Linking Remuneration Policy with Corporate Risk

Catherine Corcoran, Consulting Partner, talks to Chartered Accountants Ireland

Tuesday, May 03, 2011

The Golden Goodbyes, Golden parachutes,  Failure bonuses  and Golden hellos that  have been a feature of irish corporate life for the last decade have  made remueration and how we deal with it a ‘number one’ political agenda and a key corporate governance issue. They are a very visible symptom of the systemic failure that has wrecked havoc with our country and our sovereignity.

The public are angry and see remuneration as the visible face of all that was wrong with the celtic tiger and our governance structures. Headline after headline over the last year are testament to the damage that a cavalier approach to remuneration can ‘wreck’.

It is generally acknowledged that excessive risk taking in the Banking and financial services sector has contributed to the financial crisis we find ourselves in and global systemic problems.

There is consensus that inappropriate remuneration practices in the financial services sector induced excessive risk taking . The short term perspective adopted in the approach taken effectively incentivised risk taking. The remuneration practices which were in play ran counter to effective and sound risk management. They rewarded short-term profit and allowed for short term personal rewards versus long-term losses for the organisation.

While much of the emphasis has been on the financial services arena, there are serious lessons to be learnt by all organisations, both public and private, by understanding that sound remuneration policies will minimise their exposure to risk. 

There are a number of issues  on the remuneration agenda which must be considered when considering the impact that lack of a rigorous approach to remuneration has had in contributing to the disaster that has befallen our banking and financial services sector. All boards should have these on their agenda. These are:

1. Design of remuneration packages – They should be sufficient to attract and retain good executives and capable of motivating the executive towards the achievement of performance that is in the best interests of the company/shareholders.  Big incentives can impair judgement. Incentives should be rooted in more than financial performance indicators . We have seen over the last decade that financial performance is not necessarily indicative of success. The balance between  variable –vs – fixed elements of remuneration packages should be carefully thought out.  A long term focus should be taken since if performance criteria are too short term, it can go against the long term interests of the company.  Severance payments elements of any remuneration package should also be carefully thought out.
2. Disclosure – adopt legal, regulatory and best practice requirements to disclose directors’ remunerations. These act as an accountability measure.  
3. Remuneration Committees – having a rigorous and clear terms of reference for same can ensure that a best practice approach is taken to remuneration and that risk is minimised.
4. Use of Remuneration Consultants – Don’t over-rely on remuneration consultants. There is a view that this can be counterproductive. They are there to advise not decide policy – the board needs to do this.
5. Regulatory environment – The regulatory environment and compliance guidelines in relation to remuneration are constantly changing as more reports and more recommendations are published to address the serious issues that have arisen in this area. Boards need to know what these are and make decisions about how they should respond.

There have been a considerable number of developments in the regulatory environment in the area of remuneration and it’s relationship to risk during the past three years.

As the crisis unfolded, so too did the regulatory responses in terms of controls on remuneration policies. Interestingly, the Combined code (2008) did not highlight the the link between remuneration and risk but the FRC (Financial reporting Council) December, 2009  review of the combined code published in December, 2009 established a strong link and proposed the following actions:

• A new supporting principle should be added on the need for performance-related remuneration to be aligned to the long term success of the company
• The schedule should also be amended to add references to  the link between remuneration and risk policy, the use of non financial metrics when measuring performance and arrangements for reclaiming variable componants in certain circumstances
• The provisions on remuneration of non exec directors should be amended to clarify that all forms of performance related remuneration are discouraged for those directors – not just share options
• The FRC to keep under review whether future changes to the combined code would be appropriate in respect of the code of practice for remuneration consultants

These provisions were later enshrined in the new UK Corporate Governance Code (formerly the Combined Code) which was published by the FRC in June, 2010.

Commentators were disappointed that The ABI  (Association of British Insurers) Guidelines issued in December, 2009  had an  inadequate emphasis on risk given the financial crisis. However, there were  new references which say that the Remuneration Committee should have oversight of all associated risks arising as a result of remuneration policies. They also say that they should consider what remuneration packages may trigger in terms of risk and ask the question whether remuneration structure is compatible with risk appetite.  They also recommended an overlap between the  Risk Committee and the Remuneration Committee  to ensure all aspects covered and an overlap between the audit and Remuneration committees.

The FSA (Financial Services Authority) remuneration code published in august 2009 and updated in December, 2010 established a  very strong link between risk and remuneration policy. It included a  general requirement for firms to establish remuneration practices that promote effective risk management.

‘A firm must establish, implement and maintain remuneration policies,  procedure and practices that are consistant with and promote effective risk management’ .

The FSA remuneration code covers all aspects of remuneration that could have a bearing on effective risk management including wages, bonus, longterm incentive plans, hiring bonuses, severage packages and severance arrangements’

The Independent commission on Banking in the UK, chaired by Sir John Vickers was asked to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition and to make recommendations to the government by the end of September, 2011. They published an interim report on 11^th April, 2011. Paul Kenny, General Secretary of the GMB trade union criticised it saying it did not go far enough:

 "The elephant in the room, the bonuses and the greed which were the root cause of all the trouble and which led to the bankers' recession, has been completely ignored in this report. There is no guarantee that this root cause will be tackled so there is no guarantee that it won't bring the banks down again”

In Ireland, we have seen and heard much about the CIROC report to the Minister for Finance in February 2009 which recommended capping payments for executives in named covered institutions at 500K.  In practice however there appears to be a culture of finding a way around this by topping up the base rate with pension plans and other expenses.

‘Bouchers pension plan was contrary to committee view’ (irish times 23^rd April, 2010).

The ISE/IAIM report (2010) recommends that Remuneration Committees must identify a remuneration philosophy or policy in the annual report and that there should be clear and concise disclosure on remuneration policy in line with para. 5 of section 11 (Rem. Policy) of the EU guidance on remuneration. It says that where there are particular challenges facing a company in attracting, retaining and motivating key personnel, the specific contextual facts leading to these challenges should be described as well as the overall strategy for dealing with them.

The EU Response to regulating remuneration Policies in the Financial Services – impact in Ireland and the UK.

Of particular interest is the EU response to regulating remuneration policies and minimising risk in the financial services sector.

The Committee of European Banking Supervisors (CEBS) published its final Guidelines on Remuneration Policies and Practices in December 2010 in fulfilment of the requirement placed on it the EU Capital Requirements Directive (CRD 111) making the EU remuneration regulatory framework for remuneration policies in financial services the most demanding of any major international financial centre. CRD 111 aims to align remuneration principles across the EU.  It is now for national regulators to introduce the consequential market rule. The Guidelines will apply to relevant employees located outside of the EU;

• at least 40% - 60% of variable remuneration should be deferred and at least 50% of any variable remuneration should consist of equity-linked instruments (effectively capping the amount of bonus that can be paid immediately in cash to 20% - 30% of the total earned by affected staff);
• there is the expectation that firms will manage variable remuneration as a ratio of fixed pay, rather than as a portion of total compensation; and
• They also note that relative performance measures should be used with caution and that absolute measures are preferable.

In the UK, the FSA (Financial Services Authority) have incorporated the CEBS Guidelines in to their updated Remuneration Code published in December, 2010 to come into effect on 1^st January, 2011. The 2010 revised code will not only apply to these firms but will encompass a much larger group of firms including all banks and building societies and CAD investment firms – some 2700 in total.

Our Central Bank has published a guide for investment firms in implementing CRD 111 and written to investment firms reminding them of their obligations which took effect from 1^st January, 2011.  They emphasised the need for compliance with the CEBS guidelines on remuneration.  While the Guidelines are detailed and provide significant direction in terms of what information is to be included in remuneration policies and disclosure requirements, investment firms will more than likely have to implement significant changes to deliver the required compliance.

Delivering sound remuneration Policies requires a change in Behaviours at board room level

Delivering sound remuneration policies and principles requires much more than an understanding of the risks and knowledge of the actual principles and regulatory controls.

It requires a sound approach to ‘corporate governance’ generally with sound remuneration policies just one feature among many others that will deliver this.  Board balance, non-executive independence, Board refreshment, the work of key committees and performance evaluation mechanisms are all an essential part of the process.

Above all, it will require a change in the behaviours at board room level that lie at the root of the problem. The systemic ‘cavalier’ approach that was taken to corporate governance will not easily change even when driven by ‘Failure, outrage and regulation ‘. These three factors however will act as catalysts to changing behaviour – and give courageous people a voice around the board room table.

Catherine Corcoran,  Dip. Corporate Governance (UCD), is a consulting partner with Baker Tilly Ryan Glennon. She acts as an advisor on governance and HR issues to a number of boards both in Dublin and regional areas. She heads up the  firm's newly expanded HR consulting division following their merger with Polaris HR in April, 2011