Compensation Lessons From Across the Pond

On Tuesday, the Chairman of the SEC confirmed that the SEC will be revising the proxy disclosure rules to add new disclosure requirements covering, among other things, (1) risk management through compensation programs and (2) compensation programs for non-executives (including presumably the risk management aspects of those non-executive programs). I would anticipate the SEC moving quickly so that these rules will apply to next year’s proxies. Lots of practical issues will arise from the new requirements. Perhaps the most important is the issue of how should one think about risk management from a compensation standpoint. While it is easy to come up with procedures (e.g., meet with risk management personnel every quarter), it is much harder to do the substantive work (e.g., identify particular risks and modify compensation programs accordingly). There are very few precedents here, and most of them are in the financial services sector where the issues (e.g., credit default swap exposures) are unlikely to be relevant to the rest of the market.

As a possible starting point and precedent, let me suggest a recent report from a British financial industry regulator, the Financial Services Authority (or FSA). The FSA spent several months investigating and debating the relationship between compensation and risk-taking. Their report is a thoughtful and balanced discussion of the issue. It looks seriously at the arguments and counter-arguments for various approaches and tries to weigh the benefits and burdens. (You can find the report at: http://www.fsa.gov.uk/pubs/cp/cp09_10.pdf) Here are a couple of interesting tidbits from the report. First, they acknowledge that there is no proof that compensation programs in fact caused excess risk taking in the financial sector. The consensus to the contrary, they say, is based on anecdotes and circumstantial evidence. They even note that there are a variety of factors having nothing to do with compensation that were likely more important.  I think this explains the relatively mild reforms suggested by the  FSA.  Second, the report has a fascinating discussion of the way compensation programs can over-align the interests of shareholders and managers. They note that institutional shareholders often have very short holding periods, and may in fact prefer that management produce short-term gains and take lots of risks because they discount or even ignore gains that will come after they have sold their stake. In the context of “too big to fail” businesses, this alignment can be socially problematic, but in industries that do not benefit from government guarantees, the clear implication is that risk management may be contrary to shareholder interests. In all events, the report is as good an example as any of how to conduct a sober appraisal of risk and compensation.