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

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