The Advisors' Blog

Since 2010, Item 402(s) has required companies to disclose their policies & practices for managing compensation-related risks, to the extent that risks arising from their compensation programs & policies are reasonably likely to have a material adverse effect on the company. Disclosure under Item 402(s) isn’t limited to executive compensation arrangements. It also applies in addition to CD&A requirements to discuss management’s exposure to downside performance risk.

Although Corp Fin issued comments shortly after this rule went into effect, this line item is something that is often handled internally. It often doesn’t result in disclosure – because many companies conclude that the risks of their compensation programs aren’t reasonably likely to have a material adverse effect. The problem, though, is that “hindsight is 20/20.” In the wake of scandals, compensation risks become more apparent.

A new Semler Brossy memo analyzes a few recent mishaps to show the role that compensation-related lapses might have played. The memo also suggests improvements to compensation risk reviews that can help keep your company (and compensation committee members and executives) out of the spotlight. Here’s an excerpt:

The most effective risk reviews don’t just focus on compensation programs alone. They also help to pinpoint areas where compensation could worsen business risks. Therefore, effective processes go beyond just examining compensation structures. They also assess operational risks, critical business areas and organizational governance mechanisms. To achieve this, consider adding the following practices to your risk review:

– A comprehensive inventory of incentive programs. Document all incentive programs, detailing the number of participants, design features that could pose risks and any built-in risk mitigants.An overview of program administration. Summarize how goals are set, performance is measured, payouts are approved, while also verifying the existence and application of clawback mechanisms.

– A governance and oversight review. Evaluate the processes for reviewing incentives for risk outcomes, identify responsible parties and understand how risk-related events are escalated. Understand what data is collected, who has access to it and how it is utilized.

– Historical event analysis. Track and analyze events that prompted further review, including responses and long-term trends in the number and nature of these cases.

– Cultural indicators. Assess key cultural markers, such as trends in engagement survey scores, whistleblower hotline reports and exit interview patterns.

Directors will want to understand existing processes and ensure sound risk management practices, even though not all the elements above need to be addressed at the board level. Although these measures may require additional effort, compensation committees that treat risk management as a strategic priority rather than merely a regulatory requirement will be better positioned to safeguard employees and stakeholders, avoid reputational harm and achieve long-term success.

– Liz Dunshee