New Risk Management Requirements for Executive Compensation?

Executive Compensation Blog originally appears on CompensationStandards.com

As I have been discussing over the last several blogs, we expect that the new risk review requirements of EESA Section 111(b)(2)(A) will become best practices for board compensation committees, including outside the world of financial institutions participating in TARP.

EESA Section 111(b)(2)(A) requires that a participating financial institution impose limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the institution during the period that the Treasury holds an equity or debt position in the financial institution.

This is my personal favorite among the new CPP requirements. The Compensation Committee of the board of directors of any institution participating in CPP must meet with the institution's senior risk officers within 90 days of closing of the CPP purchase to review all SEO incentive compensation arrangements to ensure that they do not encourage the SEOs to take unnecessary and excessive risks that threaten the value of the financial institution.

Thereafter, the committee must meet annually with the senior risk officers to review relationship between risk management policies and executive compensation arrangements.

And, the committee must certify compliance with these requirements on annual basis.

One of the first tasks under this requirement is creating the Compensation Committee process required under CPP to ensure that the SEO incentive compensation arrangements do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the financial institution. If the institution has a disclosure committee (which most do), that committee likely has established a process to determine what is material to the company and what is not. That standard could be useful to incorporate here. For example, any transaction, action, matter or issue that would impact net revenues by one percent or more than $X shall come to this committee for potential materiality review. Most financial institutions have a risk committee or group that could provide input on what are material company level risks—including reputational risk. It might be prudent for the institution to define first what their business goals are, then determine how the compensation arrangements can be best suited to achieve those goals, and then determine what strategies would not be appropriate as they could cause behavior to threaten the value of the institution.

Each financial institution faces different material risks given the unique nature of its business and the markets in which it operates. Therefore, the compensation committee should discuss with the financial institution's senior risk officers the risks (including long-term as well as short-term risks) that such financial institution faces that could threaten the value of the financial institution.

We envision that at this meeting the institution's senior risk officers would describe the five to 10 areas of risk that, in their opinion, could threaten the value of the financial institution. The parties then would discuss whether each element of the institution's compensation program could create incentives that encourage SEOs to take unnecessary and excessive risks that threaten the value of the financial institution. One of the obvious items is to avoid asymmetrical incentive structures that have a highly leveraged upside payoff with limited or no downside. When an SEO (or other employee) is insulated from risk, he or she may behave differently that if the SEO were fully exposed to that risk. The committee should keep detailed meeting minutes of these discussions.