A Tip On Evaluating Compensation-Related Risk, and an Interesting Compensation Study

As many readers know, under the new proxy disclosure rules, this year public companies are required to include a disclosure in their proxy statement to the extent that “. . . risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant.” I have received questions from a number of public companies, asking how management and the compensation committee should evaluate this risk. In many cases, at the beginning of the process, they are fairly comfortable that the compensation practices at their company do not create disclosable risks (especially if the company is not a financial institution), but they want to make sure their evaluation is thorough and reasonable. In making this evaluation, the compensation committee has to broaden its scope beyond executive officers. On the other hand, it is generally not practical for the committee to evaluate the compensation of all employees.

I often point compensation personnel to the language of new Item 402(s) of Regulation S-K added by the new rules, which includes the following laundry list of “situations that might trigger disclosure”:

“. . . compensation policies and practices: at a business unit of the company that carries a significant portion of the registrant’s risk profile; at a business unit with compensation structured significantly differently than other units within the registrant; at a business unit that is significantly more profitable than others within the registrant; at a business unit where compensation expense is a significant percentage of the unit’s revenues; and that vary significantly from the overall risk and reward structure of the registrant, such as when bonuses are awarded upon accomplishment of a task, while the income and risk to the registrant from the task extend over a significantly longer period of time. . . .”

Item 402(s) specifies that the above list is not exhaustive; however, it is a good starting point. As one part of its evaluation, the committee should consider whether any of the company’s business units fit the descriptions in the above list. In any such subsidiary or division, the key employees or groups of employees should be included in the committee’s evaluation. If the compensation committee considers these employees or groups in addition to the compensation practices relating to executive officers, the committee can be more comfortable that its evaluation satisfies the requirements of the new disclosure rule.

Compensation Consultant Releases Study of Performance Metrics

Compensation consultants James F. Reda & Associates recently issued its Study of 2008 Performance Metrics Among Top 200 S&P 500 Companies. Reda studied 2009 proxy disclosures and has identified trends in compensation and disclosure practices. Among the findings included in the detailed tables:

• Long-term performance-based awards were used by 75% of these companies in 2008, compared to 67% in 2007.

• Stock option grants were used by 67% of these companies in 2008, compared to 64% in 2007.

• Short term incentive plans most often used metrics based on earnings per share or income.

• Long term incentive plans most often used metrics based on total shareholder return.

Reda also noted that the percentage of these companies that reported performance target levels in their proxy statements did not increase in 2008 compared to 2007. It will be interesting to see whether this percentage increases in 2010, as many companies have received SEC comments that ultimately would require disclosure of the performance targets for the prior year.