The Obama Administration’s principles for executive compensation reform, announced on Wednesday by Treasury Secretary Timothy Geithner, may lack the teeth of pay limits imposed earlier on companies receiving federal bailout money. But several aspects of the government’s stated intentions suggest significant changes ahead in executive compensation.
Perhaps most notably, the administration apparently plans to apply reforms to all public companies, not just those in the financial sector or those receiving assistance in the form of federal funds.
Geithner did emphasize that the government’s goal of better aligning compensation practices with sound risk management and long-term value creation was “particularly [important] in the financial sector.” But he noted that he is working on the matter with Mary Schapiro, chairman of the Securities and Exchange Commission chairman, whose oversight encompasses all public companies.
Plus, in announcing plans to make a pair of compensation-related legislative proposals, the government made no suggestion that the laws, if they are passed, would not apply across the board.
One of those proposals — a requirement that compensation committees be as independent from company management as audit committees currently are required to be under the Sarbanes-Oxley Act — by itself could cure most of the problems created by executive pay programs, according to John Martini, head of the executive compensation practice at the law firm Reed Smith.
Most large public companies, though fewer small ones, already require that compensation committees be composed entirely of outside directors. But what’s important about the proposed law is that the SEC would have to establish standards for ensuring that any compensation consultants or outside counsel that comp committees use are independent from company management. Companies would have to make sufficient funds available to the board to pay for the services.
In theory, that could eliminate widely criticized conflicts of interest whereby the same outside experts who help executives draft policies governing their own pay also consult with compensation committees on making final decisions on executive compensation.
“It’s a phenomenal idea, and probably the most important concept to come out of this [government involvement in compensation],” said Martini. “It will largely fix the compensation problems we have seen. It is difficult [right now for an advisor to management] to say that the CEO is making too much money. Compensation committees will be much more comfortable and get much more candid advice if they have completely independent consultants and counsel.”
Another attorney, Ken Raskin, head of the executive compensation, benefits, and employment practice at White & Case, said he’s the first one to suggest that an agreement he’s drafted with an executive be sent to the compensation committee for vetting before it’s brought to a vote. But he agreed that the proposed legislation is on the mark.
Of course, attorneys and consultants are far from bias-free on this issue. If management and the compensation committee have separate advisors, that means more work for the advisors. “Well, that’s true,” said Raskin. “Obviously that would be an effect of this. Notwithstanding that, it is simply a best practice for the compensation committee to divorce itself from the company in making these decisions.”
The other legislative proposal would require companies to give shareholders an advisory vote on executive compensation packages. That’s something President Obama promoted during his campaign, and it is currently required of recipients of federal bailout funds.
The two attorneys took separate sides on the matter. “Shareholders are not properly equipped to evaluate pay practices,” said Martini, “nor is it likely that they will ever become so in the future.”
Raskin, though, argued that institutional investors with a big stake in a company are likely to delve into the details of compensation proposals until they fully understand them. He noted that the law as described by the government would not impose any requirements on corporations other than to permit the non-binding vote — but a “no” advisory vote may have the same effect as a binding disapproval. “The administration is focusing more on public embarrassment than restrictions,” Raskin said.
The two proposed laws were mentioned in the fifth of five principles that Geithner put forth, namely that there should be transparency and accountability in the process of setting compensation.
The first principle, that compensation plans should properly measure and reward performance, could cause broad change in the way executive pay packages are structured, should the government opt to move beyond the principle to regulation or legislation. Geithner said that performance-based pay “should be conditioned on a wide range of internal and external metrics, not just stock price.” Martini called that statement “not completely unexpected, but radical nonetheless.”
There has been some pull-back recently in the prevalence of stock options within the total executive compensation mix, but it remains common for bonus packages to be mostly equity-based. That is unlikely to change, absent new rules.
The second principle, that pay should be structured to account for the time horizon of risks, pays homage to the widely held belief that financial firms contributed heavily to the economic crisis by rewarding executives richly for short-term gains without penalizing them for the long-term harm their actions caused.
Geithner’s third principle was that compensation should be aligned with sound risk management, and should not encourage “excessive” risks. But any efforts to mandate that could be problematic, for a couple of reasons. First, what constitutes an acceptable level of risk differs greatly between, say, an older, mature company and a start-up. Second, assessing risk is a highly subjective endeavor. “It will be the toughest thing to do to determine whether something is an excessive risk, or just a risk,” Raskin said.
The fourth principle was that there should be a reexamination of whether golden parachutes and supplemental retirement packages are aligned with shareholders’ interests.
Meanwhile, in making his announcement, Geithner made clear that the intention is not to put a cap on pay, but rather “to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives.”
What is, in effect, a tight cap on executive pay under the Troubled Assets Relief Program — bonuses can amount to no more than one-third of total compensation — has driven numerous financial institutions to push to return their government bailout cash.
“TARP recipients want to go out and compete for talent,” said Martini. “And if a cap were put on the amount of compensation [at all public companies], you would pretty quickly see an advantage develop abroad with talent creeping out of the country.” The European Commission, though, is working on its own compensation crackdown.