia Realty Trust and owner of her own management consultancy. “But now it’s another question to add to our list that might keep us or the company out of trouble.”

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