Recent corporate events have focused the corporate world on the potential for substantial financial and reputational risk that may be lurking in companies’ compensation programs. This revelation (for some) has led more companies to expand their efforts to discover, eliminate, or mitigate risk in their compensation plans and programs. Some boards are asking, “Could that happen here?”

Compensation risk assessment programs developed by companies to satisfy this SEC requirement provide the template for answering this question. Since 2010, Item 402(s) of Regulation S-K has required most public companies to disclose whether their compensation policies and practices for all employees, including non-executive officers, are reasonably likely to have a material adverse effect on the company. (Smaller reporting companies are exempt from this requirement, but emerging growth companies are not.)

Because every company of every size in every industry has a different risk profile, there can be no “one size fits all” program for conducting the required compensation risk assessment. For example, an equity compensation award of 100% stock options may be appropriate for a small growth company in the technology sector, whereas a mature manufacturing company in a cyclical industry may want to award restricted stock or RSUs. The risk factors for stock options are different than those for restricted stock or RSUs. However, most companies would be well-advised to follow a systematic action plan for conducting the compensation risk assessment, as many of the procedural steps to conduct a thorough and compliant risk assessment will be the same for all companies. Executive compensation professions have developed lists of red flags and questions to ask as part of the compensation risk assessment, as well as lists of mitigating factors for companies and plans.

If a company suffers an unexpected loss in the future that can be traced back to executive compensation—and let’s face it, the press, the government, and the plaintiffs’ lawyers will trace everything back to executive compensation—some of the questions to board members might be:

  • Did you evaluate this risk?
  • Did you take steps to mitigate it?
  • Did you sign off on a risky corporate strategy?
  • Did you approve pay programs that encouraged too much risk taking?

Generally, the business judgment rule will protect those who studied the plans and risks, and concluded they were acceptable.

After the fact, a question that surely will be posed to board members is, “Did you hold back/recoup pay from responsible executives?” But we will talk about that one next week.