“Risky Business”: The Expanding Risk-Oversight Responsibility of Compensation Committees

5 Min Read By: John Cannon

IN BRIEF

  • In the United States, the past 15 years have witnessed a parade of corporate crises and scandals in which the conventional wisdom holds that poorly designed compensation incentives played a major contributing role.
  • Accordingly, significant pressure has been placed on boards of directors and, in particular, compensation committees to ensure that incentive compensation features and overall plan design do not promote excessive short termism and risk-taking that could harm the long-term interests of the corporation and its shareholders.
  • The result: independent directors serving on compensation committees are burdened with more responsibilities than ever before, and many compensation committees are burdened with risk-mitigation-based oversight responsibility for the design of incentive compensation not just at the executive officer level, but further down in their organizations.

Overview of a Compensation Committee’s Basic Responsibilities

The listing requirements of both NASDAQ and the New York Stock Exchange mandate that a committee of independent, nonemployee directors must have principal responsibility for the compensation of CEOs and other executive officers. Accordingly, as part of their basic responsibilities, compensation committee members regularly will be engaged in assessing the performance and determining the pay levels of executive officers, the design of the compensation programs applicable to them, and the contractual arrangements governing their employment. The compensation committee members typically also are responsible for formulating share ownership guidelines, compensation clawback policies, insider-trading and anti-hedging policies, and approving compensation-related proxy disclosure.

The compensation committee also is tasked with assessing the link between compensation and enterprise risk management. In that regard, since 2009 the SEC in Item 402(s) of Regulation S-K under the Securities Act of 1933 (as amended) has required a company to disclose whether “risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant” and, if so, to disclose the compensation policies and practices as they relate to risk management. As a practical matter, this has led companies to engage in a careful risk assessment of their compensation programs, not limited to those applicable to executive officers. Given the ultimate oversight duties of a board of directors, and the specialized knowledge possessed or developed by members of the board’s compensation committee, it is unsurprising that compensation committees are frequently given the principal responsibility of overseeing the process of ensuring that compensation design throughout the organizations does not encourage inappropriate risk-taking.

The Link Between Compensation and Risk

Following the corporate scandals of the early 2000s (e.g., Enron, WorldCom, and Global Crossing), corporate-governance experts, academics, the media, elected officials, regulators, and the general public began to focus on the possible role that executive compensation played in incentivizing inappropriate behavior. In particular, many argued that the excessive risk-taking that led to such scandals was fueled by an inordinate management focus on short-term stock price gains that was tied to the overuse of stock options. The basic insight of these critics was that stock options had at least two major drawbacks. First, the flexibility as to timing of exercise allows executives to benefit from short-term stock price increases that do not necessarily reflect the creation of long-term shareholder value. Second, stock options provide an asymmetrical incentive, with the holders benefiting from stock gains but not losing any investment through stock price losses. As a consequence, all things being equal, executives with substantial stock-option holdings are more likely to favor high risk/reward investments or other corporate actions that could generate significant stock increases in the short-term (that could be captured by option exercises by those executives), but might have significant long-tail risk.

Critics recognized that there were substantial accounting and tax incentives for corporations to use stock options, and their concerns led to a revisiting of the accounting treatment of stock options and ultimately to the adoption of FAS 123R (now redesignated as ASC 718), which requires the expensing of the grant date value of stock options determined by using Black Scholes or other option valuation methodology. This led to a reduction in the use of stock options and an increased utilization of restricted stock and restricted stock units coupled with shareholding requirements—the thought being that these instruments would better align executive incentives with those of the corporation and its shareholders over the longer term, and dis-incentivize executives from excessive risk-taking.

At most public companies, compensation committees became responsible for ensuring that the design and mix of executive officer compensation elements did not create incentives for unacceptable risk-taking, and approved the annual disclosure under Item 402(s) of Regulation S-K of the Securities Act of 1933 (as amended) regarding whether the “risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant.”

Expanding the Committee’s Role

Until recently, most compensation committees focused their compensation risk assessment exclusively on the remuneration of executive officers and, in regulated financial institutions, “significant risk-takers” (i.e., the individuals who are in the position to make significant bets of company capital). The exceptions tend to be in certain industries—in addition to financial services, the pharmaceuticals and medical-device industries are the sectors in which public companies currently are somewhat more likely to involve the independent directors in overseeing broader employee incentives. Unfortunately, most companies in which compensation committees currently are engaged in overseeing the risk assessment of rank-and-file employee compensation arrangements do not provide sufficiently detailed disclosures to describe differences in approach in any depth.

More recent events, particularly the sales practices controversy at Wells Fargo, have illustrated for corporations more generally that the conduct of relatively low-level employees can have a huge reputational impact on companies, and that the role compensation may play in incentivizing inappropriate conduct cannot be overlooked. Trusting management to police incentive arrangements of rank-and-file employees without director-level oversight seems somewhat naïve in 2017.

As a result, we can expect more and more compensation committees to undertake additional oversight responsibility over compensation arrangements applicable to employees below the executive officer level. Although this is unlikely to involve retaining day-to-day decision making about rank-and-file incentives, one can expect that companies will establish structures whereby management will be required to report regularly to compensation committees about the design of such incentives and safeguards protecting against their potential for promoting inappropriate conduct. Companies also may be more likely to highlight such oversight in their public disclosures. It should be instructive to observe the different models of risk director oversight of rank-and-file incentives—and perhaps consensus best practices—that will be developed in the coming years.

ABOUT THE AUTHOR

New York City, NY

John Cannon

John Cannon is a partner in Shearman & Sterling’s Compensation, Governance and ERISA Group and co-chair of the firm’s Corporate Governance Advisory Group. In his practice, he focuses on all…

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