The Justice Department’s recent revisions to its Corporate Enforcement Program and its Evaluation of Corporate Compliance Programs stressed the importance of compensations systems and consequence management.  The theoretical underpinning of DOJ’s expanded focus is to increase the consequences to individuals who engage in misconduct or supervisors who turn a blind eye to misconduct. 

Individuals already face potential criminal prosecution for engaging in misconduct but the prospect of such prosecutions can be too remote to dissuade bad actors.  To add to the risk calculation, DOJ is requiring companies to implement compliance compensation programs that include financial penalties against those actors who engage in misconduct or supervisors that fail to rein in their underlings to ensure compliance.

A Compliance Compensation System works hand-in-hand with a Consequence Management System. 

Compliance Rewards

A Compliance Compensation System is an essential tool to reward compliance and penalize individuals who commit misconduct.

To reward compliance, companies have to create positive incentives to reinforce compliant behavior and satisfaction of compliance program requirements.  For example, individual executives or managers may have to satisfy specific compliance requirements, such as promoting the company’s ethics and compliance program at new employee orientation or staff meetings, conduct of training programs, completion of career development compliance training, speaking at Ethics Week events, and other possible assignments.  These are just illustrative examples because executives and managers could be required to satisfy a variety of tasks or functions.

An executive or manager could be eligible for incentive payments and/or bonuses only if the executive or manager satisfies the specified requirements designed to advance the company’s compliance program.  The specific standards can be further refined through compliance measurements and benchmark guidelines.  The design of the incentives requires a careful balancing and evaluation process developed collaboratively by the business, human resources, legal and compliance.  Annual performance reviews for executives, managers and employees should incorporate, at a minimum, compliance factors as part of the overall performance review process. 

Compliance Penalties

On the flip side, and to offset positive incentives, companies have to design and apply a compliance penalty that can be imposed against executives and managers.  A compliance penalty system has to hold individuals accountable (1) who engage in misconduct; or (2) “contribute to” misconduct through supervisory negligence or failure to respond to red flags.

As defined by DOJ, companies have to use retroactive discipline through imposition of financial penalties, typically through clawbacks, deferred compensation systems (e.g. restricted stock units that vest over time), or a partial escrowing benefit.  While this may sound good on paper, any retroactive system has to be carefully crafted, set forth in accurate and comprehensive terms so that there is no (or little) room for litigation defenses. 

Essential Questions

Companies have to resolve several key issues when tailoring compliance penalties. 

First, companies have to decide what level of executives and managers to apply the compliance penalty system, including clawbacks and deferred compensation programs.  In most cases, companies will apply the accountability program to executives and omit managers from the program because the sheer number of managers and the complexity of such a broad system.

Second, companies need to examine the overall incentive structure to determine what percentage of executives shall be subject to the penalty program and the percentage penalty to apply to such executives.

Third, companies have to assess every senior executive category and identify other incentives and disincentives.  For example, under the SEC mandated program, senior executives have to be subject to clawbacks in the event of a financial restatement.  In addition, DOJ mandated consideration of large contingent payouts to executives and the need to integrate ethical performance requirements.  In the context of the overall incentive structure, companies have to isolate and weigh incentives and bonus structures to target accountability penalties commensurate with the risk posed by the executive (if he or she engages in misconduct).