A partnership approach to executive compensation: five steps for improving the dynamics between management and the compensation committee in today's governance environment.

• Author: Burchman, Seymour
• Position: COMPENSATION COMMITTEE

THE NEW GOVERNANCE ENVIRONMENT has changed the dynamics between management and compensation committee members. Not surprisingly, it is taking a while for the issues to be sorted out. At times, the dynamics can feel threatening: It is not unusual for a previously amicable relationship to become contentious on occasion, or for the boundaries between the decision rights for management and those for the compensation committee to change without a thoughtful discussion of the implications. Friction can occur if the compensation committee suddenly becomes engaged on a topic that historically had been deferred to management or if the compensation committee assumes the primary relationship with an executive compensation consultant who had previously forged a relationship with management. Committee members, for their part, will understandably become concerned if management appears less than forthcoming on certain sensitive matters or defensive when challenged.

Instead of feeling threatened, both parties must find more effective ways to work together under the new rules. In an ideal collaboration, management and the compensation committee would develop and implement an executive compensation program that aligns executive gains with those of shareholders; supports the business strategy; and enables the company to attract, motivate, and retain the talent needed to execute that strategy. An optimal partnership between management and committee can improve the business impact of a company's executive compensation program. Such a partnership can also reassure both parties that the program's objectives and implementation are as unassailable as possible in the eyes of the shareholders and the outside world.

To achieve these outcomes, all partners must be willing to create an environment that fosters conversation and transparency. It's a matter of agreeing on the basic direction of the decision-making process and keeping the communication flowing. An optimum approach to management/committee collaboration involves five steps:

Step 1: Clarify expectations and articulate decision rights

A critical first step in getting the relationship off to the right start (or to take an existing relationship to a new level of effectiveness) is to step back and have a candid conversation about expectations. This is a natural conversation to have when a new committee chair comes on board or after the committee's self-evaluation. The objective is to discuss how management and the compensation committee can best work together to achieve the committee's charter. The conversation should focus on questions such as the following:

* What elements of their charter do the compensation committee members consider most important? Is the charter still appropriate, or does it require modification?

* How well has the committee adhered to its charter? Specifically, what has it done well? Where does it need to improve? What are the reasons for any shortfalls?

* How can management best help the committee fulfill its charter? To what extent has management been doing this already? What is working well? What areas could be improved?

* How can the committee help management deliver to the committee's expectations?

* Do the committee members feel as if they are getting the right information in a timely manner in order to fulfill their fiduciary obligations?

* How do the committee members want to be involved in the making of critical decisions?

When expectations are clear, management and the committee will understand each other's expectations and have a basis for periodic discussions (at least once a year) of how the relationship is working. Management may choose to have individual conversations with directors first on these matters and then aggregate themes for full committee discussion. Alternatively, a third party might facilitate this process.

These discussions can lead to greater clarity around decision rights, an important outcome. Decision rights define accountability for specific actions and decisions related to compensation, benefits, and perquisites. They guarantee that the policies and practices are in place to ensure the development of management talent, effective corporate governance, and the establishment of competitive and effective management compensation. As shown in Exhibit 1, decision rights specify the governance item (director compensation, CEO compensation, etc.), the specific actions (e.g., initiate, develop, review, approve), and accountabilities of management, the compensation committee, the full board, and the compensation consultant.

One decision right that is gaining prominence focuses on choosing the compensation consultant and "owning" the consulting relationship. Historically, the compensation consultant was hired by and reported to management in virtually all...