Compensation concerns: the role of compensation committees is an important though often overlooked part of the governance puzzle. Establishing the right processes for managing executive compensation creates the transparency essential for today's corporate realities. Make sure you're doing it right.

Corporate scandals such as Enron, Worldcom and Tyco involved financial irregularities and have affected the intended watchdog against these, audit committees. Legislation, regulation and investor scorecarding have focused on the independence of the audit committee and the assignment of specific responsibilities to that committee. However, simmering in the background before and throughout these changes were concerns about executive compensation and the role of compensation committees.

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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 are gradually being managed through legislation and reform, attention is coming back to the role and the function of compensation committees.

Problems with compensation committees arise because their role isn't clear, the wrong people are appointed to them, or their processes are not at the necessary high level. This article draws on my personal experience as a director but, having spoken with many other directors, my experiences aren't unique.

Historically, compensation committees operated on an ad hoc basis, with no written mandate defining their role, and no differentiation of their role from that of the board generally. Meetings were often disorganized, with the CEO (perhaps supplemented by the CFO) appearing to table for immediate decision recommendations on bonuses for the past year, proposed salaries for the ensuing year and option recommendations. Directors weren't appointed to compensation committees on the basis of distinctive skills or interests. Rather, they were generally directors who could be relied on by management to be both non-confrontational and sympathetic to management's compensation requests. Benchmarks against which compensation for the executives in question could be measured weren't supplied; 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 counter-balance to the recommendations of management and consultants.

Some observers have traced the origin of what they regard as executive compensation excess to the U.S. Securities and Exchange Commission requirement 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 portray its executives as other than high-performance ones. The resulting upward spiral was 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 and, accordingly, interest in stock option abuse translates into interest in compensation committees.

Compensation committees are at the cutting edge of board independence issues. Independence is an important criterion in good governance, and establishing good processes for compensation management creates the transparency that improves this.

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 weren't obligated to have compensation committees, and it was up to the board as a whole to perform compensation committee duties. As a practical matter, most boards do have compensation committees now, 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 all its members be independent. The OSC's proposed policy on effective corporate governance requires only that these matters be disclosed in a company's annual information form. "Independent" in this context has not been as clearly defined as in other areas. For instance, the OSC's audit committee rules would consider a director not independent if he or she receives any non-director consulting, advisory or compensatory fee whatsoever, however small, from the company or any of its subsidiaries, beyond director's fees. However, regardless of definitions, it is clearly a best practice for a compensation committee to include only entirely 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. For example, the OSC's audit committee rules require that every member of the audit committee be financially literate and that the education and experience of each member be disclosed. There are no such requirements for compensation committees. However, the job to be done is distinctive, and knowledge and experience of compensation and human resources issues, as well as of investor sentiment toward particular sorts of compensation arrangements, can be helpful. Other skills that may be available among board members can be useful to the tasks that compensation committees undertake. CMAs frequently have applicable skill sets, especially for the increasingly complex financial elements such as applicable accounting rules, tax treatment and financial models.

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-a-vis management.

It's 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 duties described in the categories below.

CEO and senior management

The committee would establish, monitor, review and revise, at least annually, performance guidelines for the CEO and guidance for the development of corporate strategy. It would assist the board in assessing and evaluating the CEO's performance, and review and recommend the CEO's compensation, including salary, incentives, benefits and other perquisites. On the recommendation of the CEO, it would approve the appointment of, and annual compensation plans for, each member of senior management, including salary, incentives, benefits and other perquisites. It would regularly establish, review and monitor succession plans (including emergency succession plans) for all key management personnel (including the CEO and the chair of the board). It would also recommend to the board from time to time the amount, determination and payment of remuneration by the corporation to directors, and report on executive compensation as required in public disclosure documents.

Corporate human resources

The committee would review, approve and monitor on a regular (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 executives' short-term bonus plans; review with management and confirm that the corporation's human resource policies comply with applicable laws and regulations; review management's recommendations regarding the hiring, firing (and related severance packages), transfer and promotion of senior officers; and review and monitor the overall employment environment of the corporation. The committee would also consider any other human resource issues that it considers appropriate or that are referred to it by the board.

Long-term incentive plans

The committee would establish, review and monitor the terms of long-term incentive plans. It must act as the board committee responsible for administering the corporation's stock option, stock purchase or other long-term performance plans. It must also review and approve awards under compensation plans, as well as any incentives granted outside ongoing plans. It would also consult with management regularly to satisfy itself that compensation plans are meeting their objectives and that they comply with applicable laws, regulations and best practices.

Procedural matters

Issues such as the number of members of the committee, restrictions on membership (for instance, prohibiting related directors), the role of the chair, meeting procedures, quorums, appointment of a secretary, and similar matters should also be included in the mandate.

Maintaining independence

While it's desirable that the committee operate independently, it's important to remember that it's the role of management to manage the business, and the role of the board to oversee that management. Accordingly, recommendations on matters such as compensation policies, bonus arrangements and targets, and appropriate long-term plans should typically be generated in the first instance by management. This isn't to suggest that the process isn't dynamic; but it is not the committee's place to design suitable arrangements. On the other hand, the committee may well take the lead 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 regarding the CEO's compensation. In this case, it's 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 or committee, the process can be dynamic. Reports from compensation consultants, tentative proposals being developed by the committee, discussions with the CEO and other members of senior management can all lead to an acceptable result.

The trust required to achieve results of this sort is needed more generally between management and the committee, in much the same way that an effective audit committee benefits from sound relations with management. In particular, the committee should establish good working relations with human resource 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 the legal advice of the company's outside counsel, situations can arise in which it is preferable for the committee to engage counsel to act clearly and solely on behalf of the committee (and to advise not only on the hiring but also the compensation and mandate of consultants engaged by the committee).

The compensation committee occupies an increasingly important place in corporate communications. It is now mandatory for compensation committees to issue broadly disseminated reports on executive compensation. In Ontario, disclosure is required, in a company's annual proxy circular, of all compensation earned by certain executive officers as well as of the policies of the executive compensation committee. The basis of compensation decisions and the process through which these are reached are now quite transparent and are scrutinized by investor representatives. A carefully considered and expressed compensation committee report can be a plus: a report that is boilerplate, inserted by counsel without review by the committee, can be a serious negative.

Changing executive compensation

The topic of suitable executive compensation, as a substantive matter, is beyond the scope of this article. 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; spend more time reviewing the recommendations of these consultants (and those of management itself); and 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 mandatory) need to expense the cost of options through the income statement, than as a result of escalating criticism 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 '90s 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. 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 a long-term investment plan, 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, regardless 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 (for instance, a higher stock price that may reflect no more than a generally rising stock market).

Compensation committees have heard the call of those interested in strengthening 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 Reiter ([e-mail]) is a partner and chairman of the Technology Group at Torys LLP in Toronto. He holds several directorships and positions on compensation and corporate governance committees.