Board Oversight of Risk Management and Executive Compensation

In the wake of the recent financial and liquidity crises, there are several “pressure points” boards of directors can address to ensure fulfillment of their fiduciary responsibilities to shareholders. This report, authored by Matteo Tonello, notes how many of the problems faced by some U.S. financial institutions today are likely due to inadequate risk oversight and flawed linkages between pay and performance. While especially relevant to financial institutions, boards of all companies should consider reassessing the risk management programs used and the impact of executive compensation policies on the risk culture of the organization.

Ensuring Risk Oversight

Boards are responsible for overseeing companies’ risk exposure as part of the role they play in determining a business strategy generating long-term shareholder value. There is increasing pressure on boards to oversee the implementation of top-down, enterprise-wide risk management processes to help achieve companies’ long-term goals. There are several steps corporate directors can take to reassess gaps and vulnerabilities in existing risk management programs to move towards an enterprise-wide solution.

• Boards should review and approve a risk inventory and fundamental risk management parameters such as risk appetite and tolerance levels as part of the annual business plan submitted to senior executives. Boards should also oversee the process senior management uses to identify and prioritize risks.
• Boards should be aware of potential effects of interrelated events and ensure continued allocation of resources to risk management so the company’s ERM capacity is not impaired.
• Risk management infrastructure should tie a company’s strategy-setting activities to a risk-based analysis of the firm’s market and competitive environment. ERM processes should be constantly monitored to account for new risks and opportunities, with the board determining if the company’s business strategy is aligned with an appropriate risk tolerance.
• Risk measurements used by senior executives to measure risk tolerance should be adequate and effective. Boards should ensure this process is transparent and thorough and understand the identification techniques and risk metrics chosen as well as their limitations in order to knowledgably analyze the outcomes.
• Adequate performance metrics need to be determined to avoid executive compensation policies that could negatively impact the enterprise risk culture. This involves assessing performance on a combination of financial and extra-financial metrics.
• A preliminary assessment of existing corporate governance practices needs to be conducted to determine the risk oversight structure at the board level.
• The board should have increased involvement related to risk management. This increased involvement may take the form of a dedicated risk committee.
• Establishing an ERM Risk Management Executive Committee with meetings regularly attended by at least one dedicated director with risk oversight responsibilities should be considered. Boards should also assess the strength of existing codes of conduct and the anonymity of whistle-blowing practices.
• Boards should oversee the processes adopted by senior executives to identify, categorize, and prioritize business uncertainties with respect to their reputation effects as well as the development of a response strategy to each risk category affecting corporate reputation.
• Crisis management capabilities should be reinforced by indentifying the stakeholder relations most important to the company’s long-term objectives.

• ERM should be fully integrated with existing corporate disclosure procedures and the board should be satisfied with the transparency of the reporting process.

Strengthening the Link among Pay, Performance, and Accountability

Boards are responsible for setting the compensation of senior executive officers as well as creating sustainable, long-term wealth for shareholders. The integrity and independence of the board’s compensation committee are therefore very important. Recently, the issue of pay for performance has been drawing increased attention and there are several steps boards can take to ensure compensation programs successfully balance these competing interests. These steps can also be discussed annually during periodic reviews of compensation program effectiveness.

• Compensation programs should link variable portions of total compensation to the economic objectives of the corporation. To ensure this is the case, boards should fully understand the effects of all components of a pay package to appropriately balance base pay and other components and avoid distortion of variable components by managers acting opportunistically.
• Performance should be measured over sufficiently long assessment periods to determine if decisions were successful in creating sustainable shareholder value. Boards should consider a diversified set of financial and extra-financial performance metrics and targets.
• Performance metrics should be used during annual performance evaluations and metrics that can be easily manipulated should be avoided.
• Boards should discuss disclosing performance targets to shareholders, weighing the benefits of increased transparency against any potential loss of competitive advantage.
• Boards should consider what compensation methods can be used to avoid the distortions and pitfalls of some equity-based incentive programs.
• The overall fairness of any compensation grant should be considered and reported to the full board so all directors understand the magnitude of total potential payouts.
• Benchmarking compensation to that of peer companies can provide helpful guidance in determining appropriate compensation levels.
• Boards should consider whether executive compensation should be submitted to shareholders for an advisory, non-binding vote.
• The introduction of accountability devices should be considered to avoid situations where senior executives are financially insulated from decisions contrary to the best long-term interests of the company.
• There should be very careful oversight over any arrangement permitted that has significant potential for conflicts of interest, such as contracts involving senior executives and subsidiaries or special purpose vehicles.

• The compensation policy should be coherent with the company’s succession plan for top executives. Compensation programs should be designed to balance short-term inclinations with a set of long-term behavioral incentives and to develop talent pools throughout an organization so it can promptly respond to unexpected events.

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Citation: Tonello, M. “Overseeing Risk Management and Executive Compensation: Pressure Points for Corporate Directors” The Conference Board. Dec. 1, 2008.