Compensation and Risk Oversight by Boards of Directors
Last week, the House of Representatives’ Committee on Financial Services held hearings on “Compensation Structure and Systemic Risk.” The Securities and Exchange Commission is considering similar matters, and Chairman Schapiro has promised that in July the Commission will propose rules requiring additional disclosure regarding how boards consider risks generally and more specifically in the context of compensation setting. Based on this aggressive agenda, we believe that it is prudent for companies to assume that new rules will be in effect for the 2010 proxy season. Companies and their boards, in planning their activities for the remainder of 2009, should therefore contemplate that they will called upon to discuss risk and how, during 2009, they considered it at the board level.
It is noteworthy that at the House hearing, of the eight witnesses, only one -- the General Counsel of the Federal Reserve -- directly addressed how risk might be factored into the establishment of compensation. The remainder, as well as almost all of the Committee members who spoke, for the most part bemoaned how incentive compensation had contributed to the recent financial crisis, but offered no meaningful ideas to address risk considerations. Three noted academicians, Lucien Bebchuk, Kevin Murphy and J.W. Verret, provided good insight into the problem, but no solutions. Nell Minnow, the often outspoken shareholder rights advocate, offered relatively standard, and now relatively well accepted, principles for compensation setting generally, but no significant approach with respect to how to factor risk into compensation setting. Our read from the speakers as a whole: (1) require long-term objectives for incentive compensation with required holding periods that extend beyond vesting, (2) bonus banking, the somewhat nonsubstantive concept (that we do not support) that a portion of an earned bonus should be withheld for some time period to ensure that there were no accounting errors in the original calculation (sounds like more Rabbi Trusts), and (3) less use of asymmetrical incentive compensation, i.e., stock options, with respect to which an executive has little downside and only upside. We believe these approaches do not identify how directors should consider risks except insofar as they utilize compensation tools that force executives to be more risk adverse, or at least more risk aware, because of lengthier measurement and holding periods.
In reality, recognized compensation theory has not yet progressed to the point that risk based approaches to compensation exist in the marketplace. Hence, the contemplated SEC disclosure requirements promise to go beyond current theory.
It is likely that the SEC disclosure requirements will cover not just compensation practice and policies, but also a requirement that a company disclose how its board considers risk generally. In reality, most boards, other than those at financial institutions, do not formally consider risks. Directors arrive with experience and usually have an intuitive understanding of risk, and thus factor that into their decision making. But a formal approach to overseeing the risk in the day to day operations of the business is the exception, not the rule. Except in financial institutions and the largest companies, formal programs to oversee risks by management are rare as well, with most risk managers focusing on insurance coverage, employee safety, and regulatory compliance.
The same people who brought us the concept of internal controls over financial reporting, the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, also have published their views on risk, or more specifically enterprise risk management, or ERM. In a 2004 report entitled Enterprise Risk Management - Integrated Framework, COSO details how ERM systems should work and addresses the common concern that ERM stifles innovation and risk taking. Although COSO’s work has been around for a number of years, only a few academicians and others have chosen to build upon it. Each of the Big Four accounting firms has at least some expertise, and the major consulting firms dabble in this area as well, but there is limited guidance for boards in the context of their relative narrow role of oversight.
As agendas for board meetings are set for this fall, we believe directors should give consideration to a discussion of entity-level risks and the board’s role in overseeing risk. For the largest companies, a formal ERM program may be worth considering, and for smaller companies some abbreviated approach may be warranted. For instance, at a smaller company, the board may simply receive and discuss a report from the internal auditor or management about a company’s “environmental, process and informational risk.” (In the context of ERM, “environmental” includes the financial markers, regulatory regimes and the larger environment in which a company operates.) Risk consideration by boards is a scalable concept, and clearly one size will not fit all.
While formal disclosure rules have not as yet been adopted, it is important at this point that companies at least consider how, during the remainder of 2009, they can perform sufficient activities to provide the basis for company-favorable disclosure in 2010 proxy statements.