What's all this i'm hearing about "compensation risk?" Five ways for directors to make sense of compensation risk.

• Author: Cagney, Lawrence K.

The concept of "compensation risk" is a hot topic in the press and in boardrooms these days. Rightly or wrongly, the compensation programs and policies of financial institutions are viewed as having contributed to the global downturn and, as a result, regulators have turned their attention over the last year to addressing this perceived problem. There's a lot of law (and proposed law) out there--but what is a director supposed to make of it? Should directors be changing the way they have historically managed the companies on whose boards they sit? Should there be more process? More disclosure? Are directors at greater legal risk than in the past on these issues?

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* The U.S. Securities and Exchange Commission. In December 2009, the SEC adopted a rule requiring public companies to add compensation risk-related disclosures in their annual proxy statements if the company concludes that its compensation programs (including those below the officer level) create risks that are reasonably likely to have a material adverse effect on the company. If the "reasonably likely to have a material adverse effect" standard is not met, no disclosure is required.

* Bank Regulation. In October 2009, the Fed adopted guidelines requiring member financial institutions to analyze the risk profiles of their compensation programs. The guidelines require that financial institutions effectively balance risk and financial results so as not to encourage excessive risk-taking, and have strong internal controls and risk-management processes to monitor risk outcomes; in addition, boards should play an active role in overseeing the development and operation of compensation programs. The FDIC has also proposed rules under which it would use employee compensation criteria as a basis for adjusting the risk-based assessment rate charged to insured institutions.

* Non-US Initiatives. The G20 leaders have endorsed compensation principles recommended by the Financial Stability Board and have called for coordinated international implementation of stricter rules aimed at correcting compensation practices that are perceived to have encouraged excessive risk. The G20 nations are implementing these principals and standards in a variety of forms, including both principles-based and formulaic approaches.

We see five main points for directors trying to make sense of this new legal landscape.

More than Ever, Process Counts

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