21 September 2010

Compensation and risk: Initial disclosures under new SEC rules and what you need to know about them

The concept of "unnecessary and excessive risks" in compensation has officially arrived.
United States Corporate/Commercial Law
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The concept of "unnecessary and excessive risks" in compensation has officially arrived. It first arose as part of the compensation restrictions for the Troubled Asset Relief Program (TARP) created in 2008 to combat the financial crisis. But it's not just for recipients of TARP anymore. On Dec. 16, 2009, the Securities and Exchange Commission (SEC) brought the concept to all other publicly traded companies with the adoption of final proxy disclosure enhancements effective for the 2010 proxy season.

The additional disclosures relating to compensation and risk represent a major change in the requirements for companies not already falling under the umbrella of TARP. The final rules also leave plenty of room for variance among companies, and our review of initial disclosures has yielded mixed results in both style and substance.

For many companies, it was clear that the disclosures were based on in-depth, thoughtful analyses of the risks associated with their compensation programs. These disclosures included a discussion of the compensation features with the potential to encourage excessive risk taking, such as too much focus on equity compensation, a compensation mix too heavily weighted on annual incentives and steep payout cliffs. Many of these companies also disclosed changes being implemented to mitigate these risks, such as smoother payout curves, linear payout formulas vs. payout "cliffs," and expansion of compensation recovery policies.

Many other companies found no material concerns with their compensation programs, but still disclosed the detailed results of their risk assessments. Some went even further and disclosed why they felt there were no issues with their current programs, outlining the mitigating actions taken to properly align the risk of the compensation program with the risk of the enterprise as a whole.

Conversely, some companies provided exactly what the SEC did not want — generic, boilerplate disclosures. These disclosures often said little more than "we have assessed the risks of our compensation programs and believe that it is not reasonably likely that our programs will have a material adverse effect on the company."

What exactly are the new SEC requirements?
Companies are now required to address their overall compensation policies and practices for all employees if they create risks that are "reasonably likely to have a material effect on the company." The "reasonably likely" threshold parallels that of the Management Discussion and Analysis (MD&A) requirements, which require risk-oriented disclosure of the known trends and uncertainties that are material to the company's business.

So, what does this mean? The SEC has provided some guidance to registrants in the form of examples of situations that could trigger disclosure:

  • A business unit that carries a significant portion of the company's risk profile
  • A business unit with compensation structured in a significantly different way from others
  • A business unit that is significantly more profitable than others within the company
  • Compensation policies and practices that vary significantly from the overall risk and reward structure of the company

Further, the SEC has provided examples of the types of issues that should be discussed if disclosure is required, such as the following:

  • The general design philosophy of the company's compensation policies and practices
  • Considerations in structuring the company's compensation policies and practices
  • How the company's compensation policies relate to the realization of risks in both the short- and long-term, such as clawback and hold policies
  • Material changes made to compensation policies and practices as a result of changes in the company's risk profile
  • The extent to which the company monitors compensation policies and practices to determine if risk management objectives are being met.

The final rules do not require that companies make an affirmative statement that they have determined that the compensation-based risks are not reasonably likely to have a material adverse effect on the company.

So ... now what?
So now that you know what is required, how do you use that knowledge to craft your own disclosures? Grant Thornton has five suggestions for preparing these disclosures:

1. Actually complete a compensation risk assessment
It is clear from reading disclosures that some companies are not completing a risk assessment at all and are simply reporting that their plans are not reasonably like to have a material adverse effect on the company. We suggest that all public companies conduct a compensation risk assessment in some form to confirm that there are no inherent risks.

2. Look at the entire picture
Many companies just look at any potential risk generated from the use of certain performance metrics within their incentive plans. Keep in mind there are other aspects of your compensation programs that may be a breeding ground for risk, such as program design, goal setting and program administration. For example, do you determine incentive plan payouts using a linear payout scale or a "cliff" payout schedule? What level of discretion is allowed within incentive plans? Do you communicate incentive plan opportunities in a timely manner?

3. Even if no issues are found, disclose your results and why you believe there are no potential adverse effects
Even though it is not required to explicitly state that you found no risk issues with your compensation plans, we suggest that all companies have some discussion of their assessment in the proxy. Staying silent on the issue may or may not draw SEC attention, but investors expect upfront and complete disclosure. The absence of a discussion of your assessment may be a sign to some investors that you do not put a high priority on the issue of risk management. Why take the risk of investors getting the wrong idea?

4. Discuss the risk profile of your compensation programs within the context of the overall risk profile of the company
A common misconception related to compensation and risk is that there should be as little risk as possible built into your compensation plans. Depending on your overall company risk profile, this may or may not be the case. Some industries, such as the technology industry, are inherently risky, and if your compensation plans are not in sync with this risk, you will likely not be able to attract or retain the right kind of leaders necessary to make your company successful. The level of risk inherent in your compensation programs should be commensurate with the level of risk inherent in your company and industry as a whole, and your disclosures should reflect this.

5. Take credit where credit is due
Many companies do not provide clear disclosure related to the actions that have been taken to mitigate potential risks in their compensation plans. We believe companies can and should do a better job here. Give yourselves credit for addressing potential risky behaviors with your innovative program design, compensation policies or risk assessment processes. Investors will have a clear picture of the importance you place on risk management and will appreciate your diligence in examining and addressing the issue.

These five tips provide guidelines for preparing your disclosures, but it will be important to consult specialists and perform a careful and thoughtful analysis when actually crafting the disclosures. Companies cannot afford to overlook these new rules. The SEC is very focused on these issues, and more importantly, so are investors.

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.

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