Professional Documents
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Over the past year, the exposure of major financial institutions to a rapidly weakening U.S. housing market heightened the aversion to risk in global capital markets. These concerns have cascaded into a full-fledged financial crisis the precise extent and impact of which is still unknown. While some banks and financial intermediaries have filed for bankruptcy or otherwise rushed into rescue deals with competitors or national governments, such loss of confidence escalated in recent weeks to an unprecedented liquidity crisis.
he Conference Boards most recent Leading Economic Indicators and Consumer Confidence Index data show limited access to capital is weighing on consumer spending and employment trends. Ultimately, the deterioration of the credit markets affects many business sectors and the wealth of not only the United States, but the global community as a whole.1 What should the board of directors of a public company do in critical times like these? This report highlights a series of pressure points for boards to consider in addressing these events. Each pressure point includes practical actions that can be followed to help ensure that, even in this turbulent economic environment, directors fully meet their fiduciary responsibilities toward shareholders.
1 For a discussion of the current economic indicators, see Bart van Ark,
Update on the U.S. and Global Economies. Comments on The Conference Board Forecast, October 8, 2008, available at www.conferenceboard.org/pdf_free/economics/2008_10_08.pdf
It is believed thataside from a declining housing market, which remains a somewhat cyclical and unavoidable phenomenonthe problems faced today by some U.S. financial institutions are due to inadequate risk oversight 2 and a broken link between pay and performance.3
2 Recent research conducted by The Conference Board shows that, while
companies report progress in developing an enterprise-wide risk management program, it has yet to become embedded in their strategic thinking and cultures. Most developments have occurred in early stage efforts, such as compiling a risk inventory and selecting a set of assessment metrics. However, there is empirical evidence that corporate boards are still developing an oversight process to tie the information on risk they receive through the program to their strategy-setting activities. See Ellen Hexter, Risky Business. Is Enterprise Risk Management Losing Ground?, The Conference Board, Research Report, 1407, 2007.
3 Over the last two decades, The Conference Board has documented the
expansion of components of compensation packages that do not relate to corporate revenues. See Linda Barrington, Kevin F. Hallock, and Lisa L. Hunter, The 2007 Top Executive Compensation Report, The Conference Board, Research Report 1422, 2008. (The 2008 Top Executive Compensation Report will be published in winter 20082009.)
In light of the financial crisis, boards of directors should consider reassessing the adequacy of their companies risk management programs, including the impact of the executive compensation policy on the risk culture of the organization. This report focuses on these important issues. The actionable items described below are not meant to be prescriptive. Instead, they are intended as guidelines for a pragmatic boardroom discussion on how to better align the financial interests and the motivational drivers of executives with the interests of long-term shareholders. As such, they are worth considering for any business corporation, not only those in the financial sector.
that business deliberations are made in light of widely recognized corporate governance standards.5 Clearly, enterprise risk management (ERM) has by now developed into a significant body of organizational practices documented by reputable self-regulatory organizations around the world. 6 As best practices, they do matter and, arguably, could be used as a standard of judicial review of fiduciary liability. Nonetheless, the financial disruptions of the last few weeks reveal that many business organizations were unprepared to effectively assess and manage their risk exposure. Risk management processes did formally exist but were often fragmented and left to the sensitivity of functional managers or the initiative of single business unit risk owners. Most important, since they were not driven and overseen by the board, they were not commensurate with a comprehensive vision of the enterprises long-term goals. The Governance Center recommends that corporate directors, in light of the current financial turmoil, reassess gaps and vulnerabilities in existing risk management solutions implemented by the company. In particular, the board should:
Review and approve an inventory of risks and fundamental risk management parameters (such as risk measurements, risk appetite, and tolerance levels) as part of the annual business plan submitted by senior executives. From a corporate governance standpoint, the important role of the board of directors in the compilation of a risk inventory cannot be overstated. In this phase, board members should oversee the process adopted by senior management to identify and prioritize risks. It should be understood that if a major risk is (accidentally or deliberately) excluded from this analysis, the rest of the ERM program will suffer a major deficiency.
5 See Chancellor Chandlers dicta in In re The Walt Disney Co. Derivative Litig.,
Cons. C.A. No. 15452, 2005 Del. Ch. LEXIS 113 (Del. Ch. Aug. 9, 2005), then upheld by the Delaware Supreme Court (In re Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. Supr. June 8, 2006)). Also see Stone v. Ritter, 911 A.2d 362 (Del. 2006).
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H H
regulatory and compliance risks; and other market risk, including the impact of a potentially deep recession (marked by severe declines in consumer spending abilities and production levels) on business operations.
liquidity risks, including cost of capital; interest rate, currency, and commodity price volatility risk; possible asset impairment resulting from fairvalue accounting (e.g., on securities and other marketable investments; on goodwill, patents, and other intangibles; on pension plan assets and other employee benefit programs, etc.); financial reporting risks, especially due to uncertainties regarding the application of accounting principles to securities the company may hold on its balance sheet and whose value is correlated to rapidly weakening underlying assets (e.g., mortgage-backed securities);
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business unit managers, may voice at the executive and board level any concern expressed by lower organizational levels, as well as provide feedback on the effectiveness of the program. Simultaneously, the board should assess the strength of existing codes of conduct and the anonymity of whistleblowing practices to encourage constructive criticism.
2. the workload of existing board committees; and 3. the quality of the information flow between board
members and management.
9 See Joann S. Lublin and Cari Tura, Anticipating Corporate Crisis. Boards
Intensify Efforts to Review Risks and Dodge Disasters, Wall Street Journal, September 22, 2008, reporting that, according to regulatory filings, in 2006 and 2007, when Lehman was amassing mortgage-backed securities and questionable real estate loans, the risk committee of its board met only twice per year.
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overseeing risk management and executive compensation: pressure points for corporate directors
Moreover, an Equilar study found that, in 2007, while the median value of bonuses tied to performance fell 18.6 percent, overall CEO total pay grew 1.4 percent to a median amount of $1.41 million as a result of compensation components that do not depend on corporate results.13 For these reasons, issues of pay for performance have been drawing attention in shareholder meetings and due to an increased public sensitivity to the apparent causes of the financial turmoilare likely to take center stage in the upcoming proxy seasons. In particular, during the last few years, activist shareholders have been pushing for the adoption of bylaw amendments granting non-binding shareholder ratification of executive compensation (so-called say on pay) and contractual claw back clauses to recoup bonuses and other incentive-based rewards in the event of financial restatements. Legislative reform proposals14 introducing say on pay have been endorsed by President-elect Barack Obama,15 while bonus recapture provisions were included in the relief program signed by President George W. Bush on October 3, 2008, and granting the Treasury Department the necessary funding to purchase troubled assets from financial institutions.16 Finally, as a result of the greater transparency on compensation imposed by new U.S. Securities and Exchange Commission (SEC) rules,17 investors have been increasingly willing to withhold support from board members in uncontested elections in those companies for which pay for performance appears to be a concern.18
Because of the variety of interests that should be balanced while negotiating a compensation package, the integrity and independence of the compensation committee of the board is crucial. However, recent studies document that in the last two decades executive compensation has grown substantially faster than corporate earnings and, in some cases, has rewarded decisions that turned out to be detrimental to long-term holders. For example, an analysis published in 2008 by the Wall Street Journal in collaboration with ERI Economic Research Institute shows that the median salary of the top executive of a Standard & Poors 500 company increased 20.5 percent from a year earlier compared to a median corporate revenue growth of only 2.8 percent.12
13 Jeff Nash, CEO Pay, Financial Week, March 28, 2008. 14 See H.R. 1257, which was approved by the U.S. House of Representative on
April 20, 2007. Also see S. 2866.
11 See, for example, Steve Lohr, In Bailout Furor, Wall Street Pay Becomes a
Target, New York Times, September 23, 2008.
incentives to senior executive officers to take unnecessary and excessive risks that threaten the value of the financial institution.
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overseeing risk management and executive compensation: pressure points for corporate directors
The Governance Center recommends that compensation committees review their companies compensation policy to reinforce, where necessary, the notion that compensation reflects performance as well as to introduce forms of accountability for any risk-taking that is unjustified based on the approved long-term business strategy. However, the boards ultimate responsibility is to weigh principles of pay for performance against the need to participate effectively in the market for human capital. In particular, compensation programs should be designed to address: How to establish a strong link between the variable
portions of total compensation and the economic objectives of the corporation. Motivational drivers, managerial culture, and behavioral incentives should be central topics of discussion. Committee members should fully understand the effects of each single component of the pay package (i.e., base, bonuses, equity-based incentives, benefits and perquisites, deferred compensation, and severance) on the whole compensation arrangements and be persuaded that: (1) the balance between the base salary and the other components is appropriate, and (2) the intended effects of the variable components cannot be distorted by managers to pursue opportunistic behaviors.
should guard against using financial metrics that are heavily dependent on the chosen method of accounting or that lend themselves to other types of machinations. Experience shows that, in most circumstances, CFROI and OCF are preferable to traditional metrics, such as return on equity (ROE) and earnings per share (EPS), which can be affected by revenue and expense recognition or manipulated through stock buybacks at the end of the period.
The compensation committee should consider adopting and motivating formal guidelines on incentive-based compensation for disclosure to shareholders.
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executive compensation and the salary levels of other employees. Specifically, wealth analyses may prove useful in determining the need for severance and retirement benefits, whereas equity indicators help ensure that resources are not gravitating to the top, thereby creating a retentionand possibly a succession problem. The compensation committee should also report on compensation fairness to the full board so that all directors have an understanding of the magnitude of total potential payouts to executives, particularly to the CEO, in such unique or unusual circumstances as an extreme increase or drop in the companys share price or in the event of a merger, acquisition, or going-private transaction.
knowledge of the challenges of the job market and possibly induce directors to act conservatively in the search for new talent.
19 Also see Commission on Public Trust and Private Enterprise, Findings and
Recommendations, The Conference Board, Special Report 4, 2003, p. 10.
20 Ibid.
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The Governance Center believes that the board of directors, as part of its effort to strengthen the integrity of the negotiation process, should also: Regularly assess independence standards and
performance of compensation committee members.
The compensation committee should be prepared to discuss these issues on an annual basis as part of the periodic review of the effectiveness of the compensation program.
The foregoing list of issues is not intended to be an exhaustive list of risks and other considerations resulting from current market conditions. In particular, companies facing financial difficulties will have a range of other issues to consider, which are beyond the scope of this report. Regulated entities will have additional issues, which also are beyond the scope of this report. This report is not intended to provide legal advice with respect to any particular situation and no legal or business decision should be based solely on its content.
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Acknowledgement
The author would like to thank The Conference Board Governance Center Advisory Board members for their contribution to the discussion of these issues. In addition, the author is grateful to Tony Galban, Alan Rudnick, and Yale Tauber for their comments and suggestions.
For more information on The Confernce Board Governance Center, please contact: Paul DeNicola, Ph.D., Associate Director, Governance Center, at 212 339 0221 For more information on this memorandum please contact: Frank Tortorici, Director, Public and Media Relations, at 212 339 0231
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overseeing risk management and executive compensation: pressure points for corporate directors