Compensation and Reputation Risk Under New SEC Disclosure Rules

Written on January 11, 2010 by

The Securities and Exchange Commission's (SEC) new disclosure rules mandate disclosure of material adverse risks created by compensation policies. A prominent corporate attorney's recent analysis of compensation program design and risk focuses on process, but completely ignores reputation risk.

Reputation risk based on the amount of compensation, regardless of adherence to established procedures, is "reasonably likely" to create risk that is likely to have a material adverse effect on the company. Therefore, boards of directors must consider reputation risk created by compensation packages.

Do Boards of Directors Knowingly Approve Risky Compensation Programs?

Edward Greene, partner at Cleary Gottlieb Steen & Hamilton LLP, states:

We are skeptical that any compensation committee knowingly approves compensation programs and arrangements that place the company at material risk, and insofar as the standard imports a “risk factor”-type threshold, we question whether it will elicit meaningful disclosure.

(emphasis added)

The assertion that compensation committees of boards do not "knowingly" approve compensation programs that create risk is based on a narrow view of what constitutes material risk. To summarize, Mr. Greene argues that the compensation committee should make sure that compensation and performance are rationally related, and that engaging in a process-based review of compensation and risk adequately balances risk and reward in disclosure decisions.

Large Compensation Packages Create Reputation Risk

But does completing such a review reasonably ensure that risks surrounding compensation programs have not been knowingly approved?

No, because a process-focused review of compensation program fails to account for adverse public reaction to compensation packages. Banks like Goldman Sachs, JP Morgan Chase, and Bank of New York Mellon are concerned about the reputation risk they will have to deal with after handing out large bonuses for 2009. The looming question is: How large should bonuses be?

Banks are worried about public backlash, government investigations, and heightened regulatory scrutiny over bonuses. In 2009, New York Attorney General Andrew Cuomo asked banks to provide details about executive compensation. Great Britain has imposed a special tax on bankers' bonuses, and Ohio Congressman Dennis Kucinich is drafting legislation to do the same.

Jon Reed, former Citigroup chairman, cautions that large huge bonuses will make it difficult for the industry to improve its reputation and regain the public's trust:

“There is nothing I’ve seen that gives me the slightest feeling that these people have learned anything from the crisis,” Mr. Reed said. “They just don’t get it. They are off in a different world.”

Managing and Optimizing Reputation Risk

This raises the question: Is reputation risk material? Although reputation may not directly impact the bottom line, there are indirect costs in the form of reputation, trust, and regulation. In this sense, reputation risk is concrete and must be managed.

Even better, directors can optimize reputation risk by addressing public concerns about hefty compensation packages. In this context, risk optimization involves going beyond process compliance and taking steps to deal with compensation amounts.

Some banks are taking the cue and attempting to optimize risk around compensation. Goldman Sachs reduced the percentage of revenue earmarked for compensation from 50% to 48%, and JP Morgan's investment bank decreased the percentage from 40% to 37%.  And Goldman Sachs may broaden a program under which top executives must contribute a percentage of their income to charity.

Conclusion

Whether a company should disclose reputation risk created by compensation programs depends on its industry and exposure to public scrutiny and regulation. Regardless of SEC disclosure requirements, boards of directors need to keep reputation risk on their radar screens because reputation is difficult to burnish once it is injured.

Douglas Y. Park

Twitter: @DougYPark

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6 Comments - Leave a comment!
  • Doug Chia

    You ask good questions about reputational risk as it relates to compensation and the new SEC disclosure requirement, but once you go down this road, here are just a few questions companies would have to answer that may be impossible for anyone to answer: (1) How do you measure the risk of reputational harm in order to determine whether there is a reasonable likelihood that the design of a compensation plan would lead to activity that creates material reputational harm? (2) Is it ever reasonably likely that compensation would be structured in a way that would incentivize someone to break the law, thus causing material reputational harm? (3) Does the existence of a compliance training program sufficiently mitigate the risk of material reputational harm to take it down from the reasonably likely level? (4) If an employee breaks the law and ends up causing material harm to the company's reputation, to what extent was that employee actually incentivized by the possibility of gaining additional compensation, as opposed to just receiving a job promotion? What if the real driving force behind breaking the law had nothing to do with compensation or promotion and was more a factor of cultural norms?

  • Doug Chia

    You ask good questions about reputational risk as it relates to compensation and the new SEC disclosure requirement, but once you go down this road, here are just a few questions companies would have to answer that may be impossible for anyone to answer: (1) How do you measure the risk of reputational harm in order to determine whether there is a reasonable likelihood that the design of a compensation plan would lead to activity that creates material reputational harm? (2) Is it ever reasonably likely that compensation would be structured in a way that would incentivize someone to break the law, thus causing material reputational harm? (3) Does the existence of a compliance training program sufficiently mitigate the risk of material reputational harm to take it down from the reasonably likely level? (4) If an employee breaks the law and ends up causing material harm to the company's reputation, to what extent was that employee actually incentivized by the possibility of gaining additional compensation, as opposed to just receiving a job promotion? What if the real driving force behind breaking the law had nothing to do with compensation or promotion and was more a factor of cultural norms?

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  • http://www.dypadvisors.com Doug Park

    Hi Doug,

    Thanks for reading and for your thought-provoking comments.

    (1) How do you measure the risk of reputational harm in order to determine whether there is a reasonable likelihood that the design of a compensation plan would lead to activity that creates material reputational harm?

    To measure the risk of reputational harm, you could develop a probability model based on a logarithmic function. In building the model, you would need to determine the factors associated with the risk of reputational harm. Factors might include the company’s industry (e.g., political economy), cash versus equity mix, options timing, clawbacks, and others. The model should include indicators of moral hazard.

    (2) Is it ever reasonably likely that compensation would be structured in a way that would incentivize someone to break the law, thus causing material reputational harm?

    The recent stock options backdating cases provide one example where compensation structure can incentivize someone to break the law.

    I would emphasize that material reputational harm can occur without someone breaking the law.

    Banks are concerned about how government investigations, taxes, and regulations may their reputation. Yet, banks are perhaps equally worried about negative public reaction to large bonuses. Negative public reaction, which may or may not result in governmental action, causes material reputational harm when it reduces the public’s trust.

    Negative public reaction played out in today’s Financial Crisis Commission hearings. Lloyd Blankfein, CEO of Goldman Sachs, defended his company’s compensation packages. Other bank CEOs, with the exception of Jamie Dimon of JP Morgan Chase, argued that more government regulation is not needed.

    (3) Does the existence of a compliance training program sufficiently mitigate the risk of material reputational harm to take it down from the reasonably likely level?

    I am not sure why the mere existence of a compliance training program would be sufficient to mitigate the risk. It depends on the substance of the program. Properly implemented, though, a compliance training program could achieve that goal.

    If the compensation plan’s structure provides strong incentives for breaking the law, compliance training may not have much of a mitigating effect.

    (4) If an employee breaks the law and ends up causing material harm to the company’s reputation, to what extent was that employee actually incentivized by the possibility of gaining additional compensation, as opposed to just receiving a job promotion? What if the real driving force behind breaking the law had nothing to do with compensation or promotion and was more a factor of cultural norms?

    To answer the first question, we would need to look at the employee’s compensation package.

    If the company’s cultural norms were the driving factor, then management needs to take action. Compliance training is one option, but it must be more than a perfunctory attempt to modify the company’s cultural norms.

    That said, the board might consider whether the compensation plan helped shape a cultural norm of breaking the law. If it concludes in the affirmative, then it should ask what can be done because the company will likely suffer reputational harm if the reason is the company’s culture. What company wants to be known for having a culture of breaking the law?

    If societal norms were the driving factor, the company should still address its own problems.

    Doug

  • http://www.dypadvisors.com Doug Park

    Hi Doug,

    Thanks for reading and for your thought-provoking comments.

    (1) How do you measure the risk of reputational harm in order to determine whether there is a reasonable likelihood that the design of a compensation plan would lead to activity that creates material reputational harm?

    To measure the risk of reputational harm, you could develop a probability model based on a logarithmic function. In building the model, you would need to determine the factors associated with the risk of reputational harm. Factors might include the company’s industry (e.g., political economy), cash versus equity mix, options timing, clawbacks, and others. The model should include indicators of moral hazard.

    (2) Is it ever reasonably likely that compensation would be structured in a way that would incentivize someone to break the law, thus causing material reputational harm?

    The recent stock options backdating cases provide one example where compensation structure can incentivize someone to break the law.

    I would emphasize that material reputational harm can occur without someone breaking the law.

    Banks are concerned about how government investigations, taxes, and regulations may their reputation. Yet, banks are perhaps equally worried about negative public reaction to large bonuses. Negative public reaction, which may or may not result in governmental action, causes material reputational harm when it reduces the public’s trust.

    Negative public reaction played out in today’s Financial Crisis Commission hearings. Lloyd Blankfein, CEO of Goldman Sachs, defended his company’s compensation packages. Other bank CEOs, with the exception of Jamie Dimon of JP Morgan Chase, argued that more government regulation is not needed.

    (3) Does the existence of a compliance training program sufficiently mitigate the risk of material reputational harm to take it down from the reasonably likely level?

    I am not sure why the mere existence of a compliance training program would be sufficient to mitigate the risk. It depends on the substance of the program. Properly implemented, though, a compliance training program could achieve that goal.

    If the compensation plan’s structure provides strong incentives for breaking the law, compliance training may not have much of a mitigating effect.

    (4) If an employee breaks the law and ends up causing material harm to the company’s reputation, to what extent was that employee actually incentivized by the possibility of gaining additional compensation, as opposed to just receiving a job promotion? What if the real driving force behind breaking the law had nothing to do with compensation or promotion and was more a factor of cultural norms?

    To answer the first question, we would need to look at the employee’s compensation package.

    If the company’s cultural norms were the driving factor, then management needs to take action. Compliance training is one option, but it must be more than a perfunctory attempt to modify the company’s cultural norms.

    That said, the board might consider whether the compensation plan helped shape a cultural norm of breaking the law. If it concludes in the affirmative, then it should ask what can be done because the company will likely suffer reputational harm if the reason is the company’s culture. What company wants to be known for having a culture of breaking the law?

    If societal norms were the driving factor, the company should still address its own problems.

    Doug

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