Executive Report

Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate

The New Regulatory Imperative

A sweeping new regulatory framework is emerging as a result of the global financial crisis, affecting many aspects of corporate operations, from finance and accounting, to risk management and compliance, to human resources (HR). The impending changes have the potential to make the U.S. Sarbanes-Oxley Act of 2002 look like childs play in comparison, especially since the current financial crisis is global in nature. The main challenges facing HR leaders are in the understanding of the new regulations, how they will impact their divisions and the broader business, and ultimately, what organizational and technological changes will need to occur to become compliant. Governments across the globe are in the midst of defining their new frameworks, which will combine elements of legislative and regulatory reform. How deep and wide these changes will go remains unclear. Yet one thing is certain: Reforms are dictating that companies implement more uniform processes and systems for compensation and performance, particularly in the areas of compliance reporting and auditing. The reason is that there is a distinct possibility that more than just financial services companies and more specifically, those 600+ companies 1 that have so far received bailout funds as a part of the U.S. Emergency Economic Stabilization Act (EESA) of 2008s Troubled Asset Relief Program (TARP) will be affected. The consequences of this new regulatory imperative may have far broader ramifications, as reported by The New York Times on March 21, 2009: One proposal could impose greater requirements on company boards to tie executive compensation more closely to corporate performance and to take other steps to ensure that compensation was aligned with the financial interest of the company. The new rules will cover all financial institutions, including those not now covered by any pay rules because they are not receiving federal bailout money. Officials say the rules could also be applied more broadly to publicly traded companies, which already report about some executive pay practices to the Securities and Exchange Commission.2

STRATEGY

Reforms are dictating that companies implement more uniform processes and systems for compensation and performance, particularly in the areas of compliance reporting and auditing.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
New rules and regulations are inevitable, and HR leaders need to begin preparing now to minimize future operational disruptions. And given how much visibility executive compensation practices have received thanks to the AIG bonus fiasco, HR leaders will need to be especially careful how they address this important and often radioactive issue within their companies.

STRATEGY

A Synopsis Of The Last Nine Months

H.R. 1424, an Act of Congress signed into law by President George W. Bush on October 3, 2008, created a $700 billion Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008 (EESA), commonly referred to as the financial system bailout. More than 500 financial services companies (plus a couple of automakers and a notable insurance provider) in the U.S. have received TARP funds and are therefore subject to varying degrees of executive compensation regulation. Similar programs have been executed by governments across the globe. In the U.S., the executive compensation rules set forth in Section 111 of EESA establish limits on compensation and rules for recovery (clawback) of compensation for the five most highly-paid senior executives (including the principle executive and financial officers) of companies that have received significant TARP funds. The new rules also limit senior executive tax deductions and prohibit golden parachutes. TARP eligibility and conditions vary based on whether the United States Department of the Treasury (Treasury) purchases troubled assets directly or through an auction process.3 Subsequent interim final rules were issued by Treasury on January 16, 2009, that primarily addressed certification and reporting requirements.4 On February 4, 2009, Treasury issued new guidelines on executive compensation.5 These guidelines differentiate between companies needing access to the capital access program (CAP) and those that require exceptional assistance (e.g., Bank of America, Citigroup, and AIG). Treasury also clarified compliance and certification reporting requirements, and created limits on executive compensation of $500,000 per year, not including restricted stock awards, for those companies in the exceptional category. Numerous other conditions were specified by Treasury on February 4, 2009, but perhaps most revealing was Treasurys position on long-term regulatory reform. Treasury stated: Even as we work to recover from current market events, it is not too early to begin a serious effort to both examine how company-wide compensation strategies at financial institutions not just those related to top executives may have encouraged excessive risk-taking that contributed to current market events and to begin developing model compensation policies for the futureThe Secretary of the Treasury and the Chairman of the Securities and Exchange Commission should work together to require compensation committees of all public financial institutions not just those receiving government assistance to review and disclose executive and certain employee compensation arrangements and explain how these compensation arrangements are consistent with promoting sound risk management and long-term value creation for their companies and their shareholders.6
New rules and regulations are inevitable, and HR leaders need to begin preparing now to minimize future operational disruptions.

STRATEGY

Executive compensation rules set forth in recent legislation establish limits on compensation and rules for recovery for the five most highly-paid senior executives of companies that have received significant TARP funds.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate

Two points stand out in this Treasury statement:

1.

Regulations may not be restricted to only top executives compensation. The financial crisis is calling into question compensation practices in general and sharpening the focus on merit-based pay across many levels within an organization, not just executive management. Regulations may extend beyond TARP recipients to all publically-traded companies. Should the U.S. Securities and Exchange Commission (SEC) be granted broad oversight of executive compensation within all public companies, or at the very least require improved compliance reporting and auditing practices, the scope of regulatory change could be vast indeed.

STRATEGY

2.

On February 17, 2009, President Barack Obama signed into law H.R. 1, The American Recovery and Reinvestment Act (ARRA) of 2009, commonly referred to as the stimulus bill. Title VII, Section 7001 of this Act explicitly amends EESA Section 111s executive compensation requirements. Applying to both existing and future TARP recipients, notable changes within Title VII include the recovery of compensation paid (clawback) to the top twenty-five (vs. top five originally) most highly-paid executives in certain events. Updated bonus restrictions were also established (based on the amount of TARP funds a recipient received), new compliance reporting requirements were set forth, the creation of a compensation committee review board of independent directors was mandated, and a new say-on-pay provision enabling shareholders a non-binding vote on executive compensation was established.7 On March 26, 2009, Treasury announced its framework for regulatory reform.8 The four primary components of the reform include addressing systematic risk, protecting consumers and investors, eliminating gaps in the regulatory structure, and fostering international coordination. While executive compensation was not called out in this Treasury statement, the compensation issue remains front and center. The passing of a 90% tax on the AIG executives bonuses by the U.S. House of Representatives on March 19, 2009 was the first step, and largely political to stem rampant populist outrage. This was effectively replaced by a less punitive bill passed by the House on April 1, 2009 called The Pay for Performance Act of 2009. This new bill which requires U.S. Senate approval before it can proceed authorizes Treasury to define what constitutes reasonable compensation, as well as to ban bonuses not based on performance standards for TARP recipients.9 Should this bill be passed by the Senate and signed into law by President Obama, it could have far reaching consequences on how HR organizations administer their performance and compensation processes. Treasurys most recent activity on the executive compensation front occurred on June 10, 2009. On this date, Treasury issued a revised version of 31 CFR Part 30, TARP Standards for Compensation and Corporate Governance.10 This interim final rule, directed at the recipients of TARP funds, consolidates all of the previous

Future regulations may not be restricted to only top executives compensation, and they may extend beyond TARP recipients to all publicallytraded companies.

STRATEGY

If signed into law, the Pay for Performance Act of 2009 could have far reaching consequences on how HR organizations administer their performance and compensation processes.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
provisions for executive compensation into a single rule and supersedes all prior rules and guidance related to executive compensation. Tangentially related, Treasury also issued draft legislation to Congress on July 16, 2009 focused on reforming compensation committees to ensure that they are more independent.11 There is one certainty HR leaders can bank on: The story is only just beginning. Regulatory reforms will not be isolated to the U.S. Indeed, the G20 meetings in London during the first week of April 2009 brought broad agreement on regulations to mitigate the risk of a future global financial crisis. And due to public outrage, executive compensation accountability, transparency, pay limits, and say-on-pay compensation voting by public company shareholders was a key discussion point among G20 leaders. Companies too are beginning to amend their executive compensation policies. A Watson Wyatt survey conducted in early March 2009 found that: The number of companies that froze salaries and added clawback policies to their executive pay programs has jumped sharply during the past three monthsThe survey also found that many companies plan to slash funding for annual bonuses and reduce the value of long-term incentive (LTI) awards.12 But are changes to executive compensation policies enough? Or is a more systematic approach to aligning executive and going further, all employee compensation to performance required? While the answer to this question lies within emerging regulatory reforms, there is little doubt that companies are going to need a more uniform mechanism for compensation and performance compliance reporting and auditing.

Pay-For-Performance Redux
Programs that align employees compensation salary, bonuses, long-term incentives to their actual performance have been in place for many years. The rationale for implementing these programs was not regulatory compliance, but rather, to build a culture of top performers by aligning goals, performance, and rewards across an entire organization. Motivating, rewarding, and retaining top performers is a key business objective for any company that seeks to successfully maintain or exceed growth expectations. The challenge lies in effectively aligning employee goals with organizational objectives, automating performance management processes, and linking them with complex compensation policies or time-based incentive plans at an enterprise level. Best-in-class organizations focus on a performance-driven rewards system that compensates individual contributors directly proportionate to what they achieve and what they can contribute to the bottom-line. A strong technology foundation is essential to implementing pay-for-performance processes and requisite compliance reporting and auditing capabilities. A single, centralized HR platform that natively connects all of the required components is ideal because it facilitates cross-functional reporting and eliminates the technical challenge and cost of integrating and managing disparate systems.

STRATEGY

Best-in-class organizations focus on a performancedriven rewards system that compensates individual contributors directly proportionate to what they achieve and what they can contribute to the bottom-line.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
A pay-for-performance system must include these pre-integrated components: Workforce Performance Management: Optimizes performance management processes and aligns employee development and goals with corporate objectives. Workforce Performance Management enables organizations to plan employee efforts in support of organizational goals and strategic initiatives, and to evaluate outcomes, performance, and core competencies. Compensation Planning: Simplifies planning, modeling, budgeting, and analysis of compensation policies. Compensation Planning enables organizations to develop and apply consistent compensation plans to all employees. Incentive Compensation: Motivates employees and manages financial rewards within an organization. Incentive Compensation streamlines incentive policy administration and provides longterm planning for both market- and performance-based plans, as well as variable pay flexibility for individuals, teams, sales, or executives. Reporting and Auditing: Provides accessible and secure crossfunctional compliance reports and audit trails of all transactions related to compensation and performance. Reporting and Auditing aggregates key information to facilitate timely decision making. With a well-designed pay-for-performance system, employees at all levels of the organization more clearly understand what they need to do to support overall company objectives. The workforce becomes more accountable which is increasingly important these days and can see the impact of their contributions. Perhaps the single most important benefit of a centralized HR platform pertains to compliance reporting and auditing. Treasury has been consistent in its push toward more accountability and transparency from an executive compensation perspective. Yet as discussed in the previous section, should new regulations establish broader compensation rules that impact the entire workforce, or extend to all public companies, then these organizations will need a platform that simplifies reporting and provides an audit trail of all transactions related to compensation and performance. When numerous disparate systems are involved, reporting and auditing becomes much more difficult. At a minimum for TARP recipients, the compensation management capabilities of your HR platform should provide the following out-of-box compliance capabilities: Top earners reports (top 5, 20, 100, etc.) segmented by type of compensation and tailored to firms based on TARP funds received Executive-level Board of Director as well as Compensation Committee reporting packages Audit trails and historical reporting of compensation changes, especially relevant for clawback recovery provisions Bonus and long-term incentive (LTI) to total compensation weightings reports

STRATEGY

Perhaps the single most important benefit of a centralized HR platform pertains to compliance reporting and auditing.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
Automatic pop-up alerts, warnings, and system checks for deviations to policy Native performance management integration to facilitate alignment and measurement of compensation to performance (note that a single HR platform which includes the requisite performance and compensation functionality will eliminate the need for manual systems integration)

Preparing For The Changes To Come

HR and business leaders can take a few steps today to prepare for the inevitable regulatory reforms. These steps include: Develop a cross-functional working group: This group should contain key members from your executive management team, the governance, risk, and compliance (GRC) organization, executive compensation committees, as well as HR and finance leaders, particularly those involved with performance management and compensation. The primary role of this group is to investigate and monitor ongoing legislative and regulatory developments and create future-state contingency plans. For TARP recipients, this new working group will need to work directly with the new board compensation committee mandated in Title VII, Section 7001 of the ARRA. Assess current pay-for-performance processes and systems: A current state analysis and inventory of key processes and the systems that support pay-for-performance is essential. Are current performance and compensation processes automated and integrated via technology? Have the processes been optimized and streamlined? How easy and accessible are reporting and auditing? Once some of these key questions are answered, the next step is to determine what infrastructure and systems will be required to support the future-state contingency plans established by your working group. Investigate technology infrastructure: As discussed in the previous section, a strong technology foundation (e.g., a single, centralized HR platform) is essential to implementing compliance-focused processes and associated reporting and auditing requirements across an organization. Particular focus should be on technology flexibility and configurability so that your company can more easily adapt its systems as new rules and regulations become law. If your company is multinational in scope, flexibility is also important from a global deployment perspective. Pay-for-performance and regulatory requirements will undoubtedly differ from country to country, so the HR platform you employ must support a diversity of requirements.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
Conclusion
It is clear that a new era of regulation is upon us, and that it will have far-reaching implications on your current business and HR policies, processes, and systems. It is imperative that your organization remain nimble and flexible since everything is moving so fast. Take the time to prepare today so that you are not blindsided by the inevitable regulatory reforms to come. Start with compliance reporting, then evolve toward a pay-for-performance model. Not only will your company be in compliance with new regulations, but your workforce will also be better aligned to overall corporate strategy, thereby providing your business with a distinct advantage relative to your more slower-moving competitors.

Endnotes
1 2

U.S. Department of the Treasury. TARP Transactions Report. July 17, 2009. Labaton, Stephen. Administration Seeks Increase in Oversight of Executive Pay. The New York Times, March 21, 2009. United States Congress. H.R. 1424, Emergency Economic Stabilization Act of 2008. October 3, 2008. U.S. Department of the Treasury. Treasury Issues Additional Executive Compensation Rules Under TARP. January 16, 2009. U.S. Department of the Treasury. Treasury Announces New Restrictions On Executive Compensation. February 4, 2009. Ibid. United States Congress. H.R. 1, American Recovery and Reinvestment Act of 2009. February 17, 2009. U.S. Department of the Treasury. Treasury Outlines Framework For Regulatory Reform. March 26, 2009. CNN.com. House Passes Bill to Limit Executive Compensation. April 1, 2009. U.S. Department of the Treasury. 31 CFR Part 30, TARP Standards for Compensation and Corporate Governance. June 10, 2009. U.S. Department of the Treasury. Investor Protection Act of 2009. July 16, 2009. Watson Wyatt. Companies Making Extensive Changes To Executive Pay, Watson Wyatt Survey Finds. March 17, 2009.

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Preparing HR Leaders For A New Era of Regulation & Compliance: Executive Compensation and A Renewed Pay-For-Performance Mandate
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