A look at the hidden force behind the rise of executive pay: consultants

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As the debate over rising executive pay intensifies, a key architect of Canada's current compensation landscape has largely avoided scrutiny: the consultant.

While public criticism is typically directed at board directors, shareholders and chief executive officers, people intimate with the process of setting pay want that to change, hoping consultants are also put under the spotlight.

Executive compensation levels in Canada keep climbing, and are often divorced from performance. Median pay for CEOs of Canada's 100 most valuable companies rose 47 per cent over six years between 2008 and 2014 – and shareholders are taking note. Canadian Imperial Bank of Commerce, Barrick Gold Corp. and Yamana Gold Inc. all lost say-on-pay votes in 2015, making this the first year three major Canadian companies faced a firm rebuke from shareholders on pay.

Little known outside of board circles, a handful of firms in Canada – such as Towers Watson, Hugessen Consulting, Hay Group and Global Governance Advisors – play a powerful role behind the scenes by developing increasingly complex CEO pay systems. They have a say in every element of compensation, from cash bonuses to performance share units, helping craft the complicated formulas used to calculate payouts.

Consultants say their work brings discipline that is often lacking when boards use their own discretion to decide on payouts. Critics, however, argue they have added immense complexity to pay design that has led to big payouts for executives, while also guaranteeing boards become reliant on outside advice because the process is now too difficult to manage themselves.

Bill Holland, executive chair of mutual-fund company CI Financial Corp., minces no words, calling compensation consultants "a scam." These firms make pay far too complex, he argues, and they have spurred the practice of benchmarking executive pay against peers at other companies, something that pushes it higher because companies strive to compensate their leaders above the average level, or even in the top 25 per cent of their industry.

"If everyone is in the top quartile, you have runaway inflation that cannot stop. All you have to do is pay above the median and mathematically it does not stop," Mr. Holland says. "So the consultants, I think, are essentially a negative component of this."

The compensation consulting industry emerged in the 1950s to provide companies with comparative data about their peers to help them figure out the going wage rate for various executive roles. Consultants in that era worked with management and rarely dealt with the board.

The scope of their roles expanded through the 1980s and 1990s as companies began adopting more complex systems full of equity-based pay, creating more need for expert help to manage the plans. After a wave of governance scandals in 2002, rule changes led to the emergence of new independent firms that serve only boards and do no work for management.

Consultants work with companies annually to assess compensation packages, review whether payouts were earned and shape the next year's pay plan, and they also meet with major shareholders to line up support for proposed changes. Their fees vary widely depending on the scope of the work in a given year, but some of Canada's largest companies report paying their advisers between $150,000 and $500,000 annually.

The weight these consultants carry increased after the Supreme Court of Canada's 2008 decision on a takeover offer for BCE Inc., argues securities lawyer Ed Waitzer, former chair of the Ontario Securities Commission. The ruling said directors should take all stakeholders into account when debating a corporation's best interests – not just shareholders.

However, the court said boards can sidestep this heavy burden if they can prove they relied on professional advice for key decisions. "You have this fiduciary duty that can be mitigated, if not eliminated, by reports of experts," Mr. Waitzer says.

"Corporate governance has now spawned this cottage industry of outside advisers," he says, because consultants can "bless a compensation scheme." If anyone is angry with the board, directors can defend themselves by pointing to the consultants' credentials.

Ken Hugessen, one of Canada's longest-serving compensation consultants who heads his own independent firm, says he has frequently heard criticisms that his industry fuels pay increases because it wants to please CEOs by recommending they get big raises. He says the reality is the opposite.

He points to two recent studies – one from researchers at Cambridge University and the other from the University of Oklahoma – that concluded compensation consultants who are hired by the board and operate independently of management are associated with lower pay levels and a greater link between pay and performance.

A truly independent consultant, he argues, can ensure pay packages have a steep downside for bad performance and can also help boards assess annual performance to measure whether it met the board's objectives. While management has a vested interest in painting performance in the best light possible, Mr. Hugessen says consultants verify the claims.

The hard part is ensuring their work is independent. While more common in the United States, Mr. Hugessen says some Canadian boards still technically hire the consultants yet allow management to control the process, including recommending which firms to use. "There are still many companies who essentially defer to managers to pick the consultant. I would say it's a work in progress in Canada," he says.

Paul Gryglewicz, senior partner at Toronto-based Global Governance Advisors, says consultants are more likely to propose reforms to pay models than many people realize. Some ideas are adopted, others get shot down by clients or shareholders because they are too different from the norm.

"I find the appetite for changing the way in which pay is handled is very slow, and it can be frustrating," Mr. Gryglewicz says.

He says radical change is not realistic either, because boards must create compensation plans that address the voting guidelines of their major shareholders, and especially those of proxy advisory firm Institutional Shareholder Services, which advises many large investors on how to vote their shares.

"Their model is so boxed in," he says. "It really hinders the ability to create change."

He says boards also have legal responsibilities that force them to be conservative, meaning they can't take risks with untested ideas.

Despite Mr. Gryglewicz's arguments, compensation consultant Stephen Byrne, who once worked for top U.S. firms and now runs Shareholder Value Advisors Inc. in New York, says many people in the industry don't realize the effects of their work.

Compensation consultants are "totally convinced that it's perfectly fine to promise everybody competitive pay regardless of past performance," he says. "They think of themselves as grandly representing the shareholders, and don't appreciate the program they are proposing is extremely pro-management."