ETHICAL ISSUES IN EXECUTIVE COMPENSATION

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1 ETHICAL ISSUES IN EXECUTIVE COMPENSATION Dallas/Fort Worth ISCEBS Felicia Finston

2 Overview of Ethical Considerations The first step to establishing ethical compensation practices is to have an ethical organization. Absent a continual focus on ethics, it may be easier to rationalize short-sighted or executive focused decisions without considering the longterm impact on the organization, its employees, customers or shareholders Ethical behavior should be one of the metrics for awarding compensation Government isn t equipped and shouldn t step in to regulate ethics Slide No. 2

3 Historical Flaws in Executive Compensation Incentive targets too easy to meet Incentives encourage high risk strategies Poor design rewarded executives for riding the tide of market rallies even when company under performed Penalties such as clawbacks were lacking when gains were reversed or misconduct occurred Disparity between executive pay and benefits and rank and file Slide No. 3

4 Implementing Ethical Compensation Practices Responsibility must reside with corporate boards and management the tone at the top must reflect a strong ethical tone Studies have shown that culture is the largest influence on employee conduct (e.g., Enron) Ethics must apply to day-to-day conduct and be reflected in compensation policies Slide No. 4

5 Things Corporate Boards can Do Establish an ethics committee Recruit knowledgeable ethical professionals to serve on board Call on internal ethics and compliance personnel to develop metrics to measure ethical culture and present data to the Board to help tie ethical behavior to executive pay Establish financial incentives for ethical leadership by the CEO Slide No. 5

6 Things Corporate Boards Can Do Insist on transparency in communicating compensation structure and other corporate decisions Consider whether there should be limits on executive pay to ensure pay equity Put systems in place to build ethical awareness over the long term Slide No. 6

7 Role of Ethics in Executive Pay Raise ethical expectations Legitimize discussions about ethical issues Encourage ethical decision making Prevent ethical misconduct and provide basis for enforcement Slide No. 7

8 Elements of an Ethical Executive Compensation Policy Compliance with the law Description of desired employee conduct (e.g. teamwork, respect, fairness) and values (e.g., organizational good versus individual good) Methods of rewarding desired conduct and values Incentives Discretionary bonuses Compensation increases Discretionary retirement contributions Accurate accounting Slide No. 8

9 Not required but creates accountability and defined expectations Detailed or Not Address every value and conduct an organization can think of Just state core conduct and values Clearly identify objectives Written in plain every day language User friendly Documentation Respond to real life questions and situations Include necessary forms or communications Slide No. 9

10 Contents Introduction explaining the purpose of the policy and its purpose Statement of core values of the Company explain what values of the company and how those values are to be expressed via executive conduct Substantive provisions how desired behavior will be tied to executive compensation Information and resources where to get additional guidance Backed up by executive pay and benefit plans and policies Slide No. 10

11 Development Determine corporate values desired Create task force Collect data Initial draft Leadership input Field test and final revisions Have policy reviewed by legal counsel Board approval Communicate and educate Review and update Slide No. 11

12 How many organizations incorporate the concept of ethical behavior in their executive compensation programs? Is ethical behavior a condition to incentives and other rewards? Is plan design governed by the organizations ethics? What is the scope? Limited to incentive compensation or other? Mandatory or not? Talking Points Slide No. 12

13 Talking Points Common ethical issues arising under executive compensation plans Legal compliance issues form versus operations Potential propensity to favor top management in design and administration Incentive plan designs that invite questionable behavior without considering risk/reward to the company Conflict of administrators in keeping executives happy versus complying with the plan terms or applicable law Slide No. 13

14 Case Study One: 409A Violation You are the VP HR for Best Company The CEO calls and wants you to take an early distribution from the company s deferred compensation plan to buy a new house You know this would violate the terms of the plan and 409A Slide No. 14

15 What should you do? Tell him you need to look at the plan and forget to call him back Tell him the plan doesn t allow it Tell him you need to contact legal counsel and let them be the bad guys Allow the distribution, after all he is the CEO and you want to keep your job Slide No. 15

16 Example Two: Potential 409A Distribution Failure You are the manager of the Company s deferred compensation plan The CFO calls you regarding a provision in the plan that suggests she should have received a distribution of $450,000 in 2012 You know if there is a problem with the language the 409A correction program cannot be used. You check the plan and it turns out the CFO is right Slide No. 16

17 Immediately audit all other participant accounts in the plan? Call counsel? What should you do? Are the CFO s interests adverse to the Company? Do you have an obligation to make the distribution and report the 409A error? Can you/should you gross up the CFO? Do you have an obligation to fix other participant accounts? Slide No. 17

18 Example Three: New Boss Your company is negotiating with a potential new CEO, who, to your knowledge, has no legal representation The CEO candidate asks you to explain the pros and cons of participating in the company s nonqualified deferred compensation plan Slide No. 18

19 What should you do? Meet with her to explain the pros and cons, but tell her she should also discuss with her own adviser? Provide her with a written summary prepared by outside counsel explaining the pros and cons? Advise her to consult with her own tax and/or legal adviser? Slide No. 19

20 Example 4: 409A contribution issue Executive makes an election under section 409A to defer a portion of his compensation to the company s nonqualified deferred compensation plan Company does not begin deferrals in first pay period in 2015 Deferral form and plan do not specify when the compensation will be withheld, but historically company has done it ratably throughout year Slide No. 20

21 What do you do? Begin deferrals at the next pay period so total amount is contributed by yearend? Treat as a 409A violation and ask executive to repay initial deferral amount (or take from his pay)? Ignore the deferral election? Slide No. 21

22 Additional Facts What if executive wants to revoke his deferral election? Do you allow even though a 409A violation? Does it matter if executive doesn t want to report as 409A violation to IRS? Slide No. 22

23 Example 5: Government Audit The Internal Revenue Service is conducting an audit of your deferred compensation plan The agent learns that you, like him, are an avid golfer and that the company has a membership for all employees at Wowza country club The agent suggest that if you take him to the country club as your guest that he will go easier on the plan audit Slide No. 23

24 What do you do? Invite him to club Wowza after all leniency is leniency? Report him to his supervisor? Report the incident to your supervisor and seek guidance? Tell him that what he proposes is unethical and you will not be a part of it? Slide No. 24

25 Example 6: Incentive plan design You are working with the CEO and a compensation consultant to structure the company s new incentive plan The CEO wants the plan to be simple, just based on revenue or profit You are concerned that this could lead to questionable behavior by promoting sales growth without considering the overall risk/reward to the company Slide No. 25

26 What do you do? Voice your concerns and encourage a plan design that more closely aligns with the interests of the corporation? Say nothing and leave it to the Board of Directors to determine if the plan is sound? Leave the meeting so you can report your concerns to your boss? Slide No. 26

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