02/23/2010

Compensation Alert: Are You Giving Employees Incentives to Place Your Company at Risk?

It might be a very good time to take a look at your compensation policies and practices to see whether your company might actually be giving employees incentives that put your company at risk. There has recently been regulatory attention to that very question. In the wake of the collapse of the sub-prime mortgage market, there have been numerous questions about why many loan officers at lending institutions were willing to extend home loans to people who did not have the means to repay them or whose houses did not support such loans. One of the most significant answers to this question is: they were often paid more to make more loans, regardless of whether the person taking the loan was qualified or the house was adequate security. Federal Reserve Chairman Ben Bernanke recently said, "Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability." Moreover, the Federal Reserve has issued proposed guidance for banks about how to properly incent employees, from executive suites to the mail room, stating that compensation arrangements should:

• Provide employees incentives that do not encourage excessive risk-taking beyond the organization's ability to effectively identify and manage risk;
• Be compatible with effective controls and risk management; and
• Be supported by strong corporate governance, including active and effective oversight by the organization's board of directors.

This is excellent advice for any company. Companies may be incenting their employees to take excessive risk when they, for example:

• Compensate sales solely on revenues without any regard for income or profitability;
• Do not include clawbacks or hold periods to address compensation obtained by fraud or financial manipulation; or
• Do not require that bonuses or raises be conditioned on compliance with the company's policies and code of conduct.

The SEC is addressing this compensation issue as well. The SEC recently issued rules requiring public companies filing proxy and information statements after February 28, 2010, to make a specific disclosure about risk and compensation in certain circumstances. The SEC already requires companies to disclose the extent that risk considerations are a material aspect of the company's compensation policies and decisions for senior executives. The new rules require disclosure regarding the company's compensation policies and practices for all employees (not just executives) if the company determines that the policies and practices create risks that are reasonably likely to have a material adverse effect on the company. If you are employed by a public entity, the SEC wants your company to consider and discuss:

• Your general design philosophy for incentive policies and practices, how these affect employees most susceptible to those incentives, and whether these lead to those employees taking excessive risks;
• The results of your risk assessment or other reasons that you structured compensation and incentives the way you did;
• How your compensation policies affect employees' actions, which result in short term and long term risks;
• How you will adjust your compensation policies and practices to address changes in your risk profile and how you have done so in the past; and
• Whether you are monitoring your compensation policies and practices to see whether they are meeting your risk management objectives?

In addition, RiskMetrics, a leading proxy advisory firm, recently issued guidance that it may recommend against the re-election of directors of public companies who engage in certain risky pay practices.

Now that the Federal Reserve Bank and the SEC are addressing how compensation can incent employees to take actions that are too risky for their companies, perhaps you should look at it too.