Short-term incentives in firing line amid reputational damage.

    Should boards of listed companies factor corporate-reputation issues into executive pay?

    That question is exercising the minds of more boards and remuneration committees that are building in greater flexibility to withhold aspects of pay if corporate reputation is damaged.

    The Commonwealth Bank of Australia in August required CEO Ian Narev and other group executives to forfeit short-term incentives for FY17 after the Australian Transaction Reports and Analysis Centre (AUSTRAC) initiated civil penalty proceedings.

    CBA chair, Catherine Livingstone, AO, FAICD, said in a statement: “… The overriding consideration of the board was the collective accountability of senior management for the overall reputation of the group.”

    The QBE Insurance Board in February 2017 reduced the short-term incentive of outgoing CEO John Neal by $550,000 for a delay in disclosing a relationship with a personal assistant.

    Seven West Media CEO Tim Worner forfeited his bonus this year after a court action with a former member of staff, Amber Harrison, and the headlines that followed.

    The Australian experience is mirroring overseas trends around reputation and executive pay. Wells Fargo & Co withheld US$32 million in bonuses for the former CEO and other senior leaders in February, and slashed stock awards granted in 2014 by half, after the US bank was fined US$185 million for opening accounts without customer permission.

    Yahoo CEO Marissa Mayer in March 2017 forfeited her annual bonus, reportedly worth at least US$12 million after two damaging security breaches – the largest in internet history – that exposed personal information of more than 1 billion users.

    Boards of large listed companies, it seems, are ensuring senior executives are financially accountable for corporate-reputation damage through scandals, unethical behaviour or poor management. The main avenue is through the forfeiture of executive bonuses.

    Should boards factor corporate reputation into long-term incentives?

    Although withholding executive bonuses sends a message to the market, and internally to other executives, it raises questions about whether boards should be more proactive on the issue, and if reputation should be a factor in key performance indicators for long-term incentives.

    Egan Associates chairman John Egan says the link between corporate reputation and executive pay will gain momentum and focus given increasing attention from the media, boards, shareholders, governments, regulators and the public.

    Egan wrote in the firm’s latest newsletter: “A fundamental principle of incentive reward is: what gets rewarded gets attention. A greater desire to forfeit or deny executive bonuses for performance and governance shortcomings may fix the corporate culture surrounding executive remuneration or, at the least, fix the public perception that executive pay is more acutely sensitive to accountability issues.”

    He added: “If boards continue to adopt a rigorous assessment of culture, adherence to a company’s stated code of conduct and governance protocols …, or indeed establish reputation as a zero-harm element and a gateway for incentives, it should have a positive impact.”

    Guerdon Associates director, Michael Robinson, says that reducing executive pay after damage to a company's reputation is treating the symptom, not the cause. This still risks transgressions going unpenalised.

    “Punishing reputation damage, and not the behaviours leading to that damage, suggests executives are only being held accountable because the damage has been made public,” says Robinson. “The issue should be about doing the right thing in the first place, not the reputation damage.”

    The fact that some transgressions will not be material enough to become public, and so cause reputational damage, does not mean they should be tolerated, according to Robinson. As such, linking reputation metrics to long-term incentives will be misplaced for most companies, as well as being redundant. Robinson says: “Since corporate reputation is implicitly reflected in the share price, an executive's stock holdings will reduce in value in the case of reputational damage. Such metrics could also have an unintended outcome, such as driving a culture that discourages whistleblowing.”

    He believes the better approach is to structure incentives to encourage desired behaviours and outcomes that will prevent reputational damage occurring in the first place, while discouraging behaviours with the opposite effect.

    Reducing pay for behaviours that may cause reputational damage can be done through malus or clawback provisions in short- and long-term incentives. Malus is where an incentive that has not vested is cancelled, while clawback is a contractual agreement that requires repayment of incentives.

    “Management does not like it, but boards are looking for greater flexibility on incentive structures to address a financial mis-statement or inappropriate behavior being discovered after the fact,” says Robinson. “We encourage boards to structure their incentives to better maintain a corporate culture for doing the right thing and thus preventing or minimising reputational damage.”

    Complexities of reputation damage on pay

    Corporation reputation is often hard won and easily lost. Estimating the size of financial penalties for executives after severe reputation damage is complex; years or decades of hard work to build reputations can be lost overnight in prominent scandals.

    Moreover, if boards punish executives for reputation damage, should they not reward them when reputation is strengthened? And is there a danger in including perceived “soft targets” in performance incentives that can be harder to quantify or compare across peer companies?

    The inclusion of corporate-reputation metrics in short- and long-term incentives could also encourage some executives to game the system. That is, to focus on initiatives, such as expensive marketing campaigns, which provide a short-term boost to corporate reputation.

    The rise of shareholder activism worldwide is another factor. No listed company can afford to become prey for activists through a series of corporate scandals or because it is perceived as an Environmental, Social and Governance (ESG) laggard. Boards that are too tolerant of corporate-reputation damage could find themselves in the sights of aggressive activists.

    The hard part for boards is stopping reputation damage before it occurs. There is too much at stake to react only when scandals become public and the market demands accountability. For executives paid multi-million-dollar salaries and more again in equity incentives, a lost annual bonus might be an insufficient deterrent for reputation-damaging behaviour.

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