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How can boards tie ethical conduct to executive compensation?

Barclays' former CEO could receive US$26.3 million after the Libor scandal. Boards have two options for preventing this.

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Former Barclays Chief Executive Bob Diamond after giving evidence to the Treasury Select Committee in London(Photo: Lefteris Pitarakis/AP)

Compensation drives behaviour. As reported in the Telegraph, the Barclays board of directors intends to “ask” former CEO Bob Diamond to “cut” part of his £17 million (US$26.3 million) pay package in the aftermath of Diamond’s role in artificially suppressing the rate at which banks lend money to each other. But Sky News reports that “investors have been warned that the bank faces a battle to fully withhold bonuses owed to Bob Diamond and Jerry del Missier,” the top executives who left the bank last week.

If the board is doing its job, there should be no battle and no need to ask the CEO to relinquish compensation, given what happened.

The compensation (cash and stock) should not have been awarded or vested to Diamond in the first place, if the Barclays board (and other bank boards) is complying with the Basel Committee on Banking Supervision’s guidance.

Boards have wide leverage to align ethical conduct and internal controls with executive compensation. There are two main tools: “clawbacks” and “malus.”

Clawbacks, mandated by Dodd-Frank in the United States, are more popular, but are inferior to malus. Clawbacks occur when cash and equity already vested to the executive are taken back. The executive will no doubt contest such efforts.

In contrast, malus, which is recommended by Basel (see the May 2011 report here at pages 37-39), means that the awarding of cash and vesting of stock in the hands of the executive does not occur until and unless approved by the compensation committee. This type of discretion is exactly what management does not want.

Basel however maintains that malus clauses are more feasible to implement and enforce than clawbacks—and the committee is right. Basically, with clawbacks (e.g. Barclays), the board has to pursue the executive for compensation already paid, whereas malus means the board has discretion to make the award in the first place. The board can wait to see if there are any “hidden” risks (e.g., Barclays’ Libor scandal, JPMorgan’s derivative loss) or performance effects that have yet to be fully realized.

Barclays is reported to have a clawback provision, as do many of the major banks, but it is unclear whether banks also have malus clauses. If not, they should.

The clawback and malus clauses should not be drafted by an internal or external firm, or person who serves, has served or intends to serve, management. Otherwise there is no independence and the clauses will be management friendly. The clauses should be drafted by an independent, expert service provider retained by and accountable to the board.

Basel offers guidance on provisions that leading banks have used within malus clauses, including: (i) breach of the code of conduct (this occurred with SNC Lavalin’s former CEO) and other internal rules; (ii) compliance with risk protocols and a qualitative assessment of risk by the compensation committee; and (iii) a violation of internal rules or external regulations.

If the board doesn’t have a proper clawback and malus clause, there will be no shared understanding and alignment of behaviour with compensation.

In short, if the board wants an executive to focus on ethics, tie his or her compensation to these outcomes. Doing this—which executives will resist—will focus executives’ minds on doing what’s right, as their money is on the line. This is exactly what regulators want in the aftermath of the financial crisis. And clawbacks and malus clauses for banks will likely migrate to non-banks as all companies will be expected to have risk-adjusted compensation in the future.