The Advisors' Blog

– Andy Mandel and Larry Schumer, Buck Consultants

Late last year, the SEC issued final rules that require companies to provide narrative disclosures in their proxy filings of their compensation policies and practices that create risks that are “reasonably likely to have a material adverse effect” on the company. These rules were generally effective for proxy filings occurring on or after February 28, 2010 and apply to all compensation arrangements that could result in material adverse risk — not just those covering senior executives of the company. The rules do not require affirmative disclosure in cases where it is determined that a company’s compensation policies and practices do not rise to the “reasonably likely” level.

Recently, we researched proxy filings of over 200 S&P 400 non-financial companies that filed their proxy statements on or after February 28, 2010 for the purpose of examining how companies addressed the SEC’s compensation risk disclosure. Our study concludes that there is very little consistency among companies’ disclosure practices involving compensation risk assessments.

The SEC’s risk disclosure requirement was intended to provide meaningful information for investors to evaluate how compensation programs affect risk taking. Because the assessment of risks as they relate to compensation practices and policies is a complex and subjective area and guidance has been limited, many believed that there would be a great deal of uncertainty during the 2010 proxy filing season. Our study affirms this belief and raises two key questions:

– If companies do not apply a consistent approach towards risk assessment and disclosures, can investors truly benefit from the SEC’s requirement to provide narrative disclosures where compensation practices and policies create risks that are reasonably likely to have a material adverse effect?

– Is the lack of overall consistency within proxy disclosures creating confusion and thus achieving the opposite effect of what had been intended by the SEC?

Some of the key findings of the study include:

– Although affirmative statements are not required where the “reasonably likely” threshold is not met, most companies (67 percent) included some discussion of risk assessment within their proxies.
– Of those companies, 63 percent provided an affirmative statement that there were no risks that would rise to the level of “material adverse effect.”
– Not surprisingly, no company indicated that they uncovered material adverse risks within their compensation programs.
– Very few companies described the process they used to determine that there were no material adverse risks. Rather, the disclosures emphasized how plan design elements have served to mitigate risk. Most companies (58 percent) indicated a balance of short-term and long-term incentive structures as a risk mitigation element.
– Although the majority of companies (60 percent) identified a specific employee group covered by their risk assessment, the composition of the employee groups varied widely. Only 27 percent covered all employee groups (as opposed to only executives) and 40 percent of the companies that performed a risk assessment did not identify a specific group.
– Corporate boards and their compensation committees have almost universally left day-to-day risk management in the hands of management while maintaining an oversight role.

SEC’s Response to Disclosures

The SEC has begun to question whether companies have truly established risk assessment policies and procedures that would allow for a conclusion that there are no arrangements in place that would be “reasonably likely to have a material adverse effect” on the company. The SEC has been sending out letters to companies requesting confirmation for how they drew this conclusion. While the letters have generally been targeted at companies whose proxy disclosures were silent about compensation risk, some companies have received letters even though they included a statement in the proxy about their conclusion but did not describe the risk assessment process. Certain public comments by SEC staff are revealing – e.g.,” Where there was no disclosure, did it mean the company went through an analysis or that they were not paying attention?”

The Bottom Line

As compensation risk assessment continues to evolve, both conceptually and procedurally, one could surmise that disclosures involving risk assessment (versus nondisclosure) will emerge as a “best practice.” A reasonable disclosure would be one that clearly conveys that: (i) a comprehensive risk-assessment was performed covering, not just plan design, but internal processes as well and (ii) the assessment was not just focused on plans covering executives but also covered all compensation plans covering employees throughout the organization.

Further, in light of the Dodd-Frank Act, compensation committees will be required to take a closer look at all of their policies, charters, guidelines, and procedures which includes standards associated with assessment of risk within the company’s compensation plans. While compensation committees will still maintain an oversight role, there will be more of a need for committees to fully understand the rigor with which management has conducted a risk assessment and drawn its conclusions.