Enterprise Risk Management

Executive compensation in the crosshairs

Risk managers may be asked to judge the quality of management

By Michael J. Moody, MBA, ARM

Going forward, risk managers need to expand their focus and take a more holistic approach to risk management. And while this broader view will incorporate all types of risk, one of the early candidates will probably involve the hot topic of executive compensation. While this has been a thorny issue for a long time, recent events have U.S. investors and taxpayers seeing red over the massive incentive compensation arrangements of some financial service firms.

It’s not bad enough that organizations have entered into these arrangements, but most of them have gone broke doing so. And the indication that these firms must pay the “bonuses” so they can keep these individuals does little to quiet the criticism. This disapproval by taxpayers stems from that fact that these firms have had to turn to bailout money, leaving taxpayers (now shareholders) holding the bag.

Historical perspective

The current crop of bankruptcies includes financial services firms that have been providing investment advice to us for decades. How could they have ended up in such a bad position? This is an important question and really goes to the heart of the whole executive compensation issue.

Over the past 100 years or so, a dozen or more investment firms have been formed to assist us with our investment strategies. Originally, many of these firms were focused on providing their clients with long-term investment strategies that would allow them to meet or exceed their retirement goals.

Investment firms such as Merrill Lynch, Pierce, Fenner & Smith, formed in 1914, helped many of our grandfathers and fathers design a long-term plan for financial independence. But most of those original Wall Street firms were started as partnerships. And, it should be pointed out that the partners were actively involved with every aspect of the operation of the company, and a core concept of these arrangements was the unlimited liability of the partners.

However, since the 1970s more and more of these Wall Street companies have moved to the limited liability corporation (LLC) as their operational model. A direct result of this change has been that for the most part, the incentive for senior management to monitor risk taking has been greatly reduced. And for many of these organizations, this ultimately spelled the end of their companies.

They have either been sold for pennies on the dollar, or merely left to die a slow death. After top management at these firms had no personal liability for the performance of the company, the greed of short-term goals took over and sank the firm.

Quality vs. quantity

Incentive compensation, particularly under the partnership arrangements of old, was based on the quality of the results. However, by the beginning of this millennium, many of these organizations had gravitated to a much more quantitative approach. For example, in recent years, the most popular incentive approach to mortgage banking has been based primarily on the number of loans, with little or no regard to the quality or riskiness of the loans.

Granted, some lenders may have felt more secure in their lending practices, knowing that many of the loans were packaged with other risky loans (i.e., subprime) and sold to investors. Regardless, as we now know, most loan officers practiced little, if any, underwriting with regard to these loans, yet they were amply rewarded for their “efforts.”

And as with most aspects of the corporate world, this issue was a visible sign of the “tone at the top.” Having moved away from the older partnership model, most in executive management had little personal stake in the out­come. This approach gave rise to what has become known as the “bonus culture,” and it substantially reduced the incentive of senior management to effectively monitor risk taking.

This transformation is a key reason why executive management was willing to adopt high-risk profit strategies, since failure no longer meant high personal costs. Of course, what these programs failed to recognize was that losing money, any money, should remove any justification for bonus payments. But as we know now, such was not the case.

A new approach is required

One of the long-standing issues that has been of concern to most human resource departments has been the development of the “perfect” executive compensation plan. Obviously, the recent trend towards quantity measure­ments that focuses on short-term financial results rather than long-term value and stability has fallen far short of the “perfect” executive compensation plan.

And today, there is ample evidence of the growing disconnect between performance-based compensation and actual value added to publicly held companies. In fact, Committee for Economic Development, the public policy organization, suggests that this preoccupation with short-term results at the cost of long-term success was due in large part to the nature of the compensation packages being offered to management and key sales personnel.

Today, a number of federal agencies and other organizations such as the SEC have all offered new legislative initiatives to restrict executive compensation. The public outcry for change has been overwhelming, particularly for those firms that have taken bailout funds from the Troubled Asset Relief Programs (TARP). For example, Merrill Lynch paid bonuses to employees that totaled $3.6 billion, or about one-third of the TARP funds they received. As a result, taxpayers, who have now become shareholders via TARP, have finally said “enough is enough.”

There have been several proposals for resolution to what many consider these outrageous paydays. One of the approaches that appears to be gaining some support is known as “say to pay.” In essence, this proposal would give shareholders a non-binding vote via the proxy statement on executive compensation issues, including golden parachutes.

There has been some initial concern about the non-binding aspect of this approach. However, this approach has been introduced in the U.K., where it appears to be helping curb undue risk taking on the part of executive management. Further, the U.S. Treasury Department believes that the prospects of a public vote on such matters would influence companies and persuade them to link pay more directly with performance. Obviously, this remains to be seen.

New tasks for CROs

Risk management, for the foreseeable future, will begin to have a much more active role in both the operational aspects of companies as well as their strategic aspects. And while there are many agenda items that a CRO will have to get involved with quickly, one of the first will likely be the issue of executive compensation.

Today, the risk management aspects of executive compensation plans are significant. Much of the current financial crisis can be laid at the door of excess risk taking in order to obtain short-term goals. Many investors are still in shock that pillars of the financial community risked so much, and with devastating consequences, and despite this we continue to reward their failure by paying bonuses. An important aspect of any ERM program will be the risk assessment of any pay plans. It will be necessary for corporations to develop appropriate risk-reflective pay plans, and the CRO will play a critical role in this endeavor.

For some CROs this work may be their first involvement at the executive level. Therefore, it will be important that they bring something of value to the table. The CRO must remember that this will be an early test of their abilities as corporations look for constructive involvement from their CRO. Accordingly, a good grounding of the current situation with regard to executive compensation, especially as it relates to excessive risk taking, is required. Additionally, a complete review of potential solutions will go a long way to help further enterprise risk management’s expanding reach.