Saturday, October 22, 2011

Financial Stability Board Report: Compensation Committees are Integral to Reforming Executive Compensation

Sound corporate governance is inextricably linked to the reform of executive compensation to control excessive risk taking, says a report issued by the Financial Stability Forum, and an effective compensation committee is an integral part of the governance structure. The report states that progress is being made in implementing compensation reform in light of the financial crisis, often along the line of the principles of executive compensation issued earlier by the Board.

The FSB principles require that a firm’s board of directors actively oversee the compensation system’s design and operation and monitor and review the compensation system to ensure the system operates as intended. The compensation system should include controls and should be regularly reviewed. Also, the compensation committee should be constituted in a way that enables it to exercise competent and independent judgment on compensation policies and practices and the incentives created for managing risk, capital and liquidity. In addition, it should carefully evaluate practices by which compensation is paid for potential future revenues whose timing and likelihood remain uncertain.

In so doing, the compensation committee it should demonstrate that its decisions are consistent with an assessment of the firm’s financial condition and future prospects. The compensation committee should work closely with the firm’s risk committee in the evaluation of the incentives created by the compensation system. Staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee in order to preserve the integrity of financial and risk management’s influence on incentive compensation.

Compensation committees are part of the governance structures in virtually all of the firms surveyed for the FSB report, and at most firms, are comprised entirely or mostly of independent directors. The Board recommended that members of the compensation committee collectively have knowledge and experience in compensation, human resources, finance and risk management. Further, at least one member of the risk management committee should also be a member of the compensation committee in order to provide practical skills and experience of risk management. The board should periodically review the composition of the compensation committee to ensure that it has the requisite independence, skills and experience. The compensation committee must have free and unfettered access to management and employees; and be permitted to engage external advisers..

Although the responsibilities of compensation committees vary across firms and jurisdictions, their duties typically include designing and operating compensation policies and practices and approving or recommending for board approval the amount and form of distribution of variable pay and total compensation, They also review and assess the remuneration policies and practices including compliance with regulatory requirements.