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It is nearly impossible to read any newspaper these days without encountering an article covering “excessive” executive compensation practices. The most notable example in recent days has been the controversy over bonus payments at Goldman Sachs (NYSE:GS) and other banks. While normally the question of compensation is one best left to negotiations between business owners and management, government bailouts of financial institutions have increased public scrutiny of compensation practices in general, not just at bailed out institutions.

The Wall Street Journal has reported that many corporate boards are attempting to reform their compensation practices by changing the nature of their relationship with compensation consultants. Many observers have noted for several years the inherent conflict of interest that exists when compensation consultants are brought in to make recommendations on the pay of the same managers who have the power to direct additional consulting business to the same firms. The “solution” some boards seem to have come up with is to continue using compensation consultants but to limit any additional work given to these firms.

Delegating Core Responsibilities

Boards that delegate compensation decisions to consulting firms are outsourcing one of the most critical oversight responsibilities to third parties that have inherent conflicts of interest. Even if the consultant is only retained for compensation analysis, conflicts still exist due to the tendency of boards to seek justification to increase management salaries. Since most boards are populated with executives from other companies, a general inflation in executive pay can be desirable from a board member’s perspective. However, simply raising pay without benefit of the “official verdict” of a compensation consultant may look arbitrary and self serving.

Here is what Warren Buffett had to say regarding compensation consultants in his 1994 letter to shareholders:

I can’t resist mentioning that our compensation arrangement with Ralph Schey was worked out in about five minutes, immediately upon our purchase of Scott Fetzer and without the “help” of lawyers or compensation consultants. This arrangement embodies a few very simple ideas – not the kind of terms favored by consultants who cannot easily send a large bill unless they have established that you have a large problem (and one, of course, that requires an annual review). Our agreement with Ralph has never been changed.

Of course, compensation consultants require more than five minutes to come up with recommendations since simple solutions do not generally result in the desired result: high fees. That requires more sophisticated analysis and complexity.

Take Responsibility

The Board of Directors is elected by shareholders and has the responsibility to carry out basic oversight and to determine the compensation of top management. These core tasks should not be delegated to consultants. Board members should have enough general business experience and familiarity with the industry in question to set competitive pay without outsourcing the job. Furthermore, as Warren Buffett has pointed out, board members who have substantial equity stakes in the company are more likely to act in the best interests of shareholders.

The following section on compensation practices in the latest proxy statement of The Daily Journal Corporation (NASDAQ:DJCO) is a perfect summary of how all boards should approach this important question:

The compensation committee is responsible for determining the compensation of the Company’s Chief Executive Officer and all of its other officers. In light of this straightforward responsibility, the compensation committee does not operate under a written charter. The compensation committee does not delegate its responsibilities. The Company’s only executive officer, Gerald L. Salzman, does not determine or recommend the amount or form of his compensation or of any director’s compensation. The compensation committee relies on its own good judgment in carrying out its duties and does not waste shareholder money on compensation consultants.

The Daily Journal has clearly been influenced by the views of Charlie Munger who has been the company’s Chairman since 1977.

The point here is not that management consultants never provide any value. While it may be a warning sign of lack of general industry knowledge, it may be legitimate for boards to seek data from consultants regarding compensation at competing firms if such information is not readily available and consultants can be used to uncover the data at reasonable cost. However, it is never appropriate for a board to delegate responsibility for compensation decisions to consultants. For that task, boards must rely on the collective judgment of its members. If such judgment is absent, shareholders should replace the board with individuals competent to perform basic oversight tasks such as setting executive compensation.

Disclosure: The author owns shares of Berkshire Hathaway (NYSE:BRK.A). The author does not own shares of The Daily Journal Corporation.

Source: Removing the Compensation Consultant Smokescreen