Regulation S-K Item 402(s): regulating compensation incentive-based risk through mandatory disclosure.
Author | Higgins, Danielle Angott |
"Sunlight is said to be the best of disinfectants; electric light the most efficient policeman." (1)
It is axiomatic that transparency underlies the United States capital markets and the entire public company mandatory disclosure scheme. (2) Periodic reports and public offering registration documents are intended to provide potential investors and current shareholders with the information necessary to make informed decisions whether to buy, sell, or hold securities. (3) Disclosure of such extensive information comes at a price--periodic disclosure documents can reach several hundred pages, costing companies and their management and directors, significant expense and time. (4) The federal securities laws' focus on disclosure, transparency, and informed investor choice are not only important tools against investment fraud but are also thought to be important deterrents to other undesirable corporate conduct and decision making. (5) Yet, it seems that no matter how much information is currently disclosed, with each new financial or corporate scandal, even more disclosure is compelled in response. (6) It is no surprise, then, that disclosure requirements have grown as a result of the 2008 collapse of Bear Steams and Lehman Brothers.
The unprecedented collapse of two of Wall Street's most longstanding and prominent investment banks sparked the worst phase of the most recent "scandal," or more aptly, "Financial Crisis." (7) The sophisticated and risky financial products that generated billions of dollars in profit for the financial services industry during the preceding years, culminated with dramatic and devastating effects. (8) To prevent a global economic collapse, the federal government injected nearly $250 billion into the financial sector by purchasing assets and equity from troubled financial institutions via the Troubled Asset Relief Program ("TARP"). (9) From its inception, TARP generated significant controversy and numerous critics, (10) However, when insurance behemoth American International Group (AIG) released compensation data for its failed derivatives trading group-including substantial bonuses funded by federal TARP assistance-public outrage over executive compensation practices came to a derisive head. (11)
Policymakers, commentators, and business executives have all offered various, and in many cases, competing theories outlining the "causes" of the Financial Crisis. (12) Conventional wisdom claims that "perverse" compensation bonus incentives paid to individual bankers are to blame in large part. (13) Others believe the banks themselves disregarded risk because they were engaged in a figurative "arms race" amongst each other, competing to amass the largest profits for their respective organizations and, consequently, paying their employees the largest bonuses. (14) But others contend that the empirical evidence linking incentive-based compensation and excessive risk taking is lacking, and maintain that the bankers simply lacked foresight and were ignorant of the substantial risks inherent in the various transactions in which they were engaged. (15)
Nevertheless, the notion of "excessive" or "imprudent" risk taking emerges as a common thread in the various articulations. (16) Interestingly, and perhaps intuitively, most commentators and legislators have almost myopically associated excessive or imprudent risk taking with "excessive" or "perverse" executive compensation arrangements. (17) Indeed the public is led to believe that short-term incentive-based bonus compensation constitutes a significant, and arguably obscene, portion of the total compensation awarded to many business executives and employees because huge bonus payouts make the news. (18)
Indeed, Congress viewed risk management and mitigation as focal points in the recent Dodd-Frank legislation. (19) Further, the Securities Exchange Commission ("SEC") recently released new Regulation SK disclosure enhancements aimed at increasing internal risk-management, and requiring disclosure where incentive-based compensation is likely to result in imprudent risk taking that is damaging to the corporation. (20) The new requirements largely focus on disclosure, but fail to provide meaningful guidance on how reporting companies are to gauge risk or can delineate productive prudent risk taking from excessive risk taking. (21) Nevertheless, companies are required to evaluate and disclose how their compensation schemes may encourage imprudent risk-taking behavior. In light of these considerations, this Comment first attempts to succinctly explore the SEC's intent in implementing the disclosure enhancements and delineate the likely intended scope of disclosure. Second, this Comment suggests that firms consider adopting various mitigation and deferment mechanisms to limit their exposure to potential liability stemming from disclosure requirements, and to encourage prudent risk taking in compliance with internal risk-management policies. These recommendations will be analyzed in light of traditional theories of executive-compensation and corporate-reform requirements.
This Comment proceeds in two Parts. The first Part describes how compensation practices may theoretically incentivize employees to take imprudent risks or create adverse risk in general, focusing on potential agency issues inherent in the shareholder-manager relationship. The second Part explores the scope of Regulation S-K Item 402(s), which requires public companies to disclose compensation risk that is reasonably likely to have a materially adverse effect, from the perspectives of both the SEC and subject companies.
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BRIEF OVERVIEW OF EXECUTIVE COMPENSATION IN THE UNITED STATES
Executive compensation in the United States has long been considered a problematic corporate governance issue. (22) It has generated even further attention and condemnation over the past few decades given the seemingly exponential growth of executive compensation packages in relation to the "average" employee wage. (23) Whether the dollar figure awarded to executives is patently reasonable or excessive is beyond the scope of this Comment. Rather, this Comment is concerned with the extent to which compensation practices may be tied to imprudent risk taking, and how companies should handle this situation in light of Item 402(s) disclosure requirements. (24)
A for-profit corporation's primary objective is to "conduct ... business activities with a view to enhancing corporate profit and shareholder gain." (25) Specifically, maximization of long-term, as opposed to short-term, shareholder gain is fundamental. (26) In all business dealings, however, elements of uncertainty and risk exist as potential impediments to the realization of profit. (27) Prudent corporations must therefore evaluate the risk/reward attributes of corporate actions to determine those most likely to achieve optimal results. The question then becomes: who makes this assessment?
A corporation's stakeholders typically exercise very little direct control over the direction and management of the corporation, particularly in the case of large, publicly traded corporations. (28) That task is left to corporate boards of directors, who in turn delegate responsibility to executive officers, who run the day-to-day operations of the corporation. (29) But achievement of the long-term profit objective may be compromised where corporate executives and their employees make business decisions while receiving a fixed salary and bearing little "risk." In the meantime, "those who take the risk and receive profits--the stockholders--make no decisions, exercise no control." (30) In response to this conundrum, boards often structure compensation packages to award executives with incentive-based bonuses or equity awards, based on the achievement of a particular target or benchmark. (31)
Scholars are sharply divided on the question of whether incentive-based compensation provides executives with perverse incentives to take imprudent risks at their company's expense. Professors Lucian Bebchuk and Jesse Fried have extensively studied the various forms of CEO compensation and ultimately conclude that the so-called "pay-for-performance" incentive-based payments have failed to deliver on their promise. (32) They articulate two primary criticisms of traditional corporate governance of executive compensation arrangements. First, in the executive compensation context, an inherent conflict of interest in the agency relationship exists, at least in theory, between shareholders and management. (33) Second, the notion that boards represent shareholders' interests by negotiating compensation arrangements at arm's length with management may be flawed if boards are not truly independent. (34)
Bebchuk and Fried argue that current compensation packages are often overly favorable to management because directors are reluctant to seriously negotiate and hold executives accountable for their performance. (35) Additionally, they suggest that incentive-based schemes may provide perverse incentives for executives to maximize current compensation by taking short-term hyper-risks while ignoring serious long-term systemic risks. (36) This argument is easy to understand when compensation packages are overly weighted toward short-term, rather than long-term, payouts, especially in industries where frequent lateral employment moves are common. It seems obvious that an employee who does not plan to stay at the current employer for the long term will be motivated to maximize her short-term reward, without regard for the long-term consequences. By the time the unfortunate results occur, the employee will have cashed out and moved on, often to an even more lucrative position.
The critical debate over whether short-term compensation bonus incentives actually incentivized banking executives to engage in hyper-risky transactions, or whether ignorance or underestimation of the risk alone is to...
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