Compensation committees serving public companies are facing unprecedented scrutiny as they react to recent executive pay reform efforts led by federal lawmakers and agencies, institutional shareholders and corporate governance watchdogs. Most recently, leaders of the G-20 endorsed reforms that, among other things, would curb bonuses at financial firms and grant regulators greater power over those firms' compensation practices.
In this Q&A, Pillsbury Executive Compensation & Benefits partner Scott Landau explores the issues Compensation Committees of public companies must consider under the rapidly evolving landscape of compensation design and implementation.
Q. Executive compensation has long been a hot-button issue, so why is the debate over reform coming to a head now?
Landau: There is no doubt that new regulations surrounding salaries, bonuses and perks are coming — and soon. Executive compensation practices, particularly in the finance sector, have been widely criticized for the role they played in the events leading up to last year's economic crisis and the enduring recession.
In September we saw the G-20 and the Federal Reserve endorse new compensation regulation for most financial institutions. But broader reform is on its way. We're likely to see the most sweeping changes from the Corporate and Financial Institution Compensation Fairness Act, which was passed by the House in July, and may be taken up by the Senate by year-end. Also, new SEC rules requiring enhanced compensation program disclosures are expected to become effective for the 2010 proxy season.
But Compensation Committees shouldn't be waiting to see what happens with the Compensation Fairness Act or the SEC rules — they should be acting now.
Q. What can Compensation Committees do now to meet the new challenges of compensation reform?
Landau: Compensation Committees can start by looking at their current composition and procedures: Do the Committee members meet the independence criteria that may be required under the proposed legislation? Are they willing and able to effectively negotiate compensation agreements? More fundamentally, are they adequately trained to get into the details of executive pay arrangements so they can formulate and recommend compensation policies that make sense for the company? The days of rubber stamping a compensation consultant's proposals are over.
By extension, Compensation Committees should be making the same tough evaluations of their outside consultants. Could independence standards become an issue with respect to these advisors? Does the Committee have sufficient authority over the retention of outside consultants? Do the existing compensation consultants and outside counsel have relationships with the company that raise an appearance of impropriety? Concerns over such conflicts of interest play a prominent role in the Compensation Fairness Act, the SEC rules and other proposed reforms. The watchword is likely to be "Independence" going forward.
Another big focus of compensation reform is risk assessment. What procedures, if any, are in place to evaluate risk in connection with the company's compensation programs? Compensation Committees should start forging relationships with the company's Risk and/or Audit Committee to prepare itself to efficiently handle ever-developing reporting and disclosure obligations.
Q. What types of reform are being proposed?
Landau: The principles surrounding compensation reform tend to focus on three main ideas: executive compensation should be tied to company performance; executive interests should be aligned with those of the corporation and its shareholders; and executives should not be incentivized for taking unreasonable and imprudent risks. Proposals on the table demand transparency and accountability when establishing executive compensation programs.
The Compensation Fairness Act focuses on non-binding shareholder "say-on-pay" votes and ensuring Compensation Committee independence, but the trend is clearly toward practices that seek to get the balance of "total compensation" right. What incentive-based pay works? How should it be measured and over what performance period? When and under what circumstances should payment be made? How can pay-for-failure be curtailed? Do any of the company's compensation arrangements encourage excessive risk taking?
Compensation Committees need to become familiar with the available compensation practices and understand how they fit in with their organizations' short- and long-term objectives. Moreover, they will increasingly need to demonstrate that they are undertaking this process in a diligent manner.
Q. If the Senate does pass the Compensation Fairness Act later this year, what repercussions will companies face and to whom will they fall?
Landau: Unless the SEC exempts small issuers or a similar class of reporting companies, all public companies will be subject to the new rules, and it's likely they will set the tone for private companies as well. The heaviest burden will fall to Compensation Committees. Although Boards of Directors will be obliged to provide adequate funding and support, it is the Compensation Committee members that will assume full responsibility and authority over ensuring that shareholder interests are fully reflected in the company's compensation policies.
As mentioned earlier, a major element of the legislation requires Committee members to be independent of the company, but the Committee members themselves must also make sure that the advisors they retain at a minimum meet the independence standards to be promulgated by the SEC.