Checking on Risky Pay

The SEC has expanded proxy disclosure requirements for companies with risky bonus plans. Will compensation committees crack down as a result?

If a compensation policy could be harmful to a company’s health, the Securities and Exchange Commission wants investors to know about it.

Last week the regulator approved a laundry list of new disclosure rules that will apply to virtually all proxy statements issued next year. The centerpiece of the new rules is a mandate that companies explain the risks that their compensation practices pose if they are “reasonably likely to have a material adverse effect on the company.”

A carryover from the requirements originally imposed on recipients of the Troubled Asset Relief Program, the rule says companies must consider compensation risk for all employees, not just executive officers. “Accountability is impossible without transparency,” said SEC chairman Mary L. Schapiro in a press release accompanying the decision.

In the rule, the SEC listed a number of situations that could potentially trigger the need for an explanation, such as a business unit that is significantly more profitable than other units or has a very different compensation structure from other parts of the company. The disclosure would be separate from the Compensation Discussion and Analysis, which deals specifically with executives. It would not be required for smaller companies, or those that deem no such risks exist.

Experts say that in the long term, the new disclosure may push boards to be more conservative with incentive compensation. For example, more payouts could hinge on meeting long-term goals instead of annual ones, in ways similar to the five-year vesting period Goldman Sachs is using for the all-stock bonuses it is giving top executives this year. In a recent Webinar sponsored by law firm Foley Lardner, experts said other structural changes may be coming as well.

“We expect to see clawbacks that would apply for less-than-stellar performance in subsequent years, rather than simply for financial restatements, and share-ownership requirements will continue to be important, among other items,” said Jay Rothman, chair of Foley Lardner’s transactional and securities practice.

The good news is that “for a number of companies, this is not going to be a huge undertaking,” said Rothman, who expects the burden to be very industry-dependent. While a number of employees could put a financial-services company at risk, not many could at a manufacturing company, he pointed out.

At least one CFO isn’t particularly concerned about the new requirement. “It’s going to be an extension of enterprise risk management into compensation,” says Jeff Burchill, CFO of commercial property insurance company FM Global. “This is something that should be done anyway.”

In the short term, executives and board members must decide how they will assess the risks that current incentives pose and whether or not they need to disclose them. The first step is to inventory all incentive plans, said Michael Kesner, a principal in Deloitte Consulting’s human capital practice, during the Webinar. The next step is to assess the negative behavior that such plans could create.

Along those lines, it’s important to make sure that executives “don’t look at materiality of payouts of plans, [but rather] look at the materiality of behaviors you’re incenting,” said Kesner. “Don’t be lulled into a false sense of confidence just because the plan has a very small pool.”

Other aspects of the new rules will also add to the proxy disclosure burden. Firms must now include more information about the backgrounds and qualifications of directors and nominees, catalog any legal actions that directors and officers are involved in, and explain the board’s leadership structure, such as why the CEO is also chairman.

Regarding executive compensation, the table listing various elements of pay will change slightly. Under the new rule, companies will report the value of options when they are awarded to executives (the aggregate grant-date fair value), instead of reporting the annual accounting charge as currently required.

Finally, a company must also disclose if it pays its compensation consultant more than $120,000 for any other type of work within the company, to illuminate any potential conflicts of interest such consultants may face.

 

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