Tag Archive: culture

Driving Behaviors Through Incentives and Risks

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The following blog post is one installment in a series related to board oversight of corporate culture. The National Association of Corporate Directors (NACD) announced in March that its 2017 Blue Ribbon Commission—a roster of distinguished corporate leaders and governance experts—would explore the role of the board in overseeing corporate culture. The commission will produce a report that will launch during NACD’s Global Board Leaders’ Summit Oct. 1–4.

CompensationCulture

Incentives can reward performance—and create tension and unintentional risks.

One element that helps define an organization’s culture is the set of incentives motivating employees to act. While incentives can effectively reward performance that benefits the enterprise, the compensation committee—and the board more generally—must factor in the tension and unintentional risks that incentives can create.

NACD, along with Farient Advisors, Katten Muchin Rosenman, PwC, and Sidley Austin, last fall cohosted the first-ever joint meeting between the NACD Compensation Committee Chair Advisory Council and the NACD Advisory Council on Risk Oversight. Committee chairs from Fortune 500 corporations joined governance stakeholders for an open dialogue on incentives and risk taking.

The discussion was held under a modified version of the Chatham House Rule, under which participants’ quotes are not attributed to those individuals or their organizations, excepting cohosts.

Six questions emerged that boards and compensation committees should consider:

  1. Do we have an appropriate balance of metrics?
  2. Are we calibrating goals and upside opportunity appropriately?
  3. Are we considering the quality of performance?
  4. How robust are the controls on data that is used as inputs to the compensation plan?
  5. How are our board’s committees collaborating on developing and monitoring incentive plans?
  6. Are we actively exercising discretion?

Below are details for three of those questions. More information is available for download in NACD’s complimentary brief, Incentives and Risk Taking.

Do we have an appropriate balance of metrics?

The Report of the NACD Blue Ribbon Commission on Performance Metrics states, “Corporate leaders must select metrics that encapsulate the company’s strategy, the balance of risk and reward, and the milestones along the way.” Management chooses appropriate metrics for the company. The board’s role is to decide if those metrics help create long-term value for shareholders—and also to ask management the right questions to ensure that risks associated with compensation plan incentives are being mitigated.

“Our responsibility is to understand the business and the industry,” said one director at the meeting. “The more we understand the business, the more [any] red flags will become apparent.” Meeting participants added that just as there is no silver bullet or single perfect metric to use when developing incentive plans, there is no one-size-fits-all approach to finding a satisfactory balance of metrics.

“There’s no perfect performance measure because every one of them can be gamed either deliberately or not deliberately,” said Dayna Harris, vice president at Farient Advisors. “In addition, it’s important to factor in trade-offs—for example, between metrics related to earnings and those related to revenue or returns—in order to get a combination that works.”

Thomas J. Kim, partner at Sidley Austin, said, “Performance metrics for compensation should be consistent with how management and the board think and talk about the business, both internally and externally. Qualitative metrics are generally more appropriate for, and tailored to, specific individuals, rather than for management as a whole.”

Are we calibrating goals and upside opportunity appropriately?

In addition to selecting performance measures, compensation committees must ensure the pay plan keeps the firm’s risk appetite in mind. The goal is to avoid unintended consequences that might compromise the enterprise’s reputation or its long-term viability. At one council delegate’s company, “the chief risk officer does a risk analysis of the executive compensation plans and shares it with the board. We can assess where it nets out on the risk spectrum. The analysis is repeated at the end of the year to look at incentive payouts and whether any business area took undue risks.”

Participants highlighted two areas for compensation committees and boards to consider:

  • Incentive thresholds. “Stretch goals are great and often important to strategy execution. But the board needs to ask whether high incentive thresholds may encourage bad behavior,” one participant said.
  • Slope-of-the-payout curve. Harris advised, “Make sure the upside [payout] opportunity is not excessive, especially for annual incentives. Three hundred to four hundred percent payout ranges can be dangerous.”

Are we considering the quality of performance?

Council delegates also emphasized that it is essential for compensation committees—and, indeed, for all board members—to ask probing questions about the way in which management achieves results, not just whether or not a particular performance target has been met: “How you get there makes all the difference: we have to look at the quality of earnings,” one delegate said. “If our incentive plan is heavily weighted toward rewarding revenue, did we end up with a bunch of low-margin or bad deals?”

One compensation committee chair reported, “To make sure that our results are sustainable, we’ve introduced strong metrics around employee satisfaction and engagement, along with customer satisfaction. These can count for as much as 25 percent of the CEO’s annual bonus.”

Questions about the quality of performance have risen to the top of many boards’ agendas in the wake of criticism over the consequences of aggressive incentive plans at companies such as Wells Fargo and Mylan. Reflecting on what has been publicly reported about these two situations, participants identified the following takeaways for directors:

  • Exercising skepticism is essential in times of good performance—when it is often most difficult to do. “It can be hard for directors to push back when they’re in the boardroom of a high-functioning organization and hearing lots of great stories from management,” observed one participant. Several delegates pointed out that executive sessions can be particularly useful in this regard.
  • Question over-performance as closely as underperformance. “If it looks too good to be true, it probably is,” a director said. “Wells Fargo’s cross-selling numbers were significantly above industry standard. As directors, we need to look very closely at outlier-level performance—it might be a red flag.”
  • Reputation risk can be material, even when financial losses are relatively small.

By incorporating into board discussions the above-listed questions, directors can strengthen responsible oversight of incentives. “It’s our responsibility as directors to understand the business and the industry in depth—trends, competitors, pricing models,” one director said. “That gives us a much deeper understanding about what is possible and what we’re asking management to do when we set goals and targets. It will also help us see potential risks and red flags much earlier.”

Through the Boardroom Lens

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Directors attending the recent NACD Directorship 2020® event in Denver, Colorado engaged in group discussions about how boards can anticipate and effectively respond to environmental and competitive disruptors in the marketplace.

The half-day symposium at the Ritz-Carlton on July 15 was the second of three NACD Directorship 2020 events this year addressing seven disruptive forces and their implications for the boardroom. Summaries of the Denver speakers’ main points are available here.

Following each speaker, directors developed key takeaways for boards. Those takeaways fell within the parameters of the five elements of effective board leadership defined at last year’s NACD Directorship 2020 forums: strategic board leadership and processes, boardroom dynamics and culture, information and awareness, board composition, and goals and metrics.

Environmental Disruptor Takeaways

Strategic Board Leadership and Processes

  • Crisis response plan. Ensure that the company has a contingency plan in place that takes into account a potential environmental crisis. The plan should include how the company will respond to disruptions in the supply chain and production cycle, as well as to employees, customers, and investors.

Boardroom Dynamics and Culture

  • Culture. Boardroom culture should reflect that directors are ready and willing to be held accountable for environmental or climatological issues that arise for the company.

Information and Awareness

  • Engagement. The company should have an established communications plan to use in response to requests from shareholders and stakeholders regarding environmental matters.

Goals and Metrics

  • Green metrics. Becoming a sustainability-focused company requires adopting a long-term commitment to the cause. The board can communicate that commitment by establishing environment-related performance metrics that align with the corporate strategy.

Competitive Disruptor Takeaways

Strategic Board Leadership and Processes

  • Board agenda. Set aside time on the board agenda to discuss forward-looking strategy, so that the board’s focus is not limited to reviewing the company’s past performance.

Boardroom Dynamics and Culture

  • Culture. Fostering innovation requires risk. The culture throughout the organization should support failure and risk taking within the company’s tolerances. Also invite outside experts—or “white space” teams—to help trigger new, innovative thoughts.

Board Composition

  • Composition. Board composition should reflect a diversity of thought and experience. Regardless of background, directors should be willing to ask probing questions and stay aware of marketplace trends.

Goals and metrics

  • Understanding the marketplace. Management should be able to answer who future competitors might be and what trends might gain traction.

How Boards Can Strengthen the Risk Oversight Dialogue With Management

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This spring, members of the NACD Advisory Council on Risk Oversight convened in Washington, D.C., to discuss how boards can strengthen their dialogue with management on risk oversight. Participants—including Michael Hofmann, the former chief risk officer of Koch Industries and current director of Calpine—shared experiences, lessons learned, and effective approaches for embedding risk in board-level strategy dialogue. From that discussion—detailed in the meeting’s Summary of Proceedings—delegates focused on these steps directors can take. They include:

  • Establish a clear definition of what “risk” means at the company: For management and the board to work together, they need to establish a shared definition of what risk means to the company.
  • Monitor the company-wide risk culture: Directors should ensure that the company has a culture that supports the discussion of risk throughout the entire organization and is seen as part of the company’s fabric.
  • Avoid the trap of false precision: Looking at only the expected return of a new business program or strategic move can restrict dialogue and lead to minimization of the potential downside.
  • Get out of the weeds by taking a deep dive: To help counteract the tendency of boards and management to focus on operational, regulatory, and financial reporting risks, many boards conduct an annual “deep dive” or “off-site” meeting. These meetings are dedicated to thinking about, understanding, and challenging assumptions of strategic moves and risks.

The Summary of Proceedings also investigates ways in which directors can and do incorporate these practices into their boards’ activities. NACD members can click here to access the full list of takeaways.