Tying Pay to Compliance: Will Walmart's Plan Work?

Lots of companies talk about making compliance and ethics a priority. Walmart is putting its money where its mouth is.

The retail giant announced last month that it will soon begin basing a portion of compensation for top executives, including CEO Michael Duke, on the company's ability to meet compliance goals. If top executives don't meet compliance objectives, they risk having their annual bonuses reduced.

While many companies have used language in compensation plans stating that executives must follow laws and regulations, it's rare for companies to tie pay directly to compliance efforts. “This is a very blunt instrument to use on executives who don't do things the way they should be done,” says Steven Hall, founding partner and managing director of the executive compensation consulting firm Steven Hall & Partners.

Walmart's initiative is hardly unprompted. In November 2011, the company, spurred by investigative reporting by the New York Times, notified U.S. officials of potential violations of the Foreign Corrupt Practices Act, specifically bribes paid to facilitate new store openings in Mexico. The ongoing investigation has so far cost the company $157 million, and the hit to its reputation could be even more costly.

As part of efforts to beef-up its compliance programs, the company detailed the plan to link executive bonuses to compliance goals in its most recent proxy statement. Beginning in 2014, annual cash incentives for each of the company's named executive officers (NEOs) and other top officials will be tied to achieving compliance objectives, as determined by an evaluation of policies, processes, and controls. The goals “will address the key components of a corporate compliance program,” including leadership and resources, standards and controls, communication, systems, training, and monitoring. Lacking adequate progress, the board may reduce or eliminate cash incentive compensation. 

“The protocols we put in place will show we are taking the lead in demonstrating the importance of accountability in our enhanced compliance program,” says Walmart spokesman Randy Hargrove. He added that the metrics for evaluating the success of these objectives are currently being developed. The next proxy statement, a year from now, will detail how those metrics were directly factored into compensation decisions.

If Walmart is successful at incentivizing executives to improve the culture of the company and elevate compliance, the plan could become a model for others to follow. “It certainly has the potential to draw imitators,” says Chris MacDonald, a business ethics consultant and senior fellow at Duke University's Kenan Institute for Ethics. “What would previously have been thought an unusual compensation strategy is a little less unusual, now, and a little more plausible.”

Walmart isn't the only company to try meshing compensation with compliance goals. Deutsche Bank announced in March that it was developing a “sustainable and transparent compensation system,” and a compensation review panel at the bank has offered a series of recommendations, including “aligning compensation philosophy more closely to values and strategy and anchoring risk management in the pay process.”

The Defense Industry Initiative, a consortium of U.S. defense industry contractors that have pledged common standards of business ethics and conduct, has also long supported pay practices that penalize unethical behavior.

While the idea of incentivizing executives to meet compliance goals may be untested, instituting penalties for compliance failures has been around for years. “Clawbacks” of executive pay were a central component of the Sarbanes-Oxley Act, triggered by restatements necessitated by executive misconduct at public companies. The Troubled Assets Relief Program (TARP) also included measures to recoup executive pay. The Dodd-Frank Act demanded that extensive, mandatory clawback requirements be included in the listing standards of exchanges and national securities associations. Although the Securities and Exchange Commission has yet to release the final regulations on a clawback rule, some companies are already including them in compensation plans.

In the pharmaceutical industry, some of its largest companies, including Eli Lilly and Bristol-Myers Squibb, have responded to investor demands and recently announced an effort to claw back executive bonuses from past years if evidence emerges of unethical conduct, regardless of whether it led to a restatement of financial results.

By adopting incentives to meet compliance goals, rather than penalties for compliance infractions, Walmart is ahead of the curve. “Most executive compensation or bonus plans will have subjective elements,” says Alan Johnson, managing director of Johnson Associates, an executive pay consulting firm based in New York City. “There will be wording in there that you have to comply with laws and regulations, but it has always been more about after the fact—after there is a problem—instead of upfront and proactive. Compliance should be holistic, not just following the rules, but going beyond the rules and avoiding problems.”

“This is a very blunt instrument to use on executives who don't do things the way they should be done.”

—Steven Hall,

Managing Director,

Steven Hall & Partners

Companies may also look to non-profits for ideas on how to incentivize good behavior. Dignity Health, a California-based not-for-profit public benefit corporation that operates hospitals and ancillary care facilities in 17 states, has long made compliance part of the compensation review process for executives, says Daniel Roach, vice president of compliance and audit, who oversees the program.

For the past 12 years, Dignity Health has used a “compliance score card” to assess objectives when awarding incentive pay to hospital presidents each year. Roach explains that there are typically 25 to 30 metrics related to the execution of the compliance and ethics program. If leadership fails the test, they surrender their bonus pay.

Roach says the approach stems from demands of the U.S. Federal Sentencing Guidelines, calling it “the foundation for what constitutes an effective compliance program in this country.” Specifically, the guidelines promote using incentives—both positive and negative—as corporations build upon their compliance and ethics programs.

“There are only two things that drive behavior and that's money and transparency,” he says. “If you have the attention of the head of the business unit, you have the attention of everybody else in the unit. It is a real driver of behavior.”

Dignity Health's approach has survived the test of time, but will the same be said of Walmart? That depends on the details of implementation, as the proxy provides “an outline for a plan, minus a lot of concrete details,” MacDonald says.

LINKING INCENTIVES WITH COMPLIANCE GOALS

The following, from Walmart's 2013 proxy statement, is a description of how it plans to link executive incentives with compliance goals:

Are there any significant changes to our executive compensation program for fiscal 2014?

For fiscal 2014, our executive incentive compensation programs continue to be based on the financial measures of sales, operating income, and ROI, which are aligned with our priorities of growth, leverage, and returns. In addition to these financial measures, for fiscal 2014 our executive compensation program will also have a compliance component.

Our company has made significant improvements to our compliance programs around the world and has taken a number of specific, concrete actions with respect to our processes, procedures, and people. These steps have included aligning our global compliance, ethics, investigations, and legal functions under one organization; creating new senior global compliance and investigations positions and hiring seasoned professionals to fill these positions; and implementing enhancements to how we report and investigate allegations of wrongdoing worldwide.

In order to further emphasize our company's ongoing commitment to such a program, beginning in fiscal 2014, the annual cash incentive payment of each of our NEOs and certain other executive officers will also be subject to achieving certain compliance objectives.

During fiscal 2014, our company's senior leadership will evaluate the company's key compliance policies, processes, and controls, and prepare a timetable for implementing further enhancements on a prioritized basis (the “Fiscal 2014 compliance objectives”). These enhancements will address the key components of a corporate compliance program, including leadership and resources, standards and controls, communication, systems, training, and monitoring, among others.

Senior management will provide quarterly reports to the audit committee on the progress in implementing the Fiscal 2014 compliance objectives. If, in the judgment of the audit committee, the company has not achieved adequate progress in implementing the Fiscal 2014 compliance objectives, and taking into account such other considerations with respect to compliance matters for fiscal 2014 as the audit committee in its judgment may deem appropriate, then the CNGC may reduce or eliminate fiscal 2014 annual cash incentive compensation for the relevant executive officers.

Source: Walmart.

Will It Work?

Compensation experts say the success of Walmart's plan could depend on how much the board is willing to follow through on the initiative. “If things don't go well, in terms of compliance, is the audit committee going to have the courage to give senior executives a low grade on that, and to let that have a serious impact on bonuses?” asks Johnson.  “We know that a relatively simple mechanism like this isn't going to revolutionize the way the company thinks. The best hope is that it signals that the company is serious about compliance and becomes a tiny, but hopefully meaningful, piece of a bigger puzzle about how to shift the values that make up corporate culture.”

Some compensation advisers say the plan is more about what it signals, than the actual mechanics of the plan. “A lot of what's done with compensation plans isn't  so much about having a hammer to go after executives, as the message you are sending to the outside world,” says Hall. Still, he says, Walmart's initiative is “a solid approach.”

Hall says that Walmart, and other companies may want to imitate the approach taken by pharmaceutical companies and their wiliness to pull back bonuses from prior years. “Sometimes compliance issues don't bounce out until several years down the road,” he says.

Incentivizing compensation shouldn't be about one person's “inherent ethical nature, or as a reward for making it through an entire day without being indicted,” says Joseph Murphy, co-founder of Integrity Interactive Corp. (now part of SAI Global) and a lawyer with more than 30 years experience in the field of organizational compliance and ethics. “It should be focused on compliance and ethics program leadership.”

Murphy appreciates Walmart's approach of establishing comprehensive compliance goals for executives, rather than just “rewarding them for not messing up,” which over time could transform into “rewarding them for not reporting violations.”

Murphy stresses that evaluations shouldn't be about “measuring anybody's ethics.” Instead they should assess management performance, especially how training is conducted. His suggestion is that if a business unit doesn't achieve compliance objectives, its leader should be taken off the list of those eligible for promotions.

“If somebody is known as a corner-cutter, back stabber, or someone who breaks the rules and that person is promoted, that's all you need to know about the company's culture,” Murphy says. “If a top person doesn't get their bonus or a promotion because the compliance program didn't achieve its objectives, it sends an important message.”