Tag: compensation

Categories
Blog

Executive Compliance Comp and Compliance: From Incentives to Clawbacks

There are two problems that every company must deal with at the intersection of executive compensation and compliance. The first is the presence of perverse incentives within organizations, where executives are often encouraged to take excessive risks because they personally profit from them. This misalignment of incentives can lead to unethical behavior and non-compliance, ultimately harming the organization and its stakeholders. The second is both the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) mandates for executive clawbacks.

Incentives

To address this issue, companies need to tie positive incentives directly to senior executives. By holding them accountable for compliance failures, we can align their compensation with compliance objectives. This approach ensures that executives have a personal stake in maintaining ethical practices within the organization. What makes this approach unique is that it is a business response to a legal problem, rather than a government mandate. A business response is always a better way to go, as it allows organizations to take ownership of their compliance programs and tailor them to their specific needs.

Various proposals are discussed in the podcast to ensure senior executives are held personally accountable for compliance failures. One solution, suggested by William Dudley, former president of the Federal Reserve Bank of New York, is for senior management and material risk takers to forfeit their performance bond in the case of large fines. This not only disciplines individual behavior and decision-making but also incentivizes individuals to flag issues when problems arise.

Another approach, outlined in an article titled “Ties That Bind Codes of Conduct,” recommends automatic reduction of pay for officers, directors, and advisors for failures of corporate governance. Executives would agree to pay back a portion of their gross compensation for a set period before the beginning of any improprieties, regardless of their knowledge of misdeeds within the company.

While corporate leaders may not be enthusiastic about being held accountable, these proposals offer a business solution to a legal problem. Holding senior executives responsible for the conduct of others aligns with their obligations under Sarbanes-Oxley and ensures that they are not shielded from the consequences of non-compliance. Shareholders are also becoming less accepting of the argument that leaders should not be responsible for the actions of their employees.

Data from an article by Gretchen Morgenson titled “Ways to Put Your Boss’s Skin in the Game” further supports the need for accountability in executive compensation. The article explores how to make senior executives more responsible for corporate malfeasance, with implications that apply to compliance programs and compensation tied to compliance.  Creating accountability in executive compensation is a critical step towards promoting ethical business practices and compliance within organizations. By tying positive incentives to senior executives, we can ensure that they have a personal stake in maintaining compliance objectives. The proposals discussed in the podcast, such as forfeiting performance bonds and enforcing pay reductions for failures of corporate governance, offer practical solutions to address perverse incentives and drive ethical behavior.

Clawbacks

Clawbacks, often seen as a form of guarantee for businesses, play a vital role in addressing employee misconduct. These provisions, typically included in written contracts, serve as a deterrent and allow organizations to reclaim incentive or bonus funds from employees engaged in wrongful activities. It is important to note that clawbacks apply to compensation received as incentives or bonuses, rather than salary.

The SEC has provided guidance on constructing effective clawback provisions. In their final rule titled “Listing Standards for Recovery of Erroneously Awarded Compensation,” (the Rule) the SEC directs National Securities Exchanges and Associations to establish listing standards for issuers to develop and implement policies for recovering incentive-based compensation in the event of required accounting restatements.

The DOJ has also weighed in on subject of clawbacks, most recently in the 2023 Evaluation of Corporate Compliance Programs (ECCP), it stated “Are the terms of bonus and deferred compensation subject to cancellation or recoupment, to the extent available under applicable law, in the event that non-compliant or unethical behavior is exposed before or after the award was issued? Does the company have a policy for recouping compensation that has been paid, where there has been misconduct? Have there been specific examples of actions taken (e.g., promotions or awards denied, compensation recouped or deferred compensation cancelled) as a result of compliance and ethics considerations?”

In summary, both the SEC and DOJ have now laid out the foundations for both incentives and consequence management.

SEC: The SEC Rule encompasses a wide range of scenarios. Companies are required to claw back incentive compensation erroneously received by current or former executives during the three-year period preceding the required restatement date. The definition of “received” is broad, considering incentive compensation earned even if not yet paid. The recoverable amount may differ from what executives would have received based on the required restatement. The SEC rule prohibits companies from obtaining indemnity insurance to protect executives from clawbacks. This step ensures that executives are held personally accountable for their actions and fosters a culture of compliance within organizations.

DOJ: In the ECCP has emphasized the significance of clawbacks in compliance programs. The ECCP directs companies to develop and apply compensation and clawback policies, shifting the burden of financial penalties away from innocent shareholders. The clear intent to prevent companies from shielding employees involved in illegal and unethical conduct. The DOJ will consider whether a company has incentivized compliance by designing compensation systems that defer or escrow certain compensation tied to conduct consistent with company values and policies. Enforcement of a contract provisions that permit the company to recoup previously awarded compensation if the recipient of such compensation is found to have engaged in or to be otherwise responsible for corporate wrongdoing is now a critical metric that prosecutors will consider. Finally, prosecutors may consider whether provisions for recoupment or reduction of compensation due to compliance violations or misconduct are maintained and enforced in accordance with company policy and applicable laws.

 Practical Steps

To create a robust compliance program that promotes ethical behavior and compliance, companies should consider the following practical advice:

  1. Documented Policies and Procedures: It is crucial for companies to document and reflect clawback policies and procedures in their compensation agreements. This documentation showcases a commitment to compliance and serves as a deterrent for potential misconduct.
  1. Clear Disciplinary Procedures: Companies should have appropriate and clear disciplinary procedures in place when enforcing a compliance program. Publicizing disciplinary actions internally and under local law can have a deterrent effect on employees, emphasizing the consequences of engaging in unlawful or unethical behavior.
  1. Personal Accountability: The DOJ and SEC prioritize holding individuals accountable for misconduct. Prosecutors evaluate whether a corporation’s compensation agreements incorporate clawback provisions that enable penalties to be levied against employees, executives, or directors involved in criminal conduct.

 Conclusion

Clawback provisions have become a crucial element in compliance programs, promoting ethical behavior and ensuring accountability within organizations. The SEC Rule, along with the DOJ’s emphasis on clawbacks from the Monaco Memo to the ECCP, highlights the significance of these provisions in the business world. By implementing well-documented clawback policies, companies can create a culture of compliance that rewards ethical behavior and protects innocent shareholders. Both initiatives prioritize ethical practices and compliance to build a better business environment for all stakeholders.

Categories
Blog

The Power of Compensation: Building a Culture of Compliance

The Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have repeatedly emphasized the importance of aligning compensation plans with compliance goals. According to Tom Fox, aligning the compensation plan of salespeople can have a greater impact on compliance revenue than other forms of communication. By incentivizing ethical behavior, companies can reinforce the message of compliance and create a culture that prioritizes adherence to regulations.

To maximize the impact of compensation structures, immediate implementation is crucial. Waiting too long can dilute the message and hinder the desired behavioral changes. Employees should clearly see the connection between their actions and the incentives they receive. This immediate feedback loop motivates them to align their behavior with the goals of the compliance program.

While transparency is important in the incentive system, it should not solely be a democratic process where salespeople design the program around their own needs. However, involving employees in the process can help them appreciate changes that may not be favorable to their individual situations. Transparency fosters a sense of trust and accountability, leading to better acceptance and adherence to the compensation structure.

Compensation can be a powerful motivator for salespeople to act in ways that support the company’s evolving business model and strategy. By integrating compliance incentives into the compensation program, companies can make compliance an integral part of their organizational values. This not only drives compliant behavior but also ensures that employees understand and support the company’s overall strategy.

If your company has not yet integrated compliance incentives, it’s time to catch up. The DOJ and SEC recognized the importance of compliance incentives over 15 years ago, so companies without them are lagging behind. A practical way to start is by allocating a percentage of the discretionary bonus program to compliance. Even a small percentage can demonstrate the company’s commitment to ethical conduct and encourage employees to prioritize compliance.

Compliance incentives play a crucial role in shaping the behavior and mindset of employees within an organization. While disciplinary actions are essential, incentives provide a positive reinforcement mechanism that encourages individuals to embrace compliance as an integral part of their work. Tom Fox emphasizes that compliance incentives need not be elaborate or groundbreaking; what matters most is their consistent implementation.

There are six core principles that form the foundation of successful compliance incentives.

  1. Consistency is Key. Compliance incentives must be consistently applied throughout the organization. By doing so, companies can create a sense of fairness and predictability, reinforcing the message that compliance is non-negotiable.
  1. Supporting Systems. To ensure compliance incentives are followed, it is crucial to have supporting systems in place. These systems can include regular training, clear guidelines, and robust reporting mechanisms, enabling employees to understand and adhere to compliance standards.
  1. Transparency. Making compliance incentives transparent within the organization is essential. By showcasing the recognition and rewards associated with compliance, companies can inspire others to embrace ethical behavior and create a positive ripple effect.
  1. Overcoming Competing Goals. If safety is No.1 within an organization, doing business ethically and in compliance should be goal 1A. But often challenges can arise when competing goals, such as financial pressures, overshadow compliance incentives. To counterbalance this, a strong counterweight is necessary to ensure that compliance remains a priority, even during financial downturns.
  1. Rewarding Performance. Compliance incentives can be used to hold leaders accountable for their performance, aligning their goals with the company’s compliance objectives. This approach ensures that compliance is not sacrificed for short-term financial gains.
  1. Non-Linear Alignment. Compliance incentives should align work in an oblique, non-linear way, allowing employees to choose their own pathways while still adhering to compliance standards. This flexibility empowers individuals to contribute to compliance efforts in a manner that suits their strengths and preferences.

All of these guidelines mean that you must align compliance as an integral part of your company’s DNA. Regularly communicate the importance of compliance and the benefits it brings to the organization and its stakeholders. It is critical to implement compliance incentives at all levels of the company. Division or business unit heads can define pro-social goals and establish supporting structures and systems. Even lower-level employees should have their own version of the compliance incentive process.

There must be tangible incentives offered to employees;  both financial and hierarchical, to those who consistently demonstrate ethical behavior and compliance within your Code of Conduct and relevant laws. These rewards can range from cash awards to certificates, plaques, or even coffee mugs and t-shirts. Obviously Document Document Document is critical. Just as all other parts of your compliance program are documents, so should your incentive program.

Document compliance actions to demonstrate to regulators, if necessary, that your organization takes compliance seriously. This documentation showcases your commitment to ethical business practices and provides evidence of your compliance efforts. There must be support systems in place to reinforce the message of compliance, even during challenging times.

Creating a culture of compliance requires a multifaceted approach, and compliance incentives play a vital role in driving ethical behavior within organizations. By consistently implementing these incentives, aligning employees around compliance goals, and leveraging tangible rewards, companies can foster a sustainable culture of compliance. Remember, compliance is not just a checkbox; it’s an integral part of your organization’s success.

Incorporating compensation systems into compliance programs is a vital step towards building a culture of compliance within organizations. By aligning salespeople’s compensation plans with compliance goals, implementing immediate and transparent structures, and involving HR in the process, companies can reinforce ethical behavior, promote compliance, and drive the success of their compliance programs. Remember, simplicity, alignment with company values, and immediate impact on behavior are key factors to consider when designing your compensation structure. Finally always remember to prioritize compliance and create a workplace culture that values integrity and ethics.

Categories
31 Days to More Effective Compliance Programs

One Month to a More Effective Compliance Program: Day 7 – Designing Compensation to Operationalize Compliance

In this podcast episode, Tom Fox highlights the importance of incorporating compensation systems into a company’s compliance program. He discusses how the DOJ and SEC view monetary structures as a way to reinforce compliance and reward employees who adhere to compliance programs. Fox advises compliance practitioners to revise incentive systems to align with the goals of the compliance program, ensuring simplicity, alignment with company values, and immediate behavior change. He also emphasizes the need to align compensation programs with compliance goals and shares examples of how this can be done effectively. These episodes provide valuable insights into the role of compensation in promoting compliance and integrating compliance into HR practices, emphasizing the importance of transparency and immediate action in implementing effective compensation structures for compliance.

When it comes to compliance programs, many companies focus primarily on policies, procedures, and training. However, designing a compensation system that reinforces compliance is equally crucial. According to the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), rewarding employees who conduct business in compliance with their employers’ programs is an effective way to promote compliance.

  1. Incorporating Compliance Incentives:

To align your compensation system with your compliance program, consider revising your incentive structure. Fox advises compliance practitioners to ask themselves three key questions: Is it simple? Is it aligned with company values? Does it affect behavior immediately?

Keeping the compensation plan simple is essential to prevent employees from reverting to old, non-compliant behaviors. By aligning the goals of compliance practitioners with the entity’s compliance goals, you can ensure that the compensation program effectively drives desired behaviors.

2. The Impact of Sales Compensation:

Salespeople often generate the majority of a company’s revenue, making their alignment with compliance goals crucial. Immediate implementation of incentive structures is important, but it should also incentivize employees to support compliance initiatives. Transparent communication with employees or third-party sales bases is necessary for effective implementation.

3. Transparency and Accountability:

Transparency plays a vital role in gaining acceptance for compliance initiatives. While designing the incentive system may not be a democratic process, openness is essential. Employees should appreciate the transparency in the compensation structure, leading to accountability and their acceptance of compliance goals.

4. Integrating Compliance Incentives:

The podcast suggests incorporating compliance incentives into the compensation program. Even a small percentage of a discretionary bonus can be significant to employees. For example, a discretionary bonus program based on overall sales can be a starting point for incorporating compliance incentives. Fox recommends allocating 5-10-20% of the discretionary bonus program towards compliance incentives.

5. The Role of HR in a Fully Operationalized Compliance Program:

To fully operationalize compliance, it is essential to integrate compliance into HR practices. HR can play a crucial role in ensuring transparency, simplicity, and alignment of the compensation structure with company values. By making compliance part of the incentive structure, employees will understand and support the evolving business model and strategy of the organization.

As compliance practitioners, it is our responsibility to prioritize integrity, ethics, and compliance within our organizations. Incorporating compensation systems into our compliance programs is a powerful tool in driving desired behaviors. By aligning our incentive structures with compliance goals, keeping them simple, and fostering transparency, we can create a culture of accountability and acceptance.

Three key takeaways:

  1. The DOJ and SEC have long advocated compensation to motivate employees into ethical and compliant behaviors.
  2. Keep the compliance aspects of your compensation structure simple and easy for your employees to understand.
  3. Have full transparency in the frame of your compensation structure.

For more information, check out The Compliance Handbook, 4th edition, available on LexisNexis.com.

Categories
Blog

Some Thoughts on Clawbacks

Clawbacks have become a new topic in Foreign Corrupt Practices Act (FCPA) enforcement and compliance with the announcement of the Monaco Doctrine and release of the Monaco Memo. Matt Kelly, writing in Radical Compliance, noted, “The Securities and Exchange Commission [SEC] enacted a rule today that will require public companies to adopt and disclose executive compensation clawback policies, echoing the Justice Department’s effort to make companies exercise clawbacks more often when their executives commit misconduct.” With these developments, I thought it would be a good time to look at clawbacks and what they might mean for a corporate compliance program.

Let’s start with the basics, as in what is a clawback? According PayCor.Com a clawback “is a provision within a business or employment contract that allows—under a prescribed set of circumstances—an organization to reclaim incentive or bonus funds previously paid to an employee. Clawback clauses provide a form of guarantee in situations where a business needs to respond to employee misconduct, poor job performance, low achievements or a general decline in revenue.” The two key requirements are that (1) it is a ‘provision’ i.e., a written clause in a written employment agreement and (2) it is for compensation received in the form of an incentive or bonus, i.e., not salary. This second provision will be a critical point for employees.

Sanjai Bhagat and Charles M. Elson, in a Harvard Business Review (HBR) article entitled “Why Executive Compensation Clawbacks Don’t Work”, said, “the executive pay “clawback,” an idea that had its debut during the discussion around the passage of the Sarbanes-Oxley Act [SOX] in 2002, has become an increasingly common provision in executive compensation packages. In theory, clawback policies enable companies to recover incentive pay granted to executives for achieving financial performance targets on the basis of decisions and actions that subsequently turn out to be ethically and legally questionable, and which impose significant monetary and reputational liabilities on the company.” Indeed, as reported in the Wall Street Journal(WSJ), there have 11 executives sued by or who have settled with the SEC, based upon SOX.

Michael Schrage, in a 2012 HBR piece entitled “Bonuses Are Good, But Clawbacks Make Them Better”, said of the actions which can lead to clawbacks, “The behaviors may not be criminal or even unethical but they undeniably lead to decisions where individuals maximize their own compensation at the expense of their organization in potentially destructive ways. This typically holds true for the highest-ranking and most dynamic slices of industry, whether financial services, professional sports, health care or high tech.” This articulation would seem to fit in both the Department of Justice (DOJ) and SEC recent pronouncements.

While the regulators have focused on the punitive aspects of clawbacks, Schrage also notes they are the mirror for incentive-based compensation. “The fundamental asymmetry, of course, is the presence of bonuses and an absence of clawbacks. That is, individuals and teams may receive impressively large and ostensibly “performance-based” bonuses if they hit their numbers.” If there is no response for those who lie, cheat and steal to get such compensation, he believes an organization “is guilty of bad behavioral economics and even worse management” and that clawbacks are “deterrents and insurance policies for organizations that fear that talented individuals may take inappropriate and unsustainable shortcuts to get the bonus. Clawbacks are an essential technique for balancing long-term business health against short-term bonus wealth.”

All of this means that you should not think of compensation incentives and clawbacks as separate tools in your compliance tool kit but as complimentary tools to help foster a best practices compliance program. Bhagat and Elson propose “incentive compensation of corporate executives should consist only of restricted equity”; that is, an executive cannot sell shares of stock or exercise the options for six to 12 months after their last day in office. They believe, “This would prevent executives from capturing the financial gains from questionable decisions or actions before the longer-term costs of those decisions or actions became apparent. And from the company’s perspective, it is clearly easier to simply withhold the stock or options than to attempt to recover cash paid out.”

It would also make things from the SEC reporting perspective a bit easier as well, because as Kelly noted, the “SEC is requiring companies to develop and implement a policy providing for the recovery of erroneously awarded incentive-based compensation” which must “be filed as an exhibit in the company’s annual report, and the report must include disclosures about “any actions an issuer has taken pursuant to such recovery policy.””

The bottom line is that while both the SEC and DOJ’s thinking on clawbacks has evolved, the business commentary has been talking about clawbacks as a part of a best practices compensation program for some time. Bhagat and Elson wrote, “It is critical to good governance that companies be able to recover compensation from senior executives that has not been fairly and fully earned.” Schrage went further, stating, “Healthy conversations around clawbacks are as important to risk-management and employee morale as well-designed incentive-based compensation programs and a generous bonus pool. I’d argue there’s no such thing as well-designed incentive compensation programs that don’t have a carefully calibrated clawback component. Emphasizing bonuses at the expense of clawbacks is bad for everyone.”

With these new statutory requirements from the SEC based upon Dodd Frank and the pronouncements laid out in the Monaco Memo, clawbacks represent one of those rare mechanisms which represents a convergence between legal and regulatory concerns and better business outcomes. The government wants assurances that executive compensation is not determined by FCPA violations, financial fraud or other nefarious conduct and business want processes that those who do business ethically and in compliance by creating value through best practices compliance rather than cheating and law-breaking are properly incentivized.