Incentive Compensation | Commentary
GAME OF RISK Executives are playing dangerously to earn incentive compensation
conditional on Mylan more than doubling the company’s adjusted per share earnings over a five-year period, ending in 2018. Because Mylan was in the mature and low-growth generic drug business, this had seemed an unattainable goal. Still, the company’s top five executives stood to gain an estimated $82million collectively if this target could be achieved. So incentivised, they spiked the price of EpiPen, its leading product, and attempted to ride out the storm. But, in October, Mylan settled alleged regulatory violations with the US Department of Justice relating to EpiPen for $465million, and the dispute still continues. A final example this year of incentive compensation producing ethically dubious risk-taking and fraudulent behaviour is supplied by Wells Fargo & Co, until recently the US’s largest bank. At least 5,300 of its staff had their employment terminated over a five-year period for opening an estimated two million bogus accounts or credit cards for customers, without the customers’ knowledge or consent. Employees did so apparently to satisfy ambitious, but arguably unrealistic, sales quotas imposed by senior management. Under pressure, lower echelon employees opted to cheat to avoid termination. But why did senior management persist in insisting on high cross-selling quotas once it became evident that the resulting pressure had produced systemic fraud? Again, the answer appears to lie in the incentive compensation senior executives could earn. Carrie Tolstedt, the executive vice president who supervised Well Fargo’s ‘community www.ethicalboardroom.com
banking’ operations, made up to $1.7million in annual salary, but up to an additional $9million in some years in incentive compensation. Given this disparity, her motivation in imposing high cross-selling quotes on lower-level employees becomes understandable. Although such a formula paid her extraordinary compensation, it ultimately subjected her company to a reputation-shattering scandal.
Modernised clawback provisions may soon become the next focus of shareholder activism. Clearly, incentive compensation is here to stay, but it should be reasonable, not extreme, and counterbalanced by broad clawbacks Incentive compensation is, however, the norm today. The days when senior management was paid primarily in cash are long gone. Equilar, a leading compensation specialist, reports that in 2015, CEOs of companies in the S&P 500 received on average 60 per cent of their total compensation in equity. If enough incentive is created, it produces risk-preferring behaviour. So what should a reasonable and prudent board or compensation committee do? Obviously, one answer is to avoid the kind of extreme equity award that Valeant used to motivate its former CEO. Interestingly, that formula was actually designed by a risk-loving
hedge fund that had a seat on Valeant’s board. But another answer is to counter-balance the impact of incentive compensation with an appropriately designed ‘clawback’. Clawbacks mandate the forfeiture of incentive compensation (including unexercised stock options and equity awards) on the occurrence of specified events. They are only required under US law in the event of a subsequent accounting restatement that reduces the earnings that produced the incentive award. Still, a responsible board can design a broader clawback that does not require a restatement to trigger it. For example, Wells Fargo has just clawed back a record $60million in unexercised stock options and performance stock awards from its now-retired CEO and Ms. Tolstedt. Wells Fargo’s clawback provisions are in fact a model for other companies to emulate, as they authorise the board to clawback unexercised options and awards for conduct that foreseeably exposed the bank to reputational damage or that involved negligent supervision. This is far broader than the Dodd-Frank Act requires. Interestingly, this clawback policy was adopted in 2013 in response to pressure from New York City pension funds, who were seeking to impose an even tougher policy through a shareholder proxy resolution. Modernised clawback provisions may soon become the next focus of shareholder activism. Clearly, incentive compensation is here to stay, but it should be reasonable, not extreme, and counterbalanced by broad clawbacks. Shareholders unite! You have nothing to lose, but your equity. Winter 2017 | Ethical Boardroom 13