Compensation Risk Review

In 2009, the SEC began requiring companies to disclose material risks arising from the compensation programs for all employees. The rationale for this new risk disclosure requirement was the perception that certain forms of compensation arrangements (e.g., uncapped bonus plans, stock options, or commission plans) could create incentives for management to expose the company to risk in the hopes of getting outsized returns. It should be noted that while the disclosure requirement is triggered only when material risks are identified, all companies are also required to search for such risks proactively.

Since 2009, there have been almost no examples of companies disclosing that their compensation programs raise meaningful risk concerns. To date, most companies instead disclose that the company has reviewed its compensation programs and determined that they do not generate a meaningful risk for the company.

What does this mean for you as a compensation committee member? In practical terms, it should mean that some time prior to filing your annual proxy statement, the company should provide the committee with a risk assessment of the company’s compensation programs. This is most often done by a company’s HR and risk staff, often in conjunction with outside compensation advisors. Critical to this assessment is ensuring that the compensation program does not encourage employees, individually or as a group, to make decisions or take actions that will expose the company to significant risk. Most companies address this concern by demonstrating that their compensation programs balance different performance measures over different time frames. Additionally, they demonstrate that there are supporting design features and operational and governance processes to help ensure that undesirably risky behavior will not result in outsized compensation payments. There are a variety of approaches used to conduct the risk review, but they all tend to incorporate several key features as summarized in the table below:

Aspect	Description	Purpose
Summarize Plans	Number of participants Timeframe Performance measures Total spend Low/median/max payouts	Ensures that compensation committee knows relative scope of the various compensation plans
Pay-Mix Analysis	Percentage of pay delivered as salary, bonus, and long-term incentive vehicle (at target and based on actual pay) Broken out by employee level/area of the business	Demonstrates degree of balance in compensation program across different measures and different time frames Demonstrates how pay mix varies with executive’s ability to impact performance
Risk-Mitigating Design Features	Aspects in aggregate or by plan that mitigate risk (e.g., bonus caps, multiple measures, deferrals, ability to exercise negative discretion, stock retention requirements, stock ownership guidelines, clawbacks, etc.)	Ensures compensation committee that plan has “built-in” risk mitigators that reduce the likelihood of risky behavior resulting in outsized compensation
Internal Controls	Process for calculating performance results for plans and determining payouts Auditing process Potential conflicts of interests in control functions, if any	Ensures compensation committee of accuracy of plan payouts and addresses concerns about self-interested parties biasing results
Plan Governance	Role of control function staff in plan design process Role of compensation committee in approving plan designs and overall payouts	Provides comfort to the committee that there is adequate oversight of plans up front in the design process and at year-end in determining payouts

For most compensation committees, the compensation risk review tends to be addressed in a brief discussion, as most companies have few risk concerns related to compensation. However, for compensation committee members operating in the financial services industry, the risk review can involve significant time and effort because these companies are subject to considerable regulatory scrutiny. Because of the severity of the financial crisis and the view that inappropriate incentive compensation design contributed to undesirable employee behavior, large financial services companies (primarily banks) have been required to change processes around incentive compensation design significantly.

At this point, it is unclear if the type of regulatory scrutiny around compensation and risk applied to the financial sector will ever be applied to other industries, as most industries do not have the same potential for systematic risk as financial services.

Key Questions for Committee Members to Ask:

• Do participants in the design play a critical role in assessing performance and determining payouts? If so, what controls are in place to ensure that they act in the company’s interests?
• Do we have any uncapped incentive payments? If so, what processes are in place to avoid windfall compensation for participants in these plans?
• What ability do we have to reduce incentive compensation payments or recover payments already made in the event that an executive has engaged in inappropriate risk-taking?