Is it a conflict of interest for a C&E officer to receive incentive compensation?

I don’t think so – at least not in most cases.  But given the general importance of incentives to compliance the question is a fair one, and has been raised occasionally over the years.  (The conflict, of course, would be that to the extent that a C&E officer’s compensation was tied to the profitability of her company, she might be discouraged from challenging improper conduct that contributed to that profitability.)  And, the  issue has recently been raised again – at least indirectly – by two researchers at Stanford’s Graduate School of Business.

In “Fixed or Contingent? How Should ‘Governance Monitors’ Be Paid?”,  David F. Larker and Bryan Tayan discuss compensation approaches for two types of  such monitors – general counsel and internal auditors.  Of course, C&E officers are no less monitors than are internal auditors (and indeed, as Joseph E. Murphy – a long time leader in the field – has pointed out, they tend to be in a more pure monitoring role than are general counsel, who typically have many duties beyond their monitoring related ones).

The authors suggest that to the extent the role of monitors is to prevent errors, “monitors should be paid on a fixed salary basis, with failure to prevent malfeasance punishable by a substantial reduction in salary or outright termination from the firm.” But they also note that such an approach “might not provide sufficient incentive for vigilant monitoring.” They further point out that to date there has been little research to guide firms in finding the best approach to compensating monitors (other than research regarding directors, whose monitoring related duties are very different than are those of management).

But a recent study by Larker, Chris S. Armstrong and Alan D. Jagolinzer described in the paper found “a lower frequency of adverse outcomes (class action filings, financial restatements, SEC actions, and material weaknesses) among firms that offer higher incentive payments” to their governance monitors. They conclude that such an approach either incents better monitoring efforts or helps attract a better class of monitors.

So, good news for C&E officers!

A separate question, that goes beyond what is discussed in the Larker/Tayan paper, is what should the basis an E&C officer’s incentive compensation be?  We will explore that in a future posting.