Executive Compensation: What Obama’s Plan Means

Editor’s Note: This article was recently published by the author, Ben Heineman, in Business Week. Mr. Heineman is General Electric’s former senior vice-president for law and public affairs, and is author of “High Performance with High Integrity”.

The Administration’s attempt to deal with excessive pay is more about procedure than substance and will allow most companies to self-govern

Despite headlines along the lines of “Obama Caps Exec Pay,” the Administration’s executive compensation initiative sets relatively few fixed, substantive requirements for most companies receiving funds under the Troubled Asset Relief Program (TARP).

Primarily, it imposes procedural requirements. To wit: that boards of directors and senior executives develop positions on pay levels, on whether compensation creates undue risk, on “clawbacks” of pay for financial misstatements, and come up with policies on luxury items—and then disclose the results and the reasoning; seek shareholder approval in some instances; and have CEOs certify company compliance with the new approach.

TARP Forces Company Hands

The new compensation rules appropriately force TARP companies to focus on some of the issues that caused the financial meltdown and to make their answers transparent in the belief that in this climate, excess pay will invite public or shareholder denunciation.

These proposals should be seen as just the opening regulatory shot in what will be a months-long or even multiyear debate on a variety of regulatory mechanisms—such as capital requirements, a product approvals process, an enhanced Fed role in evaluating risk to the financial system—that would limit or constrain business decision-making. These various regulatory responses would seek to address the immediate causes of the financial-sector meltdown that has thrown the global economy into crisis: e.g., the failure of risk functions; internal conflicts of interest rather than checks and balances; leadership failures; and a lax culture. Business must ultimately address the root causes: a failure to balance risk-taking with risk management, and to fuse high performance with high integrity.

In addition to opening the “deal with the causes” debate, the executive comp reforms are a necessary political precondition for using the second tranche of TARP money to deal with the direct effects of the meltdown—lack of credit and liquidity—and to gain support for the stimulus package.

Given the public’s white-hot anger over the financial sector’s unwillingness or inability to ease credit since TARP I and seemingly tone-deaf acts by corporations receiving taxpayer dollars (indiscriminate use of corporate jets, for example), the forthcoming proposals on TARP II will likely be dead on arrival if they don’t appear to be tough on executive compensation.

Senator McCaskill’s Hard Cap
The reforms also provide a more moderate alternative to any number of draconian and ill-conceived provisions that could be attached to the stimulus package in the Senate, such as Senator Claire McCaskill’s proposal to set a hard cap of $400,000 (the same as the President’s salary) on total compensation for all employees of every institution receiving funds under TARP.

With its emphasis on procedural requirements, the Administration is being political in another sense. By leaving it to boards, senior officers, and shareholders to address issues, design programs, and make disclosures, the Administration for now avoids imposing a set of detailed, substantive rules whose effects will be uncertain, and allows the private sector to develop a variety of responses appropriate to each corporation. These responses will then be considered as part of a longer-term regulatory reform process (also announced this week) for the alignment of compensation with proper risk management and long-term value and growth.

The main provision from the Administration illustrates the problems of applying fixed, substantive rules in complex circumstances. For companies receiving future “exceptional financial assistance” from TARP, pay for senior executives is capped at $500,000 and additional compensation may be provided through restricted stock that vests only after the government is repaid (or other negotiated conditions, as yet undefined, are satisfied).

This “exceptional assistance” is defined as special deals negotiated one-on-one with companies, such as those made with AIG (AIG), Citigroup (C), and Bank of America (BAC), though the new rules apply only to future special arrangements.

This prospective “hard” cap may only apply to a few companies in the future (and only if there are more special negotiations), and it will not apply to many executives who were part of the problem in the past because the government cannot unilaterally modify their contracts.

Who Would Run Bank of America?
The Administration contends that allowing restricted stock on top of the $500,000 cap will create incentives for sound risk management. But senior executives in future “exceptional” cases may have to wait for an indeterminate period before repayment can occur and restricted stock vests. Or they may decide to take actions to pay back the government that are not the best deployment of capital in terms of accelerating vesting. Amid such limits and uncertainties, will troubled institutions be able to attract new talent—people not implicated in the past mistakes—to provide critical leadership?

For example, if Bank of America needed new “exceptional assistance” under TARP and if CEO Ken Lewis were asked to leave, could a new executive team be assembled for $500,000 per person and a very uncertain payday in restricted stock?

For companies participating in TARP’s “generally available capital access programs” (under which the same terms apply to all recipients), the $500,000 cap and restricted-stock rules may be avoided if they disclose compensation arrangements and explain why the comp plans do not encourage “excessive and unnecessary risk-taking.” Thus, for “regular TARP recipients,” there will likely be no cap—just more complex disclosure language.

Time for “Say on Pay”
In addition, if requested by shareholders (a virtual certainty), regular TARP recipients will have to submit these alternative pay arrangements to shareholders for nonbinding “say on pay” votes. Such “say on pay” proposals are likely to be approved by shareholders of regular TARP recipients in any event. (The average vote in favor of such proposals in all sectors in 2008 before the meltdown was more than 40%—and a number of companies have already adopted such a process.) Whatever the pros and cons of “say on pay,” its time has clearly come in financial services.

Regular TARP recipients must also review and disclose reasons that the compensation arrangements “do not encourage excessive and unnecessary risk-taking”—not just for executives but for all employees, such as floor-traders.

In addition, regular TARP recipients must have “clawback” provisions relating to their top 25 “senior executives” that allow the companies to recover bonuses and incentive compensation from those who “knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay.” Again, this requirement reflects an existing trend. Per 2008 proxy statements, 27 of the Dow 30 companies had clawback provisions. If the Administration is concerned about integrity, it should require companies to broaden this clawback provision to include any intentional violation of law.

Finally, in response to the political uproar, the initiative requires the boards of regular TARP recipients to adopt a policy on luxury items such as private aviation and office renovations; to require CEO certification for items outside the policy; and to make the policy public. (All these procedural requirements are final and have immediate effect on any new “exceptional assistance” companies—but these rules for regular TARP recipients won’t take effect until after a short notice-and-comment period.)

Key Executive Compensation Questions
Whether these executive compensation provisions help address the fundamental issue of balancing risk-taking with risk management and fusing high performance with high integrity turns on a number of questions. They include:

• Will the TARP companies address issues creatively and in good faith?

• Will their disclosures be clear and coherent (and not obfuscatory boilerplate)?

• Will public and shareholder response be rational in a time of tremendous economic dislocation?

• Will these reforms fit coherently with other complex financial changes being considered to ensure the safety and soundness of the global financial system, such as structural changes in regulatory institutions, capital requirements, regulatory approval of certain products, and more disclosure of off-balance-sheet items and for private equity/hedge funds?

• Will talent move to boutiques, foreign banks, or other non-TARP financial companies?

• And, at the end of the day, will there be the right balance between public and private roles, between innovation and creativity and risk management and discipline?

The generally sensible procedural requirements (if not the rigid substantive requirements) in the Administration’s executive compensation reforms are just the first chapter—maybe even just the first paragraphs—in what will be a long and complex story about the governmental responses to the risk and integrity causes of the financial crisis.

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