Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
Source: Ameriprise Financial, Form DEF 14A, Filed March 19, 2010
To better understand the relation between executive compensation structure and risky behavior, we can look no further than the recent disclosure by Ameriprise Financial in the CD&A section of their latest proxy:
“There are no objective tests to determine whether one type of incentive compensation plan encourages executive officers to take excessive and unnecessary risks while another type of plan encourages only prudent and appropriate risk taking. Nevertheless, we will continue to examine our incentive compensation plans during 2010 to identify any plan features that may be incompatible with our enterprise risk management program. With that said, it is not always easy to categorize risks as excessive or appropriate, except with the benefit of hindsight. […] The question we have been asking ourselves is this: ‘Are the Company’s enterprise risk management framework and internal controls effective to prevent or to identify and mitigate risk taking by our executive officers that exceeds our risk tolerances, regardless of the incentive compensation plan in which he or she participates?’ We believe that the answer to that question is ‘Yes.’ Nevertheless, we will continue to give additional attention to the subject of risk and compensation as we continue to enhance our enterprise risk management program.”
This, of course, is a long-winded way of saying “we really have no idea.” And we don’t blame the company. Although many so-called governance “experts” have stated that excessive compensation was a primary cause of the financial crisis, there is as of now no hard evidence that this is true, or, if it is true, the extent to which poorly structured compensation packages increase enterprise risk exposure.
Until such studies are developed, we encourage a common sense approach. Investors should ask themselves the following: Does management have sufficient exposure to the stock price so that their change in wealth is roughly in line with mine? Do management communications satisfy me that they properly understand risks to the organization? Do I accept management’s explanation of the steps they are taking to mitigate those risks? Does the board of directors have sufficient experience and judgment, based on their background, to understand the risk-level of the corporate strategy and oversee management?
If the answer to any of these is no, it is likely that no compensation structure or internal risk controls will shield the investor from poor management decision making (i.e., sell).