June 13, 2016
Although managing risk has always been an important priority for Boards of Directors, even before it was reportable, most people agreed there were a number of cracks in the system that at least contributed to, if not drove, the last financial crisis. With the issues around “perverse” incentives at one brand name financial institution and a well-known pharmaceutical company, very few CEOs and board members want to be the next cover story in the mainstream press. Many responsible boards are asking, “Could we have a problem?” or “Are we encouraging excessive risk?” Compensation committees are struggling to evaluate the relationship between compensation and risk in a credible, clear, and consistent way to minimize surprises and unintended consequences.
Farient’s Point of View
At Farient, we know companies are in business to take prudent risks to optimize long-term shareholder value. But shareholders and boards alike need to be vigilant of executives and other employees being encouraged by the pay system to take financial risks that are inappropriate for the business. Moreover, Farient believes a quantitative approach to measuring risk provides better guidance than the qualitative checklists that are most often used. This approach can help monitor risk without interfering in building a sustainable business for the long haul.
How Farient Can Help
To help companies evaluate the appropriateness of their risk-taking behavior, Farient developed the Quantitative Risk Assessor™ that evaluates the propensity of the compensation system to cause undue risk-taking relative to a company’s business context. The Risk Assessor works by: (1) evaluating the riskiness of our client’s business relative to the broad market, (2) quantifying our client’s total direct compensation package in terms of leverage, upside potential, performance measures, goals, time horizon, and other risk indicators, and (3) comparing business risk to compensation risk to assess the ways in which the compensation system could encourage undue risk-taking. This quantitative approach, significantly more revealing than the checklist method, sets up compensation committees and boards for better discussions pertaining to risk, and provides a stronger platform for meeting SEC requirements and shareholder expectations.