Beware unintended consequences: mandatory disclosure of the impact of compensation on risk will force boards to review risks in great detail.

• Author: Lenehan, Pamela F.
• Position: Director Perspective

With new rules on compensation coming out of Washington, the focus of boards has been on disclosure. Boards, however, should be concerned about unintended consequences of these well-intentioned rules. As an example, Sarbanes-Oxley has brought more structure to internal controls, but boards now spend much of their limited time together on oversight responsibilities, rather than on strategy--which is where boards add the most value.

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The latest rule that needs serious consideration is the required disclosure of the relationship between risk and compensation. After the recent financial crisis, it is logical that regulators want to be sure boards understand risks throughout an organization and are not encouraging unacceptable risk through compensation programs. Mandatory disclosure of the impact of compensation on risk will force boards to review risks in great detail and look at compensation through that prism. The old adage--"If you can't explain it, you don't understand it"--is true, but it may not be as simple as it first sounds.

Culture Impacts Compensation

These rules were written in response to the financial crisis, where poor trading decisions were magnified by leverage. However, financial services firms are dramatically different from other organizations and one of the main differences is cultural. Compensation in that industry has historically been heavily weighted toward individual performance, which attracts people with supreme confidence in their ability to succeed. Many of those businesses talk about teams but reward stars.

Most organizations outside financial and professional services have compensation plans with common goals for a significant percentage of the bonus pool. These targets are often financial objectives, but they can also relate to product development or operational measures. One thing is clear: in any company that sells a tangible product, results cannot be achieved alone. Products that need to be designed, sold, produced and shipped require a lot of people working together. Where people work together risk and responsibility are shared.

Management teams negotiate their contributions to the common goals through balanced scorecards or similar tools. These interrelationships are complicated and the board needs to understand them.

Management is Risk Management

Managers take risks every day--they just call it "managing." One of the most positive things about an enterprise risk management program is...