October 15, 2010

Compensation and Risk: Keeping up with the Joneses

Mike Melbinger noted yesterday on his blog that the disclosure of the relationship between compensation and risk will be an important element of consideration for ISS and investors in the upcoming proxy season, so now is the time to start thinking about how to “do it right.” One thing that I have found helpful in benchmarking risk assessments has been the plethora of data points that can be gleaned from the hundreds of comments letter responses that have been submitted on EDGAR in response to the Staff’s comment asking companies to explain what they did to reach their conclusions as to whether disclosure was required under Item 402(s) of Regulation S-K (which effectively resulted in disclosure that was not otherwise required). In most cases, these responses talk about a process whereby:

– compensation programs were reviewed, particularly focusing on incentive compensation programs;

– program features were identified which could potentially encourage excessive or imprudent risk taking;

– the specific business risks that related to such features were identified;

– mitigating factors (if any) were identified;

– an analysis was undertaken to determine the potential effects of the risks and the impact of the mitigating factors; and

– an analysis was undertaken of the particular situations described in Item 402(s) as they apply to the company.

The findings that companies often reached were similar, focusing on:

– the mix of compensation, which tended to be balanced with an emphasis toward rewarding long term performance;

– the use of multiple performance metrics that are closely aligned with strategic business goals;

– the use of discretion as a means to adjust compensation downward to reflect performance or other factors;

– caps on incentive compensation arrangements;

– the lack of highly leveraged payout curves;

– multi-year time vesting on equity awards which requires long term commitment on the part of employees;

– the governance, code of conduct, internal control and other measures implemented by the company;

– the role of the compensation committee in its oversight of pay programs;

– frequent business reviews;

– the existence of compensation recovery (clawback) policies;

– the implementation of stock ownership or stock holding requirements;

– the use of benchmarking to ensure the compensation programs are consistent with industry practice;

– the uniformity of compensation programs across business units and geographic regions, or alternatively, the differences employed to reflect specific business unit or geographic considerations; and

– the immaterial nature of some plans.

In terms of employee plans, there was a lot of discussion in the comment responses regarding sales incentive plans, often focusing on controls in place on those plans such as caps, negative discretion, prepayment review, and recovery in the event of error or fraud, etc. The responses often note that the analysis was conducted by management with the concurrence or consultation of the compensation committee, and they also frequently referenced the use of compensation consultants in performing the analysis, with that consultant in many cases being the same compensation consultant that the compensation committee used for other compensation matters.

Our Quick Survey on Clawback Policies

As noted above, one of the items cited often in response to the evaluation of compensation and risk is the existence of a clawback policy. Based on a number of requests from members, we have posted a “Quick Survey on Clawback Policies.” It’s anonymous and just takes a few seconds to complete. Once you participate, you will see a link to the running results.

And while you’re at it, please participate in this “Quick Survey on Disclosure Controls and Disclosure Committees.”

Getting Ready for Your Upcoming 10-Q

Broc blogged a couple of weeks ago about the SEC’s short term borrowings rule proposal and related MD&A interpretive release. One thing to keep in mind about the interpretive release is that is was no doubt timed to provide some guidance in advance of third quarter 10-Qs, so that companies could evaluate their liquidity disclosure in their interim period MD&A and make adjustments accordingly. One good thing about this approach is that you can “ease” into these disclosures by trying them out in the 10-Q, rather than incorporating potential changes for the first time in the 10-K. A few of the key points to keep in mind from the interpretive release as you are drafting or reviewing the 10-Q are:

1. Revisit whether more disclosure is necessary in the MD&A about cash management and risk management policies that are relevant to an evaluation of financial condition. The short-term borrowings disclosure concerns that the SEC has, in particular (but not limited to) the use of repurchase agreements, share-lending transactions and off-balance sheet arrangements or contractual repurchase obligations that may be accounted for as sales, all get back to one simple notion: cash is king. There is a concern, expressed in this release and also in comments on MD&A that the Staff has been issuing over the last couple of years, that the liquidity discussion in MD&A too often gives short shrift to the availability of cash, what companies are doing with their cash, where short-term cash is coming from and how risks related to liquidity are managed. This notion has manifested itself outside of the context of short-term borrowings, for example, in frequent Staff comments seeking more disclosure about the availability of cash balances held overseas.

2. Revisiting leverage ratio disclosure. The interpretive release gives some very specific guidance about disclosure of leverage ratios and the conditions under which such ratios can be disclosed. Now is a good time to revisit any disclosure along these lines to see if it is consistent with the Staff’s views.

3. A focus on the Contractual Obligations Table. While not necessarily an item for the 10-Q, it is not too early to start thinking about potential changes to the Contractual Obligations Table required in MD&A, to determine if you need to add to or revise your disclosure – through footnotes, a revised presentation, or otherwise – to provide “a presentation method that is clear, understandable and appropriately reflects the categories of obligations that are meaningful in light of its capital structure and business.” It has been my experience that this table hasn’t received a whole lot of attention (other than updating the numbers, adding new obligations and taking out old obligations) since it was adopted in the wake of Sarbanes-Oxley, so now might be the best time to take a hard look at what is being captured in the table and how it is presented.

For more tips regarding the implementation of the latest MD&A interpretive release, check out our “MD&A” Practice Area.

– Dave Lynn