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Principles for Managing Executive Compensation

Principles for Managing Executive Compensation

In recent months, numerous regulatory and advisory groups have contributed to an ongoing dialogue about the application of techniques of good corporate governance to managing executive compensation.

Risk Metrics (formerly, Institutional Shareholder Services), The Conference Board Commission on Public Trust and Private Enterprise, The National Association of Corporate Directors (NACD) Blue Ribbon Commission on Executive Compensation, and others have joined experienced professional advisors to offer opinions and guidance on the issue. Although there is plenty of room for discussion, substantial agreement exists on a handful of core principles that we summarize below:

1. The Compensation Committee Must Drive the Process. Whether it is a legal requirement (for publicly traded companies) or a best practice to aspire to, a compensation committee made up of at least three (3) to as many as five (5) independent directors is essential. Committee members should be knowledgeable, inquisitive and diligent. They must be keenly aware of their fiduciary responsibility to shareholders when making decisions about the structure of the executive compensation program. Finally, they must be prepared to operate in a fishbowl, rather than in a vacuum.

2. First, a Charter; Then, a Philosophy. The compensation committee should have a clear charter from the Board defining the scope of its responsibilities and the processes it will undertake to devise and maintain fair, competitive compensation opportunities for executives. Then, the compensation committee must articulate an executive compensation philosophy or “story” which becomes the basis on which to evaluate various compensation elements and determine how those components reinforce corporate values, goals and objectives.

3. Measure What You Manage. A fundamental goal of an executive compensation program is to provide a total compensation opportunity that is both attractive and “reasonable”. Without a clear understanding of what kinds and how much compensation the market provides, the compensation committee can only guess. Further, what is “reasonable” compensation for a high-performing company may be completely unreasonable for one that significantly trails its peers. You don’t have to follow the herd, but you should know where it’s going.

4. Control the Relationship With Outside Consultants. In the interest of having fair, unbiased input about industry practices and trends, the compensation committee should hire and manage the services of outside consultants who provide executive pay information and recommendations. In following this approach, it is important that top management continue to be an integral part of the executive compensation process. However, it is the compensation committee that must “own” the consulting relationship.

5. Pay for Performance. A significant portion of total compensation for executives should be tied directly to performance of the business. Rewarding sustained, longer-term results, and not merely short-term, annual results, is essential. Compensation that is “at risk” (conditioned on performance) is critical to aligning executive pay with long-term shareholder interests and corporate goals.

Accepting and Applying these Principles. The first step is to accept the wisdom of these fundamentals; the second is to apply them. Now more than ever an executive compensation program, and the compensation committee entrusted to devise and oversee it, will be judged on how well the “walk” measures up to the “talk”.

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