Overseeing Risk Management and Executive Compensation

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ExecutiveactionseriesNo. 292 December 2008

The Conference Board’s most recent Leading Economic

Indicators and Consumer Confidence Index™ data show

limited access to capital is weighing on consumer spending

and employment trends. Ultimately, the deterioration of the

credit markets affects many business sectors and the wealth

of not only the United States, but the global community as

a whole.1

What should the board of directors of a public company doin critical times like these?

This report highlights a series of “pressure points” for boards

to consider in addressing these events. Each pressure point

includes practical actions that can be followed to help ensure

that, even in this turbulent economic environment, directors

fully meet their fiduciary responsibilities toward shareholders.

It is believed that—aside from a declining housing market,

which remains a somewhat cyclical and unavoidable

phenomenon—the problems faced today by some U.S.

financial institutions are due to inadequate risk oversight 2

and a broken link between pay and performance.3

Overseeing Risk Managementand Executive Compensation“Pressure Points” for Corporate Directors

by Matteo Tonello, LL.M., S.J.D., Associate Director, Corporate Governance Research,The Conference Board

Over the past year, the exposure of major financial institutions to a rapidly weakening U.S. housing

market heightened the aversion to risk in global capital markets. These concerns have cascaded into

a full-fledged financial crisis the precise extent and impact of which is still unknown. While some

banks and financial intermediaries have filed for bankruptcy or otherwise rushed into rescue deals

with competitors or national governments, such loss of confidence escalated in recent weeks to an

unprecedented liquidity crisis.

1 For a discussion of the current economic indicators, see Bart van Ark,

Update on the U.S. and Global Economies. Comments on The Conference

Board Forecast , October 8, 2008, available at www.conference-

board.org/pdf_free/economics/2008_10_08.pdf

The Role of the Board in Turbulent Times . . .

2 Recent research conducted by The Conference Board shows that, while

companies report progress in developing an enterprise-wide risk

management program, it has yet to become embedded in their strategic

thinking and cultures. Most developments have occurred in early stage

efforts, such as compiling a risk inventory and selecting a set of assessment

metrics. However, there is empirical evidence that corporate boards are still

developing an oversight process to tie the information on risk they receive

through the program to their strategy-setting activities. See Ellen Hexter, Risky

Business. Is Enterprise Risk Management Losing Ground?, The Conference

Board, Research Report, 1407, 2007.

3 Over the last two decades,The Conference Board has documented the

expansion of components of compensation packages that do not relate

to corporate revenues. See Linda Barrington, Kevin F. Hallock, and Lisa L.

Hunter, The 2007Top Executive Compensation Report , The Conference Board,

Research Report 1422, 2008. (The 2008 Top Executive Compensation Report

will be published in winter 2008–2009.)


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3 executive action oversee ing r isk management and execut ive compensat ion : “pressure points” for corporate d irectors the conference board

• Be sensitive to the fact that, in the current economic

climate, the business may be particularly subject to the

effects of interrelated events. Specifically, where the

company engages in relationships with third parties (e.g.,

vendors, customers, partners, etc.) in financial distress,events affecting those organizations’ standing may

reverberate on the continuity of the company’s business

operations. Moreover, the occurrence of major financial

risks (such as the limitations in accessing new capital

and the exposure to excessive volatility) may undermine

the company’s ability to fully support internal programs

aimed at addressing process risks (e.g., internal audit

and disclosure procedures, Six Sigma, and other quality

control initiatives; compliance and ethics programs).

Corporate boards should ensure that resources continue

to be appropriately allocated to risk management so that

the company’s ERM capacity is not impaired.

• Ensure that the risk management infrastructure ties

the company’s strategy-setting activities to a sound

risk-based analysis of the market environment and

competitive position in which the firm operates. To

survive in today’s rapidly changing business world,

ERM should be a continuous and uninterrupted process

in which strategic objectives are constantly monitored

to factor in new uncertainties and capture new

opportunities. On its part, the board should regularly

determine whether the business strategy is adjusted to

the levels of risk tolerance the company can afford,based on indicators such as its capitalization, liquidity,

and debt-to-equity ratios, as well as the exposure to

environment and geopolitical risks that may be difficult

to assess properly. In these turbulent times, the board

should ensure that management understands and is

effectively managing key financial risks, including:

H liquidity risks, including cost of capital;

H interest rate, currency, and commodity price

volatility risk;

H possible asset impairment resulting from fair-

value accounting (e.g., on securities and other

marketable investments; on goodwill, patents, and

other intangibles; on pension plan assets and other

employee benefit programs, etc.);

H financial reporting risks,especially due to uncertainties

regarding the application ofaccounting principles to

securities the company may hold on its balance sheet

and whose value is correlated to rapidly weakening

underlying assets (e.g., mortgage-backed securities);

H regulatory and compliance risks; and

H other market risk, including the impact of a

potentially deep recession (marked by severe

declines in consumer spending abilities and

production levels) on business operations.

• Be persuaded that risk measurements used by senior

executives to monitor those levels of tolerance are

adequate and effective. Since the accuracy of

the risk assessment process is a precondition to

the success of the whole program, the board should

ensure that such process is transparent and thorough.

The most recent events affecting the financial market

showed how important it is for corporate directors to be

aware that certain business risks may represent personal

opportunities for managers who are ill-intentioned or

simply driven by short-term incentives. In such cases,

managers may have an interest in avoiding having those

categories of potential events brought to the surface and

addressed in a systematic and effective way. The board

should therefore become familiar with any identification

technique or risk metric chosen by senior executives,

understand their limitations, and be able to critically

analyze their outcomes.

• Determine adequate performance metrics to track

and compensate managerial results in the pursuit of

the business strategy to avoid executive compensationpolicies that may negatively impact the enterprise risk

culture. In particular, performance should be assessed

based on a combination of financial and extra-financial

metrics.7 For example, in addition to short-term

results that are measurable in terms of stockprice,

compensation could also vary based on the quality of

long-term institutional investors the company can attract

to its stockholderbase. Given that it is a fiduciary duty

of pension fund advisors to evaluate the riskexposure

of any company the fund is considering investing in,8

the increasing presence of large institutional investors in

the stock ledger could further assure corporate directorsabout the sustainability of the business strategy in the

long period.

7 For a discussion of the need fora diversified set of performance measures,

see Matteo Tonello, Revisiting Stock MarketShort-Termism, The Conference

Board, Research Report 1405, 2007.

8 Section 404(a) of the Employee Retirement Income Security Act of 1974

(ERISA).



• Forthe purpose of determining the risk oversight

structure at the board level, conduct a preliminary

assessment of existing corporate governance practices,

including:

1. the independence, professional expertise, and time

availability of each board member;

2. the workload of existing board committees; and

3. the quality of the information flow between board

members and management.

• This assessment should be also based on the

reasonable expectation that the business environment

emerging from the crisis will raise new challenges and

require a heightened level of involvement by the board.

In particular, with respect to the need to establish a

dedicated risk committee, the Governance Center

believes that substance should prevail over form.

In fact, some of the financial institutions that found

themselves embroiled in today’s crisis did have a risk

committee, but its involvement in the risk management

process was marginal and ultimately proved ineffective.9

While it acknowledges that some companies still assign

risk oversight responsibilities to the audit committee,10

the Governance Center is concerned that the current

workload of that committee may impair its ability to

thoroughly oversee the business exposure to

uncertainties.

• As part of the ERM procedure design, consider

establishing an ERM Risk Management Executive

Committee led by the chief financial officer or the

chief risk officer and whose meetings are regularly

attended by at least one dedicated director with risk

oversight responsibilities. This executive committee

could operate as the arena where functional managers,

who have a direct working relationship with

business unit managers, may voice at the executive

and board level any concern expressed by lower

organizational levels,as well as provide feedback

on the effectiveness of the program. Simultaneously,

the board should assess the strength of existingcodes of conduct and the anonymity of whistle-

blowing practices to encourage constructive criticism.

• Especially in these times of heightened levels of public

scrutiny on business conduct, oversee the process

adopted by senior executives to identify, categorize,

and prioritize business uncertainties with respect to

their reputation effects. Directors should ensure that

prioritization criteria and other techniques used in

compiling a risk portfolio comprise, among others, a

set of reputation metrics. Specifically, the inclusion

of a risk event in the portfolio should also be decidedbased on the likelihood and impact of the event

consequences on the company’s reputation capital.

Likewise, the board should oversee the determination

of a proper response strategy to each risk category

affecting corporate reputation. Directors should be

skeptical of attempts at restoring stakeholder confidence

solely through the use of savvy communication tactics

and request instead that response strategies fully

address the underlying strategic or operational risks. In a

well-designed ERM program, communication tactics and

better disclosure should be seen as tools to corroborate

and complete a business risk-response strategy,not to

replace it.

• Reinforce crisis management capabilities by identifying,

in collaboration with management, the stakeholder

relations that are most important to the company’s

long-term objectives and on which the organization

should allocate its resources in times of crisis. Senior

managers should be overseen as they develop simulation

exercises for the purpose of preparing various organi-

zational ranks to the functions they would need to

perform when the company operates in crisis mode.

In particular, board members should be persuaded about

the strategy management intends to implement should

the firm suffer a liquidity problem and experience

difficulties in raising new capital. The board should

consider designing a plan for its own operations during

a crisis and determine how often meetings should be

convened, what financial and human resources the board

should have access to, and the most effective way to

streamline communication with senior executives.

4 executive action oversee ing r isk management and execut ive compensat ion: “pressure points” for corporate d irectors the conference board

9 See Joann S. Lublin and Cari Tura,“Anticipating Corporate Crisis. Boards

Intensify Efforts to Review Risks and Dodge Disasters,”Wall Street Journal ,

September22,2008, reporting that, “according to regulatory filings, in

2006 and 2007, when Lehman was amassing mortgage-backed securities

and questionable real estate loans, the risk committee of its board met only

twice peryear.”

10 A review of Fortune 100 board committee charters conducted by

The Conference Board showed that, as of January 2006,66 percent of

companies had assigned riskoversight duties to the audit committee.

See Carolyn Brancato et al., The Role of the U.S. Corporate Boards of

Directors in Enterprise Risk Management , The Conference Board, Research

Report 1390, p. 26.



• Verify that ERM is fully integrated with existing

corporate disclosure procedures and be satisfied with

the transparency of the reporting process. In particular,

the board should be confident that the company can

effectively communicate with securities analysts andinvestors and reassure them about its ability to prevent

or promptly respond to business risks.

Strengthening the Link among Pay,Performance, and AccountabilityIt is believed that the excessive risk-taking by some

financial firms might have been encouraged by

improperly designed incentive-based compensation.11

Boards of directors set the compensation of senior

executive officers. In performing their duties, directors

should be mindful of their responsibility to create

sustainable, long-term wealth for all shareholders. It

means designing compensation arrangements suitable to:

1. attract and retain key talent in a competitive marketplace;

2. motivate managers in the pursuit of long-term goals; and

3. reward managers financially based on their actual performance.

Because of the variety of interests that should be

balanced while negotiating a compensation package,

the integrity and independence of the compensation

committee of the board is crucial.

However, recent studies document that in the last two

decades executive compensation has grown substantially

faster than corporate earnings and, in some cases, has

rewarded decisions that turned out to be detrimental to

long-term holders. For example, an analysis published

in 2008 by the Wall Street Journal in collaboration with

ERI Economic Research Institute shows that the median

salary of the top executive of a Standard & Poor’s 500

company increased 20.5 percent from a year earlier

compared to a median corporate revenue growth of only

2.8 percent.12

Moreover, an Equilar study found that, in 2007, while

the median value of bonuses tied to performance fell

18.6 percent, overall CEO total pay grew 1.4 percent

to a median amount of $1.41 million as a result of

compensation components that do not depend on

corporate results.13

For these reasons, issues of pay for performance have

been drawing attention in shareholder meetings and—

due to an increased public sensitivity to the apparent

causes of the financial turmoil—are likely to take

center stage in the upcoming proxy seasons. In particular,

during the last few years, activist shareholders have

been pushing for the adoption of bylaw amendments

granting non-binding shareholder ratification of

executive compensation (so-called “say on pay”) andcontractual “claw back” clauses to recoup bonuses and

other incentive-based rewards in the event of financial

restatements. Legislative reform proposals14 introducing

“say on pay” have been endorsed by President-elect

Barack Obama,15 while bonus recapture provisions were

included in the relief program signed by President George

W. Bush on October 3, 2008, and granting the Treasury

Department the necessary funding to purchase troubled

assets from financial institutions.16

Finally, as a result of the greater transparency on

compensation imposed by new U.S. Securities and

Exchange Commission (SEC) rules,17 investors have

been increasingly willing to withhold support from

board members in uncontested elections in those

companies for which pay for performance appears to

be a concern.18


11 See, for example, Steve Lohr,“In Bailout Furor, Wall Street Pay Becomes a

Target,” New YorkTimes, September23, 2008.

12 Compensation Indices, Economic Research Institute/ Wall Street Journal

(Career Journal), February 15, 2008, available at www.erieri.com/

index.cfm?FuseAction=NewsRoom.Dsp_Release & Press ReleaseID=149

13 Jeff Nash, “CEO Pay,” Financial Week , March 28, 2008.

14See H.R. 1257, which was approved by the U.S. House of Representative onApril 20, 2007. Also see S. 2866.

15 “The President-Elect Wants a Say on Pay,” Financial Times, November13,

2008.

16 Emergency Economic Stabilization Actof 2008 (Pub. L. 110-343): Section

111(b)(2)(A) prohibits participating companies from providing compensation

incentives to senior executive officers “to take unnecessary and excessive

risks that threaten the value of the financial institution.”

17 SEC Releases 33-8732 and 34-54302(available at www.sec.gov).

Also see, Item 402of Regulation S-K.

18 2008 Postseason Report , RiskMetrics Group, October 2008, p. 17and p. 31.



The Governance Center recommends that compensation

committees review their companies’compensation policy

to reinforce, where necessary, the notion that compensation

reflects performance as well as to introduce forms of

accountability for any risk-taking that is unjustified based

on the approved long-term business strategy. However, the

board’s ultimate responsibility is to weigh principles of pay

for performance against the need to participate effectively

in the market for human capital. In particular, compensation

programs should be designed to address:

• How to establish a strong link between the variable

portions of total compensation and the economic

objectives of the corporation. Motivational drivers,

managerial culture, and behavioral incentives should

be central topics of discussion. Committee membersshould fully understand the effects of each single

component of the pay package (i.e., base, bonuses,

equity-based incentives, benefits and perquisites,

deferred compensation, and severance) on the whole

compensation arrangements and be persuaded that:

(1) the balance between the base salary and the other

components is appropriate, and (2) the intended effects

of the variable components cannot be distorted by

managers to pursue opportunistic behaviors.

• How to measure corporate performance to ensure

that it is properly rewarded and that assessment periodsare long enough to determine whether management

decisions were, in fact, successful in creating sustainable

shareholdervalue. Depending on the business strategy

and the key performance objectives on which the

company should focus, in designing the compensation

policy, the board should consider a wide array of financial

and extra-financial performance metrics and targets.

Financial metrics may include operating cash-flow (OCF),

cash-flow return on investment (CFROI), and other

measures of economic value added. Non-financial or

operational metrics include compliance standards,

product quality improvements, customersatisfaction

data, and otherreputation measures. A more diversified

set of metrics would stimulate management to deploy all

of the company’s assets (including valuable intangible

assets) in the pursuit of its strategic goals.

• The compensation committee should plan on using

the selected metrics during the annual performance

evaluation of each executive. To avoid possible

distortions to the evaluation process, the committee

should guard against using financial metrics that are

heavily dependent on the chosen method of accounting

or that lend themselves to other types of machinations.

Experience shows that, in most circumstances, CFROI

and OCF are preferable to traditional metrics, such asreturn on equity (ROE) and earnings pershare (EPS),

which can be affected by revenue and expense

recognition or manipulated through stock buybacks

at the end of the period.

• The compensation committee should also discuss

disclosing performance targets to shareholders,

especially if such targets are necessary to understand

the material terms of the company’s compensation

program. However, directors should be sensitive to

the potential loss of competitive advantage value

that may result from disclosure and therefore weigh

transparency against strategic needs.

• What tools should be used to avoid the distortions

and pitfalls of certain equity-based incentive programs.

Companies should consider moving away from traditional

stock options that vest based on continued service since

they are proven to encourage an excessive focus on

short-term stock price results to the detriment of long-

term, sustainable business goals. Other solutions include:

1. adopting stock retention policies (orpost-vesting

holding periods), including possibly the requirement

for top executives to hold a substantial portion of

equity after ending their service for the company and

until their retirement;

2. granting restricted stock (which is forfeited unless

“earned out” over a stipulated period of continued

employment); and

3. designing stockoption plans in which the options vest

only upon meeting certain long-term performance goals

uncorrelated to the current stock price.

The compensation committee should consider adoptingand motivating formal guidelines on incentive-based

compensation for disclosure to shareholders.

• The overall fairness of any compensation grant, including

benefits and perquisites (e.g., housing and relocation

allowances, use of corporate jets or limousines, etc.).

To examine this aspect, the committee may develop

internal analytical tools, such as wealth accumulation

analyses and studies on the correlation between top




executive compensation and the salary levels of other

employees. Specifically, wealth analyses may prove

useful in determining the need for severance and

retirement benefits, whereas equity indicators help

ensure that resources are not gravitating to the top,thereby creating a retention—and possibly a succession—

problem. The compensation committee should also report

on compensation fairness to the full board so that all

directors have an understanding of the magnitude of total

potential payouts to executives, particularly to the CEO,

in such unique or unusual circumstances as an extreme

increase or drop in the company’s share price or in the

event of a merger, acquisition, or going-private transaction.

• Whether the company’s compensation levels should

match or exceed those of a peer company and, if so, to

what extent. Benchmarking is a common practice thatcan offer helpful guidance in determining appropriate

compensation figures. Nonetheless, the compensation

committee should reiterate an independent judgment

and not be constrained by or captive to industry averages

or the company’s own past practices. While using industry

benchmarks to set senior executive compensation levels,

the committee should again be mindful of the differences

in compensation levels within the organization and among

different ranks of employees.19

• Whether the compensation of executives, as disclosed

under the SEC rules, should be submitted to shareholders

for an advisory, non-binding vote, and whether such

“precatory” ratification should also be required for any

compensation arrangement between the executives and

third parties soliciting the shareholder approval of a plan

of merger, acquisition, or business consolidation (so-called

“golden parachute”). Advocates of“say on pay” clai

that, where adopted, the practice has promoted a less

adversarial dialogue between managers and corporate

owners on issues of compensation while encouraging

boards and executives to make a convincing case for

the pay program they propose. In particular, the voting

process would require board members to be more specific

and analytical in motivating their decisions in disclosure

documents and, in turn, to fully comprehend the effects

that certain compensation devices may have on the

behavior of executives. However, those who oppose such

advisory votes fear that the fiduciaries’ decisions might be

second-guessed by shareholding groups with limited

knowledge of the challenges of the job market and

possibly induce directors to act conservatively in

the search for new talent.

• Whether the compensation program should introduceaccountability devices to avoid situations in which

senior executives are financially insulated from the

consequences of acts contrary to the best long-term

interests of the company. These devices may include

contractual claw-back provisions to recoup bonuses

or other incentive-based rewards in case of financial

restatements or when the company determines

that the executive—without informing the board and

submitting the issue to the review and approval of the

compensation committee—willingly made a business

decision that is inconsistent with the board-approved

business strategy. Factors to consider in determiningwhether such accountability devices are appropriate

for a specific company are the corporate culture,

the size of the organization, its performance history,

its employee retention rate, and the degree of competition

in attracting the best managers. Should the compensation

committee or the full board conclude that such

accountability devices would impair the ability of the

enterprise to create long-term shareholder value, the

company should considerdisclosing the rationale for such

a decision in the compensation discussion and analysis

(CD&A) section of annual reports to shareholders. At a

minimum, compensation arrangements should require

that, in all cases of failed performance, executives forfeit

severance payments and accelerated vesting benefits.

• The explicit prohibition of any arrangement that could

be interpreted as an attempt to circumvent either the

requirements or the spirit of the law, accounting rules,

or stock exchange listing standards. In particular, the

committee should remain vigilant and demand specific

approval of any contract involving a seniorexecutive

and a subsidiary, a special purpose vehicle, or other

affiliates of the company. Because of the significant

potential for conflicts of interest, these compensation

arrangements should be permitted only in very special

circumstances and upon full disclosure to the SEC. When

these arrangements are approved, the committee orthe

full board should closely monitor their execution.20


19 Also see Commission on Public Trust and Private Enterprise, Findings and

Recommendations, The Conference Board, Special Report 4, 2003, p. 10.

20 Ibid.



• Ensuring that the compensation policy is coherent

with the company’s succession plan for top executives.

Management succession is one of most critical strategic

risks a business faces and a favorite topic of discussion

on the role of the board in business crises. Nonetheless,research shows that short-term profit pressures have

rapidly curtailed the tenure of sitting CEOs,21 increasing

the likelihood of succession riskas well as its potential

impact on long-term business prospects. NYSE listing

standards require boards to explicitly address CEO

succession plans in corporate governance guidelines,

including succession in the event of an emergency

or retirement.22 It is the responsibility of the

compensation committee to design a compensation

program that is aimed at both: (1) opposing this trend

of declining executive tenures by counterbalancing

short-term inclinations with a set of long-term behavioral

incentives,and (2) developing talent pools throughout the

managerial ranks of the organization so that the business

can promptly respond to the unexpected. With respect to

the latter, the role of the compensation committee is also

to ensure that the company’s compensation policy does

not encourage a “horse race”mentality that may lead to

the loss of key officers when the new CEO is chosen.

The compensation committee should be prepared

to discuss these issues on an annual basis as part

of the periodic review of the effectiveness of the

compensation program.

The Governance Center believes that the board of

directors, as part of its effort to strengthen the integrity

of the negotiation process, should also:

• Regularly assess independence standards andperformance of compensation committee members.

• Adopt additional safeguards when the chairman/CEO

positions are not separated. When the same person

serves as both chairman and chief executive officer,

it becomes more difficult to objectively monitor the

executive’s own performance.

• Understand the nature and scope of compensation

consulting services engaged by the company and,

where necessary because of actual or perceived

conflicts of interests, retain a different consultingfirm than the one used by management.


21 Board Practices. The Structure of Boards of Directors at S&P1500 Companies,

RiskMetrics Group, 2008, p. 41.

22 NYSE Listed Company Manual, Section 303A(9).

The foregoing list of issues is not intended to be an

exhaustive list of risks and other considerations result-

ing from current market conditions. In particular, compa-

nies facing financial difficulties will have a range of other

issues to consider, which are beyond the scope of this

report. Regulated entities will have additional issues,

which also are beyond the scope of this report.

This report is not intended to provide legal advicewith respect to any particular situation and no legal or

business decision should be based solely on its content.



About the AuthorMatteo Tonello, LL.M., S.J.D., is a corporate governance

and regulatory compliance expert and the Associate

Director of research of The Conference Board Governance

Center in New York City. A corporate lawyer by back-

ground, Matteo has conducted for The Conference Board

corporate law and risk management analyses and research

in collaboration with leading corporations, institutional

investors and professional firms. Also, he has participated

as a speaker and moderator in educational programs on

governance best practices.

Before joining The Conference Board, Matteo Tonello

practiced corporate law at Davis Polk & Wardwell.

He received a Master of Laws degree from Harvard

Law School and a J.D. from the University of Bologna.

He also earned a S.J.D. from the St. Anna Graduate

School of the University of Pisa (Italy) and was aVisiting Scholar at Yale Law School.

About The Conference BoardThe Conference Board is the world’s preeminent

business membership and research organization.

Best known for the Consumer Confidence Index™

and the Leading Economic Indicators, The Conference

Board has, for more than 90 years, equipped the

world’s leading corporations with practical knowledge

through issues-oriented research and senior executive

peer-to-peer meetings. The Governance Center at

The Conference Board brings together senior executives

from leading world-class organizations and institutional

investors in a non-adversarial setting to debate and

develop innovative governance practices.

AcknowledgementThe author would like to thankThe Conference Board

Governance Center Advisory Board members fortheir contribution to the discussion of these issues.

In addition, the author is grateful to Tony Galban,

Alan Rudnick, and Yale Tauber for their comments and

suggestions.


The Conference Board, Inc., 845 Third Avenue, New York, NY 10022-6600

Tel 212 759 0900 Fax 212980 7014 www.conference-board.org

Copyright © 2008 by The Conference Board, Inc. All rights reserved.

The Conference Board and the torch logo are registered trademarks of

The Conference Board, Inc.

For more information on The Confernce Board Governance

Center, please contact: Paul DeNicola, Ph.D., Associate

Director, Governance Center, at 2123390221

For more information on this memorandum please

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