From the March 2010 issue of Treasury & Risk magazine

Avoiding Pay Pitfalls

The Securities and Exchange Commission saddled companies with a new chore late last year when it announced regulations requiring them to disclose risks associated with compensation plans in their proxies. The timing of the announcement gave calendar-year companies just a few months to put together the disclosures. And the process could push some companies into new territory, since risk hasn't been high on the list of considerations when they put together pay plans.

"I just have not run into anyone yet who says they do a thorough assessment of compensation policies and practices as they relate to risk exposure," says Mat Allen, who leads the ERM services and solutions practice at Marsh Risk Consulting.

While companies already disclose details of the compensation they provide to their top executives, "now we're talking about disclosure of risk relative to compensation for every employee," says Allen. "As a general rule, publicly traded companies don't spend a lot of time analyzing risk relative to broad and specific compensation policies."

Risks in pay plans come down to "root-level behavioral economics," says Allen. "If you're compensating someone and a disproportionate amount of that compensation depend on activities that could, in certain scenarios, reflect poorly on the company, then you need to rethink that compensation."

The new SEC regulations reflect concerns that the credit crisis stemmed partly from problems related to the compensation of employees, in some cases lower-level employees rather than top executives. For example, consultants say, the fact that mortgage brokers wrote mortgages for many people who ended up defaulting could have stemmed from poorly designed pay plans.

Jason Adwin, a vice president at Sibson Consulting, says while companies will be looking at the financial risks involved in plans, there are also parts of plans that could involve reputational risk, like perquisites and severance plans for executives. Companies might use the disclosure requirement as an opportunity to re-examine those elements, he says. "While not being a financial risk, they are irritants to the system."

Companies should start the process of looking at their risks by putting together a list of all the plans they have, Adwin says, adding that big companies could find they have quite a few. "We were talking with a multinational some time ago, and we said the first thing to do is inventory," he says. "When they came back, the list was in the hundreds."

While most companies don't have that many plans, "when you're dealing with a multinational organization, especially if it's decentralized, between executive compensation plans, divisional compensation plans, sales compensation plans, the special contests they have--the list can be daunting," Adwin says.

Once companies figure out how many plans they have, they should assess which entail the most risk by considering factors like the number of participants and the amount of money involved, he says. "Deciding whether they're capped or uncapped is a big point. If they're uncapped, you really don't know what the exposure is."

Dave Johnson, national leader of Ernst & Young's executive compensation practice, says that since the SEC regulations talk about "material adverse effects," companies should keep in mind the concept of materiality. "If a company has 12 business units, the starting point may be those business units that carry a higher percentage of the aggregate profits of the enterprise or that have pay programs that are more creative or complex," he says.

Once a company identifies the plans with the most potential risk, they can dig further to look at factors like plan design, what the plan has paid employees in the past, and how possible payouts compare to base salaries.

Sales incentive plans can often provide salespeople with payouts that are much larger than their base salaries. "That's why I think a lot of organizations will look at the risk in their sales plans," Adwin says. "But because the sales plans have been out there and operating for such a long time, I don't think companies will be qualifying in their proxy statements that they're creating a material adverse risk."

Rose Marie Orens, senior partner at New York-based consultancy Compensation Advisory Partners, recommends that companies set up internal compensation committees to gather information on the risks involved in pay plans and provide that to the board's compensation committee. "Compensation committees are overwhelmed, so they need a robust internal process," Orens says. The internal committee should include representatives from risk, finance, human resources, and legal and business leaders, she says.

In the end, proxies this year may say relatively little about compensation-related risks given the wording of the SEC regulations, which say companies should disclose whether pay plans are "reasonably likely to have a material adverse effect on the company."

"I think when you start reading these proxy statements, there's going to be much less discussion of risk than the SEC envisions or maybe wants," Adwin says.

Arthur Kohn, a partner in the New York office of law firm Cleary Gottlieb Steen & Hamilton, says the new SEC requirement makes it clear that companies whose assessment shows they don't have risks related to their compensation plans "are not required to affirmatively state that."

"Where the regulatory authority very specifically says you only have to make disclosure if you come to conclusion X, there's not a lot of benefit to disclosing that we've come to conclusion Y," Kohn says. "My expectation based on my experience is that very, very few companies are going to come to the conclusion that disclosure is required."

But he notes that in the fall of 2008, John White, then head of the SEC's Division of Corporation Finance, said that if compensation committees considered risk as a factor in their decisions on compensating top executives, they should be discussing that in the compensation discussion and analysis (CD&A) portion of the proxy. "Many companies even in last year's proxy statement did address that issue in the CD&A," Kohn says. "I think we'll continue to see disclosure of that type in the CD&A."

Experts say that the new disclosures are another factor pushing companies to change the way they deliver pay.

"You're going to see a big shift toward much more long-term oriented performance incentive compensation," says Marsh's Allen. "You're going to see senior level executives' compensation married to the broader performance of the company in a much different way than in the past."

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