Ethics, Compliance, and the Role of Compensation

Fraud and other criminal or unethical activities can cause harm not only to corporate entities but to their shareholders, communities, and employees. When unethical business practices become engrained into corporate culture, they can bring down a whole sector or the entire economy. The sudden bankruptcy of the cryptocurrency exchange FTX in 2022 and the shuttering of Silicon Valley Bank (SVB) by its regulator in March provide striking examples of the risks faced by companies and their stakeholders when guardrails are insufficient to prevent alleged wrongdoing and oversight mechanisms are not in place to identify and resolve potential problems before they reach a tipping point. There is no shortage of other examples.

Ethics and compliance (E&C) programs have existed for as long as companies have sought to promote responsible business behavior. In recent years, however, corporate interest in E&C programs has increased amid the #MeToo movement and COVID-19 pandemic and as employee expectations on what is owed to them by their employer shifted.

Companies often adopt E&C practices as a key part of their value propositions. This is particularly true within industries subject to government regulation, for whom an ethics or compliance violation can risk customer loss or a license to operate. For instance, compliance and ethical behavior are particularly important for regulated utilities due to the nature of their operations and customers—failing to comply with the industry’s laws and regulations can lead to damaging legal and financial penalties and jeopardize business with cities and states.

Recent Developments in E&C

Economic and societal changes create new risks that smart companies continuously address and mitigate through their E&C programs; for example, globalization, new technologies (e.g., artificial intelligence systems), and the growth in alternative work arrangements have created equal measures of opportunity and risk. The best E&C programs and practices evolve to meet the changing conditions within existing environments. Individual companies, however, can fail, refuse, or be slow to adapt, thus placing them at greater risk of ethics or compliance lapses or outright failures.

Today, more companies are placing even greater emphasis on E&C practices. The growing focus on environmental, social, and governance (ESG) factors by companies and their investors has helped to highlight issues of governance, and within that category, E&C and its oversight are highly important. Shareholders understand that well-governed E&C systems help mitigate risks by establishing foundations that support sustainable value creation.

One good example: In its annual 2022 report on sustainability, Lockheed Martin details its ethical business practices. The company states: “…earning and maintaining the trust of our stakeholders is essential to our business. We are proud of our culture of integrity and work to create an environment that supports ethical behavior and empowers employees to speak up with concerns. We are deeply committed to doing business the right way and strive to strengthen our programs to ensure our employees and anyone who works with us adheres to the same high ethical standards.” Lockheed’s reported E&C statistics include the number of business units analyzed for risks related to corruption and the number of ethics contacts per 1,000 employees. It discloses policies and procedures around new issues such as AI ethics. Additionally, Lockheed established a goal to increase the percentage of employees taking action after observing misconduct to at least 35% by 2025.

E&C in Incentive Compensation Plans

Many companies also tie E&C measures to incentive compensation plans as a way of enhancing their E&C program and communicate to employees and the market the importance the company places on adhering to policies. Among ESG incentive measures, governance-type metrics often get the least attention relative to environmental or social measures, but they can be just as crucial in creating sustainable value.

Overall, about 10% of large cap S&P 500 companies incorporate E&C measures in their executive compensation programs. These measures are most used in highly regulated sectors such as financials (50% prevalence), health care (33% prevalence), and energy (25% prevalence). While most large-cap companies have E&C programs, they may not be considered such a key part of their corporate or sustainability strategy that they are sufficiently material as a component of incentive compensation.

Source: Farient Advisors database of S&P 500 proxy data

 

E&C measures vary from those that promote compliance versus others that penalize for violations. Edison International will cut short-term incentive award payouts for executives in the event of any major non-compliance event at the company. Interestingly, Signature Bank reported using a measure for maintaining a “culture of high ethical standards” as part of its strategic priorities in its 2022 incentive plan, just months before it collapsed in the wave of bank failures that followed the downfall of SVB.

Source: Farient Advisors database of S&P 500 proxy data

 

E&C measures are typically used qualitatively in STI plans usually as part of a broader scorecard and using both upward and downward payout leverage. About one-fifth (21%) of companies using an E&C measure apply only downward payout leverage—i.e., the measure will only shift payouts downward and cannot increase them. While 68% of companies use E&C measures with upward and downward payout leverage, the measures are typically part of a scorecard that includes other metrics, and it is unlikely that the E&C measures individually are providing much (if any) upward leverage.

Source: Farient Advisors database of S&P 500 proxy data

 

Farient’s Point of View

“Governance” is arguably the least sexy category in the ESG trio, but it has a key role to play in sustainability strategies and, by extent, in ESG-related incentive compensation measures. While at present the market is highly focused on addressing environmental issues, companies cannot lose sight of governance and oversight mechanisms like E&C functions. These functions help provide a stable foundation by which companies can prosper and address issues across financial, environmental, and social areas.

• Governance and compliance are especially important in this moment amid rapid change, technological innovation, and shifting sociopolitical issues
• The incentive program is just one way among many that companies can use to mitigate risk by promoting ethical and compliant behavior
  • An E&C program that includes elements such as codes of conduct, audits, training, whistleblower protections, disclosures, etc., are equally important
• Companies shouldn’t wait until something bad happens before they review their practices and address holes in E&C policies

In sum, determine how “material” E&C is to strategy and stakeholders, and if relevant, review goals around maintaining or expanding programs and instilling an E&C culture. The board’s compensation committee should bring E&C objectives into the review process when designing incentive programs; a well-designed plan can focus executives and employees on key strategic priorities and send a clear message to shareholders and other stakeholders that the company is on the right path.

 

By Brian Bueno