The Administration’s Executive Pay Guidelines

Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk in today’s Wall Street Journal.

Critics of the administration’s proposed guidelines on executive compensation say they are a dangerous intrusion into corporate boards’ authority and would make it difficult for financial firms to fill executive positions. These criticisms are unwarranted. If anything, the guidelines are too modest and should be tightened.

Concern that the guidelines would undermine firms’ ability to attract or retain executives has been fueled by media coverage stressing the $500,000 cap on salaries. Because salaries commonly represent a small fraction of total executive pay, and firms would be free to make up for this reduction by providing additional compensation in other forms, the salary cap’s significance would be mainly symbolic. Indeed, I would have no problem with a somewhat higher salary cap, especially if that would facilitate tightening the elements of the guidelines that are practically more significant.

Companies falling under the guidelines will retain the ability to provide large compensation when necessary. The guidelines don’t impose any cap on the total pay; they only influence its form. Indeed, firms which get taxpayer funds under “generally available government programs”—which likely will constitute the lion’s share of firms receiving government capital—will be permitted to provide unlimited compensation in any form they choose provided they disclose it (as is already required) and allow shareholders to have advisory “say on pay” votes on the firm’s pay policy. Even firms that receive “exceptional assistance” (such as provided to AIG or Citibank in the past) will be permitted to compensate executives with unlimited amounts in restricted shares that can be cashed out after the government is paid back.

This is not excessive government meddling. As a major provider of capital to firms receiving exceptional assistance, the government has a legitimate investment interest in executives’ being properly incentivized. The proposed guidelines are a rather modest intervention relative to the control rights that private investors providing so much capital would likely seek.

Furthermore, this modest intervention can significantly improve incentives and performance. In a 2004 book and prior articles, Jesse Fried and I warned that common executive pay practices produce perverse incentives to focus on short-term results. To the extent that such incentives have contributed to the current crisis—as has now come to be widely suspected—the adverse consequences have been dire indeed.

Executives’ ability to profit from early dumping of their equity-based compensation can impose large costs on investors. To protect its investments in firms receiving exceptional assistance, the government is warranted in restricting executives’ freedom to unload their restricted shares quickly, before the government is repaid.

For executives to view any number of restricted shares that cannot be quickly unloaded as inadequate compensation, they must believe the firm will likely fail to repay the government, and that the restricted shares will lose their value if not cashed out beforehand. In such circumstances, the firm should be immediately taken over by the government or otherwise reorganized. It should not continue operating with a structure under which executives may be retained only if allowed to cash out before things fall apart.

After a period of public comment, the Obama administration will finalize the guidelines for firms receiving capital under general programs. I believe the final version should impose tighter restrictions, at least for firms receiving a substantial capital infusion from the government.

While the proposed guidelines seek to encourage companies participating in general programs to use restricted stock, they do not limit how quickly such restricted shares may be unloaded. This should be changed. To provide incentives to focus on long-term results, executives should be precluded from unloading restricted shares for a specified period, say three years, after they vest.

The proposed guidelines also make it too easy for firms participating in general programs to opt out of the restricted stock requirement and compensate executives in whatever form they choose. Companies that opt out only need to adopt “say on pay” votes.

While such votes may be a good governance arrangement for public firms in general, they are merely advisory and, moreover, take place in the year after compensation is awarded. Furthermore, and importantly, because the government can be expected to hold investment rights (such as preferred shares) that are senior to those of common stockholders, these stockholders may prefer executive pay arrangements that would induce more risk-taking and short-termism than would be in the interest of the government as an investor.

In short, the guidelines are a useful step in the right direction. To ensure that executives of firms receiving government capital are well incentivized, however, the administration should use the comment period to significantly tighten them.

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  1. Bernard Sharfman
    Posted Friday, February 6, 2009 at 11:43 am | Permalink

    I also agree that the proposed salary caps are mainly symbolic. In 2008, Wall Street paid out $18.4 billion in bonuses to its approximately 164K plus employees. Based on this data and the limited number of firms and number of employees (5 per firm) the pay caps could apply to, I would say that 99.9% of Wall Street employees are safe from the wrath of the proposal. If you want to reduce large company wide bonus payouts in bad years, which I believe was the original intent of these proposed guidelines, that is not the way to do it. However, the real significance of the proposal may be as an implied threat to Wall Street to get its compensation act together or else face something real later on.

    For a recently posted paper on how corporate law should respond to Wall Street compensation policies, see Bernard S. Sharfman, Enhanced Duties for Excessively Risky Decisions, available at

  2. David Wilson
    Posted Friday, February 6, 2009 at 1:25 pm | Permalink

    A symbolic $500k salary cap may have unintended consequences. As Mr. Bebchuk points out, firms are still “free to make up for this reduction” with other forms of compensation. Because of this, the cap will alter the form in which executives are paid. Executives will require higher levels of incentive-based compensation to make up for the reduction in their “guaranteed” cash salaries.

    Further, a dollar of incentive-based compensation is worth less than a dollar in cash. A CEO who sees his salary cut from $2m to $0.5m will not be in the same financial position if he receives an additional $1.5m in incentive-based pay. Michael Jensen, Kevin Murphy and Eric Wruck point this out in their 2004 paper “Remuneration: Where We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them” (, in which they state “[r]isk-averse executives will ‘charge’ for bearing risk by discounting the value of the risky elements of pay.” If this is true, we can expect to see significant increases in equity-based incentives.

    As Mr. Bebchuk points out, a myriad of issues that need to be addressed surround the use of equity incentives.

  3. Richard D. Greenfield
    Posted Sunday, February 8, 2009 at 2:55 pm | Permalink

    The letter set forth below to The Wall Street Journal was in response to an op-ed piece written by Carl Icahn entitled “Capitalism Should Return to Its Roots” (WSJ 2-7-09):

    As a lawyer who has specialized in corporate governance for more than 35 years and as a former director of a NYSE-listed bank holding company, I have often been intrigued by Carl Icahn’s quests in support of shareholder value. Even though he has used the mantras of “shareholder rights” and “good corporate governance, ” he has typically done so in support of his own personal interests (a worthy goal of capitalism). Despite such personal interests, he has concurrently been one of the nation’s foremost spokesmen for the so-called “little guy” whose interests frequently get lost in corporate boardrooms.

    His op-ed piece, “Capitalism Should Return to Its Roots” (WSJ February 7, 2009), is one of the “it’s about time” calls for real shareholder rights and not those to which some courts and state legislatures pay nominal fealty. Mr. Icahn, in urging shareholders to seek re-incorporation in shareholder-friendly states, of which there are precious few, misses the point entirely. What we really need is a Federal Corporations Code which would govern the respective rights and responsibilities of corporations regardless of their states of incorporation, their shareholders and the directors charged with their oversight. Such a Code would be applicable to those corporations with publicly-traded stock whose stockholders reside in more than a single state and which conduct business in at least 5 states.

    The abuses in Wall Street and, indeed, in many corporate boardrooms, will not disappear overnight. Nor will increased oversight do the trick since our regulatory resources are stretched too thinly to bring about needed fundamental changes, even if the will to do so were to exist. Among other corrective measures, a Federal Corporations Code can facilitate changes to the suffrage process, making it less cumbersome for legitimate shareholder-originated resolutions to be presented for a vote, provide for clear liability for directors who have been grossly negligent in the performance of their responsibilities, eliminate anti-shareholder “poison pills” and other existing devices by which managements and boards of directors abuse their powers such as through the awarding of excessively generous compensation packages, “golden parachutes,” etc.

    Richard D. Greenfield
    Greenfield & Goodman LLC
    250 Hudson Street-8th Floor
    New York, NY 10013
    (410) 320-5931

    February 8, 2009