Excessive risk taking was one of the major factors that led to the financial crisis of 2007/08. Prior to this period, executives operated nearly without proper supervision by the Boards of Directors (BoDs). They were mainly driven by greed and the unhealthy desire to significantly increase their incentive pay. Most of the incentive schemes did not comply with the basic design principles of defining threshold, target and superior performance and specifying the appropriate pay for those levels of performance. Where the design principles are complied with, the BoDs (through the Remuneration Committee) completely abdicated their responsibilities of setting key performance objectives for executive performance and measuring results against those objectives.
To curb the perceived excessive compensation of executives, various governments have introduced Legislation and Regulations. The United Kingdom Government introduced the super tax on Executive bonuses. The United States has since implemented the claw back provision, which is meant to deter the executives from excessive risk taking. In other jurisdictions, shareholders are demanding a say on executive compensation. This article examines some of the key developments on Executive compensation and the way forward.
Some Key Developments
- Risk and Executive Compensation
It has become critical for every company to conduct a periodic assessment of whether its executive compensation plan creates a significant risk. Companies will need to integrate their risk review into the audit cycle. Consequently, both the Board Audit and Remuneration Committees should be involved in this process. It may also be a leading-edge practice if companies seek independent review of the risk process and its findings as part of the annual board appraisal exercise.
The assessment should determine potential risks that can materially affect the business of the company and its ability to survive in a very competitive environment. Focus should be on how the current compensation plan can be manipulated by unscrupulous executives to serve their interest. It may therefore be necessary to review the key metrics and design features of the incentive scheme and assess the controls in place to mitigate risk.
- Claw Back Policy
Some compensation professionals are of the opinion that companies should develop and implement a claw back policy. Under such policy, companies can recover any incentive compensation, which was erroneously awarded, as a result of account restatement due to non-compliance with any financial, accounting and regulatory requirements.
Companies implementing such policy will need to resolve two potential thorny issues: which executives (all the executives or the CEO and CFO?) should be subject claw back, and the time period to be covered. One possible consequence of implementing a claw back policy is for newly hired executives to demand more guaranteed-based compensation rather than accept incentive compensation; especially where there are concerns about the 'accuracy' of the company's published financial statements.
- Severance Pay
Globally, executives are compensated at the point of disengaging from their companies for "good" reasons. The justification for severance pay is to encourage the executives to take longer-term value increasing yet risky investment on behalf of the company. In recent times, shareholders have seen this as a reward for failure and are increasingly questioning the rationale and size of such payout. In the United States, some shareholders have instituted various court cases to challenge the quantum of the discretionary payout to executives that were sacked before the expiration of their contracts.
One way of managing potential disputes is to define and incorporate the size and conditions for receiving separation pay into the employment contracts or the compensation policy, which would have been approved by the shareholders. It is also important that the size of such awards reflect global best practices.
- Shareholders' say on Executive Compensation
Debate has been ongoing in some jurisdictions as to what role shareholders should play with respect to Executive compensation. Those in favour of shareholders' say on executive compensation have argued that such an arrangement will encourage the Remuneration committee to properly review pay packages, promote board accountability and improve the design of Compensation plans. Those against such an arrangement are of the opinion that it may undermine the ability of the Board to exercise sound judgement and may potentially be disruptive. There are merits in both arguments. It therefore seems that some sort of compromise may be necessary to resolve this issue.
Executive compensation will continue to attract close scrutiny of both regulators and shareholders. Companies will continue to feel the pressure to change the design and structure of executive compensation plans. Possible changes may include:
- Implementing a pay mix that focuses less on incentive compensation,
- Modifying performance measures to reflect more of operational rather than financial performance,
- Introducing a deferred bonus arrangement which will enable companies hold back compensation that could be subject to a claw back. For this to be attractive to executives, companies may need to provide a matching contribution.
- Reducing the incentive values while increasing the performance period.
One thing is clear: the era of excessive risk taking is over. While companies may not have the free hand to fix executive pay as before,it is important that they are able to attract, motivate and retain executives that can help them compete in an increasingly challenging business environment. BoDs need to ensure that they discharge their responsibilities effectively and should consider engaging the services of tested remuneration professionals to manage any potential risk from executive compensation plans.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.