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BoardMatters Quarterly, January 2010 - Risks to compensation policies - EY - United States

BoardMatters Quarterly, January 2010Risks to compensation policies

The escalating debate on executive compensation and risk means companies need to develop tools to understand the balance between risk and reward.

Forward View  by Tapestry Networks

Despite widespread public outrage over how executive compensation programs drove excessive risk taking in financial institutions, recent conversations with audit committee members from a number of industries make it clear that boards are still grappling with the implications.

One audit committee chair remarked, “We’ve opened this up to the full board for discussion. It’s healthy. And it’s evolving.”

All public company boards, regardless of industry, are under pressure to address the issue of compensation. Reinforcing this agenda are the SEC’s new proxy disclosure requirements on the links between compensation and risk, board leadership and board oversight of risk management.

For some boards, assessing how compensation policies affect risk may be a new responsibility. Even in the Compensation Discussion and Analysis (CD&A), disclosures often contain extensive information about compensation levels and policies, but typically say little about the links to risk.

 SEC added new proxy disclosures on compensation

Pay for performance exists because greater risk often means greater reward — for the company and the executive. Examples of evaluation criteria to assess the link between compensation and risk include:

  • The number and type of performance measures used to determine compensation. A higher number and diversity of measures may be less likely to distort behavior.
  • The materiality of compensation payouts and the amount of variable compensation. Payouts that constitute a higher percentage of the company’s earnings, and compensation structures with very high variable pay components, constitute a risk that should be counterbalanced.
  • The extent to which employee evaluations take into account the employee’s risk management practices. Rewarding specific practices (as well as outcomes) encourages better risk management and strengthens a culture of risk awareness.

When it comes to disclosing the link between compensation and risk, oversight may fall to the audit committee even though the disclosure will appear in the CD&A. Some of the activities audit committees are often involved in, usually with input from the external auditor, include:

  • Assessing the quality of earnings and determining the data used by the compensation committees are accurate. An audit committee chair recently stated, “This has become a routine part of my audit committee role. We work with the external auditor and management to get together the raw material for the compensation plan.”
  • Assessing whether the metrics used to assess performance are appropriate and unlikely to encourage the wrong behavior. An audit committee chair said, “Our audit committee approves the compensation plan. We ask, ‘Does this goal make sense or not?’”
  • Reviewing the proxy statement and the related executive compensation disclosures for consistency with other disclosures in the financial statements. The audit committee should help the compensation committee make sure that the amounts disclosed, and the related explanations, are accurate, clear and consistent with other disclosures. As one member said, “There are so many numbers in the CD&A. It would be embarrassing to get this wrong.”

SEC added new proxy disclosures on compensation

The SEC’s amendments require enhanced disclosure about executive compensation and corporate governance to be included in proxy materials. The rules are effective for the 2010 proxy season. The highlights of the amendments that deal with executive compensation disclosures include:1

  • Discussion of the company's compensation policies or practices as they relate to risk management and risk-taking incentives are required to be disclosed to the extent that risks arising from a company’s compensation policies and practices for employees are reasonably likely to have a material adverse effect on the company.
  • The stock and option awards in the Summary Compensation Table (SCT) and the Director Compensation Table (DCT) should disclose the full grant date fair value of equity awards made during the covered fiscal year, and the total compensation column should be recomputed for previous fiscal year(s).
  • Disclosure about the fees paid to compensation consultants and their affiliates who play any role in determining or recommending the amount or form of executive and director compensation, if they also provide other services to the company.

1. "SEC final rule: Proxy disclosure enhancements," Hot Topic, 18 December 2009, Ernst & Young.

Forward View is written by Tapestry Networks. Views expressed by Tapestry Networks are those of Tapestry Networks and not necessarily of Ernst & Young. Tapestry Networks convenes eight audit committee networks sponsored by Ernst & Young that collectively consist of more than 120 individuals, who chair more than 170 audit committees and sit on over 300 boards at some of the world’s most admired companies.

Used by permission of Tapestry Networks. This article may not be reproduced, distributed, displayed or published without the express written consent of
Ernst & Young and Tapestry Networks.


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