Principles for Reforming Executive Pay

Reining in excessive management compensation will be high on the “to-do” list of the 111th Congress.

The rocket fuel that sent the financial sector soaring into the stratosphere (where it ultimately exploded) was excessive executive compensation, which rewarded the churning of paper and risk-taking rather than the creation of sustained economic value and risk management.

The day of regulatory reckoning on the causes of the financial meltdown will soon be upon us, even as governments struggle with the severe effects and the world waits for a “mega-stimulus” proposal from President-elect Barack Obama. Reforming executive pay will likely be high on the financial re-regulation “to do” list for the 111th Congress as anger at executives remains white-hot.

To be sure, partial ad hoc measures are popping up, both in the U.S. and abroad, from a flat cap on executive pay at German companies receiving bailout funds to active oversight of payouts by the British government in its varying roles as shareholder, director, and regulator of troubled companies. Under the Troubled Assets Relief Program (TARP), Congress last fall hastily imposed executive compensation limits on senior leaders in financial sector entities, including limiting tax-deductibility on exec comp over $500,000; providing new clawback rules for material mistakes; capping or eliminating golden parachutes; and requiring board assessments of the relationship between compensation and risk-taking.

Striking a Balance
As more thoughtful, comprehensive approaches evolve, agreeing on principles will be key to effecting any real change. Here are three principles that I believe should be the foundation of any substantive change.

First, executive pay should promote a fundamental balance between taking risk and managing risk as the core of high performance. Executives must be rewarded both for stimulating value-creating innovation and for disciplines that assess, spread, and manage risk. There can be little doubt that compensation in the financial sector was not based on personal ownership and understanding by top leaders of risk assessment and management.

Second, compensation must clearly reward a foundational fusion of high economic performance with high integrity. That means a tenacious adherence to the spirit and letter of formal rules, legal and financial; voluntary adoption of uniform ethical standards that bind the company and its employees to act in its enlightened self-interest; and employee commitment to the core values of honesty, candor, fairness, reliability, and trustworthiness.

Promoting a Culture of Integrity
Third, to reward that balance—and that fusion—the annual compensation of top financial-sector executives and key “risk-takers” should be redirected away from short-term cash toward longer-term payouts. Affirmative performance goals, which measure the creation of real value and the implementation of a culture of integrity, should guide the amount. But a significant portion of a year’s compensation should be withheld; to be paid out over time if value is sustained and cancelled if adverse events occur.

Such adverse events could include: financial results that exceed established risk parameters; outsize, unpredictable financial losses; significant financial restatements due to accounting failures; and major legal or ethical lapses for which the pay recipient is responsible in whole or in part. The withheld compensation may be either cash (held in escrow) or equity instruments (subject to cancellation).

Such reform would encourage a focus on creating real economic value and discourage baleful “short-termism.” It would also retain control of payouts, rather than requiring boards to go through a cumbersome clawback process to recover monies already paid to culpable executives. And it would make it more difficult for employees to leave after bonus season.

Rewarding Durable Success
An example of such program is the “bonus/malus” system UBS announced in a report late last year on its new compensation model. This interesting report, which received little public notice, is one of the first systematic responses to a company’s recognition that prior payouts failed to assess large risks or evaluate “the quality or sustainability” of earnings. A similar approach has been announced by Morgan Stanley.

This stretch-out of annual compensation can, of course, also be combined with other longer-term bonus/malus plans—awards based on total performance over five years, as well even longer-term equity grants that pay out (after 10 years or at retirement) only if the corporation has durable success and if the executive remains with the company due to sustained personal performance.

Putting the balance of risk-taking and risk management and the fusion of high performance with high integrity at the center of executive compensation systems will require significant thought and redesign based on knowledge of the industry and the particular corporation. This redesign would, customarily, be the task of the board and senior management. But the striking failures in the financial sector have quite rightly made people question whether industry leaders are capable of creating a new culture and implement needed compensation change.

Putting It Out in Proxies
But government regulation in this complex area—either as policy-maker or shareholder—also has problems: bright-line pay caps or limits on deductions can be ham-handed and counterproductive; detailed substantive rules are difficult to administer; given the complexities of pay, more disclosure may just mean more obfuscation; and, per TARP, imposing “procedural” requirements on board compensation committees to ensure that executive comp doesn’t lead to “unnecessary and excessive risks” can end up as a box-checking exercise. Most importantly, ill-conceived rules may stifle the calibrated risk-taking and creativity that are so central to capitalism and could adversely affect the labor market for corporate leadership.

Finding the appropriate balance between government autonomy and corporate responsibility on executive compensation is an extraordinarily challenging and complex task. The best course for the next three or four months is for corporations to follow the UBS and Morgan Stanley examples and rethink, redesign, and put out for public scrutiny and debate reformed systems of executive compensation in anticipation of, or as part of, the 2009 proxy season. Such a public discussion should also include thoughtful questions about the hastily assembled reforms enacted in TARP. Such reassessments—if they came from numerous companies, reflecting different perspectives and circumstances—would greatly inform the inevitable regulatory debate that will soon start in earnest.

Continuing corporate silence on this seminal issue will constitute an unconscionable private-sector default to the political process. The public debates on executive compensation are going to among the most difficult in financial reregulation. Corporate abdication on new pay systems will dramatically compound that difficulty.

A Call to Arms
HSBC Chairman Stephen Green recently said, “There is clearly urgent work to be done to ensure that compensation structures…do not encourage short-termism and excessive risk-taking. Any responsible bank will be looking hard at this issue.”

Let’s hope they do that—and then speak out. Soon.