“Independent” Consultants' Role in the Executive Remuneration Design Process under Restrictive Guidelines

• Author: Seppo Ikäheimo,Leena Kostiander
• Date: 01 January 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00892.x
• Published date: 01 January 2012

“Independent” Consultants’ Role in the

Executive Remuneration Design Process under

Restrictive Guidelines

Leena Kostiander* and Seppo Ikäheimo

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study explores the remuneration consultant–client relationship in a non-Anglo-American

context, focusing on what consultants do under heavy political remuneration guidance.

Research Findings/Insights: A qualitative social constructivist approach was adopted, drawingon interviews with the CEO

and “independent” chairman of the board of 23 Finnish state-owned enterprises, as well as four leading consultants. The

research context considerably differs from that of the US, since the State takes an active role in providing remuneration

guidelines. Finland also represents a country with a high level of corporate governance and low level of corruption.

Nonetheless, our results strongly support the managerial entrenchment perspective fraught with problems and f‌illed with

game playing, where “specialized” consultants and CEOs play the major roles, resulting in increased salarylevels, slack, an

emphasis on share-based incentives, and public outrage. The effectiveness of these guidelines would be hard, even

impossible, to understand, without proper analysis of human interaction related to it.

Theoretical/Academic Implications: The study questions the def‌inition of consultant independence based on external data.

Second, routine practices commonly bypass rules, leading to the unintended consequence of forced change. Third, the

structure of consultancy markets and long consultant–client relationships play an important role in the services offered by

consultants.

Practioner/Policy Implications: The f‌indings show that restrictive remuneration guidelines can be ineffective and lead to

standardized pay designs without providing competitive advantage. Shareholders should request greater transparency

concerning remuneration design. The role of consultants should be considered proactively in the guidelines, even by

limiting the length of the consultant–client relationship or increasing their transparency.

Keywords: Corporate Governance, Qualitative Analysis, Compensation Committee, State-Owned Enterprise (SOE),

Corporate Governance Codes, Executive Compensation

INTRODUCTION

The majority of recent corporate governance and execu-

tive remuneration research has reported that executive

pay is generally higher in organizations that are the clients

of remuneration consulting f‌irms (Armstrong, Ittner, &

Larcker, 2008; Cadman, Carter, & Hillegeist, 2010; Conyon,

Peck, & Sadler, 2009; Goh & Gupta, 2010; Kabir & Minhat,

2011; Murphy & Sandino, 2010; Voulgaris, Stathopoulos, &

Walker, 2010). Although these studies have indicated that

remuneration consultantsprovide a mechanism for company

executives to increase their pay and to justify this increase,

none of these have identif‌ied the nature of this mechanism.

This study examines the role of remuneration consultants in

the remuneration design process in a governance environ-

ment with restrictive guidelines, which are designed to

prevent excessive remuneration. The importance of the pay-

setting process has recently been underlined in recommen-

dations on executive compensation (Bebchuk & Weisbach,

2010; Faulkender, Kadyrzhanova, Prabhala, & Senbet, 2010).

Our study helps us to understand the inf‌luence of consult-

ants in the remuneration design processes, the validity of

their assumed roles in the pay-setting process, and their role

in an environment with restrictive remuneration guidelines.

*Address for correspondence: Leena Kostiander, Department of Accounting, Aalto

University School of Economics, P.O.Box 21210, Helsinki, 00076 AALTO, Finland.Tel.

+358-40-702-4144; E-mail: leena.kostiander@gmail.com

64

Corporate Governance: An International Review, 2012, 20(1): 64–83

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00892.x

Very little research has attempted to integrate social rela-

tionships into questions of remuneration practices, due to

the diff‌iculties in gaining access to interview members of the

board of directors, Chief Executive Off‌icers (CEOs), and

consultants. Since the exchange of consultants and clients

is embedded in ongoing social practices (Devinney &

Nikolova, 2004; Granovetter, 1985) governed by remunera-

tion restrictions, it is essential to focus on what consultants

and clients actually do during the process of remuneration

design in order to understand the client–consultant relation-

ship and its consequences.

To address these issues in corporate governance and

executive remuneration research, this article presents an

exploratory (Scapens, 1990), theory specifying (Keating,

1995), interview-based qualitative (Ahrens & Chapman,

2006; Silverman, 2001) study that adopts a f‌ield study meth-

odology (Hoque, 2006). While the role of consultants has

been extracted from corporate governance and executive

remuneration research, the empirical evidence is used to

explore and understand the inf‌luence of consultants rather

than to test a particular hypothesis concerning the relation-

ship between consultants’ independence and increasing

executive pay.

The research focuses on the richness and depth of detail

(Ahrens & Dent, 1998) following the lead of Bender (2003,

2007, 2011), Bender and Moir (2006), Main, Jackson, Pymm,

and Wright (2008), the injunctions of Eisenhardt (1989) and

Tosi and Gomez-Meija (1989:185), and looks inside the black

box of remuneration design with the aim of exploring and

understanding the process that connects restrictive remu-

neration guidelines, the remuneration consultant business,

and executive remuneration design practices. The overarch-

ing question addressed in this study is: What is the role of

consultants in a remuneration design process in an environment

with restrictive guidelines, and what are the outcomes of these

engagements?

The study examines the executive remunerationprocesses

of 23 state-owned enterprises (SOEs) in which the State of

Finland is a major owner. Of these enterprises, 11 are listed

on the OMX Nasdaq Helsinki and 12 are unlisted. For this

purpose, we had a unique opportunity to conduct inter-

views with the CEOs and chairpersons of the board of these

companies and in four leading executive remuneration con-

sultancy companies within the same market. The Finnish

SOEs offer an interesting research setting, since common

executive remuneration guidelines for these SOEs had

already been introduced in 1999, and had thereafter been

revised several times due to excessive pay scandals in some

of these SOEs during the period 2001–2009.1The remunera-

tion information for these scandals to become public was

provided either by the Finnish tax authority (the transpar-

ency of the level of remuneration concerns all tax payers), by

the State (the level and structure of CEOs of all state-owned

companies) or by the company itself (the level and structure

of the CEOs of listed companies).

This study makes three important contributions. First, it

enriches our understanding of the consultant–clientrelation-

ship and questions the possibility of def‌ining the indepen-

dence of the remuneration consultant based on external

information. Second, the study provides an important

understanding for corporate governance of the ways in

which routine practices can be used to bypass rules, as well

as presenting a rich description of the various consequences

that can result from imposing restrictive guidelines on

remuneration, and shows how consultants may serve execu-

tives regardless of these remuneration guidelines. Third, our

study illustrates how the mechanisms of the consultant

market play a signif‌icant role in the remuneration design

and in generating excessive pay levels. Long-term

consultant–client relationship reduces the eff‌iciency of con-

sultancy markets, making them concentratedand diff‌icult to

enter. These ineff‌icient markets are characterized by a stan-

dardized remuneration design and gradually increasing pay

levels, which are introduced by the dominant consultant,

and a few excessive pay levels introduced by those minor

remuneration consultants attempting to gain a better foot-

hold in the markets. Finally, we suggest means to improve

the design and level of executive remuneration by improv-

ing the shareholders’ role in decision making and by limit-

ing the length of the consultant–client relationship.

This paper proceeds as follows. The next section reviews

the previous research pertaining to the present study. There-

after, the research design and methodology are discussed,

followed by a presentation of the f‌indings of the study. The

f‌indings are then discussed combining evidence from the

f‌ield with theoretical insights from the corporate governance

and general consultant–client literature,and the f‌inal section

concludes the paper.

REMUNERATION PROCESS AND

CONSULTANTS

The explanations for increases in executive pay in the 1990s

and 2000s both in the US and in Europe have ranged from

the equilibrium outcomes of an eff‌icient labor market (e.g.,

Bolton, Scheinkman, & Xiong, 2006; Gabaix & Landier, 2008;

Kaplan & Rauh, 2010; Terviö, 2008) to managerial entrench-

ment (Weisbach,1988), in which managers are considered as

having too much power in setting their remuneration,

thereby leading to excessive pay levels (e.g., Bebchuk &

Fried, 2004, 2005; Jensen & Murphy, 2004; Kandel, 2009).

Managerial entrenchment studies claim that remunera-

tion consultants play an important role in this pay-setting

process. In these analyses (Bebchuk & Fried, 2004, 2005;

Jensen & Murphy, 2004), remuneration consultants, who

have incentives to please executives (i.e., they are reliant on

the executives for current and future business), provide

benchmark information and remuneration package propos-

als for the board of directors, which then raise the total

remuneration of the executives (Bebchuk & Fried, 2004).

Studies focusing on the role of remuneration consultants

indicate that their use increases executive remuneration

(Murphy & Sandino, 2010; Voulgaris et al., 2010).

Apart from offering services on remuneration level and

design, remuneration consultants may also provide a variety

of other remuneration-related services to the board and the

executives. Although consultants are expected to offer inde-

pendent and legitimate advice, the services provided to

executives raise potential conf‌licts of interest (Jensen &

Murphy, 2004). Armstrong et al. (2008) and Cadman et al.

(2010) examined whether a dependence on consultants

“INDEPENDENT” CONSULTANTS’ ROLE 65

Volume 20 Number 1 January 2012© 2011 Blackwell Publishing Ltd