UK Walker Report Urges Limits on Variable Compensation and Stronger Board Oversight

A blue ribbon committee empanelled by the UK Treasury has recommended sweeping and fundamental changes in executive compensation at financial institutions. While falling short of capping executive pay, the eagerly awaited report of Sir David Walker recommended the significant deferral of bonus schemes and increased public disclosure about the compensation of highly-paid executives. As a matter of sound corporate governance, the Walker report also urged remuneration committees to oversee the pay of highly-paid executives not on the board and, more broadly, conduct an intense scrutiny of firm-wide pay. The report also called for a code for institutional shareholders. The report calls for enforcing the proposed standards through inclusion in the Combined Code on Corporate Governance, which operates on a comply or explain basis.

According to Sir David Walker, a former Assistant Treasury Secretary, failures in corporate governance at financial institutions made the financial crisis much worse. Many boards inadequately understood the type and scale of risks they were running and failed to hold the executives to high standards of sustainable performance. In addition, bonus schemes contributed to excessive risk-taking by rewarding short-term performance. He believes that the recommendations are as tough or tougher than anything to be found elsewhere in the world. An important and urgent challenge is to promote adoption of similar approaches internationally.

Going hand-in-hand with compensation reform is the enhancement of risk management. Given that a core function of a financial entity is the successful arbitrage of risk, said the report, board-level engagement in the high-level risk process must be materially increased with particular attention to the monitoring of risk and discussion leading to decisions on the entity’s risk appetite and tolerance. This will call for a dedicated focus on risk issues in addition to and separately from the executive risk committee process and there should be full independence in the group risk management function. Companies should employ a chief risk officer with enterprise-wide authority and independence, with tenure and remuneration determined by the board.

Companies should set up board risk committees, separately from the audit committee, with oversight of risk exposures of the entity and future risk strategy. The board risk committee should file a separate report within the annual report describing the strategy of the firm’s risk management, including information on the key exposures inherent in the strategy and the associated risk tolerance of the firm. In addition, the report should provide at least high level information on the scope and outcome of the stress-testing program. Also, there should be disclosure of the membership of the committee, the frequency of its meetings, and whether external advice was taken and, if so, its source.

The remuneration committee should be authorized to cover all aspects of remuneration policy on a firm-wide basis with particular emphasis on the risk dimension. Specifically, committee oversight should be extended to remuneration policy and remuneration packages of all executives for whom total pay exceeds the median compensation of executive board members on the same basis. The remuneration committee report should confirm that the committee is satisfied with the way in which performance objectives are linked to the related compensation structures for this group and explain the principles underlying the performance objectives and the related compensation structure if not in line with those for executive board members.

Deferral of incentive payments should provide the primary risk adjustment mechanism to align rewards with sustainable performance for executive board members and executives whose remuneration exceeds the median for executive board members. Incentives should be balanced so that at least one-half of variable remuneration offered in respect of a financial year is in the form of a long-term incentive scheme with vesting subject to a performance condition with half of the award vesting after not less than three years and of the remainder after five years. Short-term bonus awards should be paid over a three year period with not more than one-third in the first year. Clawback should be used as the means to reclaim amounts in limited circumstances of misstatement and misconduct.

The Walker report did not recommend a move from the unitary model to a two-tier board stricture with separate executive and supervisory boards, such as found in Germany and the Netherlands. The two-tier board model is already an optional alternative in the UK since company law does not exclude it, noted the report, but UK firms have not moved to a two-tier approach and shareholders do not appear to have pressed for it.

The two-tier approach is not a panacea, the report concludes, since it does not assure members of the supervisory access to the quality and timeliness of management information flow that would generally be regarded as essential for non-executives on a unitary board. Moreover, since in a two-tier structure members of the supervisory and executive boards meet separately and do not share the same responsibilities, the two-tier model would not provide opportunity for the interactive exchange of views between executives and non-executive directors.

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