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Feature

Robin A. Ferracone and
Todd M. Gershkowitz
Farient Advisors LLC

Selecting an Independent Compensation Consultant

Here are the important criteria boards should apply.

By Robin A. Ferracone and Todd M. Gershkowitz

The need for independent third-party advisors to boards of directors became starkly evident in the wake of spectacular corporate implosions like Enron, WorldCom, and Arthur Andersen, culminating in the passage of the Sarbanes-Oxley Act in 2002. Following these scandals, accounting firms were prohibited from providing consulting and other advisory services to their audit clients so as not to compromise their independence.

Similarly, as public concern over executive compensation has intensified, shareholders increasingly have become concerned about the independence of compensation consultants who advise board compensation committees.

In December 2009, the SEC issued a new rule that requires companies to disclose to shareholders whether their board compensation consulting firm also provides services to management that exceed $120,000 in annual fees.

In response to these changes, the compensation consulting industry has been restructuring, with most multiline firms spinning off their executive compensation units, and several compensation consulting leaders launching new boutique consultancies.

Making the Move
Amidst these changes, most companies have either moved or will move toward retaining an independent resource that reports solely to the compensation committee of the board. In this regard, boards do not want the slightest hint of a conflict of interest, real or perceived, nor do they want the slightest risk that their multiline consulting firm may be doing business, even unwittingly, elsewhere in the company.

Further, with so many new consulting firms out there, a number of companies are curious to see just what the new firms have to offer.

In this new era of change, boards need to decide which criteria, in addition to independence, they will use to select a new consultant. Last year, in partnership with Directors & Boards, Farient Advisors conducted a survey of board members involved in executive compensation decision making. We asked the survey respondents to list the criteria they either used, or would use, to select a compensation consultant. The top criteria were: (1) ability to give an objective opinion, (2) industry knowledge/knowledge of business performance measurement, and (3) good chemistry.

1. Objectivity
Given the visibility and criticism around executive compensation, we were not surprised that board members value objectivity.

In our experience, to be most effective, the compensation consultant must develop informed opinions based on company-specific facts, an understanding of the industry and competitive situation, sensitivity to the regulatory environment, creativity to develop practical approaches to thorny issues, and sufficient experience to “see around the corners” and predict how a particular course of action likely will play out.

The consultant should not be a tie breaker, an advocate of one side or the other, or someone who merely supports the loudest voice or most popular point of view. As one board director put it, “I want to hire an advisor who doesn’t say one thing before the meeting, another during the meeting, and yet another after the meeting.”

2. Industry Knowledge
Industry knowledge also is an important factor. What this means is that the consultant understands the competitive environment for the company’s business and talent, and then can translate this knowledge into an understanding of how the pay system will work.

Understanding the company’s business, competitive environment, economics, and strategy will enable the consultant to better predict how various measures of performance and goal-setting processes will work over time and what problems might be encountered. This understanding will assist compensation committees on the performance, and not just the pay side, of the equation.

But caution also is advised in this regard. Industry knowledge should not be mistaken for the consultant doing work for competitors. In fact, this can potentially lead to confidentiality issues, blind acceptance of untested assumptions, and the development of “me too” compensation plans that do not reflect to the company’s unique strategy.

3. Good Chemistry
Finally, good chemistry and trust are critical factors. Good chemistry essentially means that the consultant can speak the company’s language, engage with the organization, and form a constructive relationship with all parties involved in the compensation planning process.

This might translate into a quantitative approach for an engineering-oriented company; a simple, but compelling, story line for a sales-driven organization; or a good sense of humor, at just the right interludes, for a company in which tensions run high.

Independence will continue to be a watchword when it comes to compensation committee selection of outside advisors. However, independence and knowledge of executive compensation are necessary but insufficient requirements for a compensation committee engagement.

The ability of the consultant to demonstrate objectivity, business acumen and knowledge of performance measurement, sensitivity to shareholders and other concerned and influential parties, and a keen understanding of how to best communicate and manage processes for the best outcomes will be enduring selection criteria.

Robin Ferracone is the executive chair and Todd Gershkowitz is a senior vice president of Farient Advisors LLC, an independent executive compensation consulting firm. Ms. Ferracone is the author of the just-released book, “Fair Pay, Fair Play: Aligning Executive Performance and Pay.” (Jossey-Bass, a Wiley imprint).

The authors can be contacted at robin.ferracone@farient.com and todd.gershkowitz@farient.com.