Monthly Archives: February 2009

Subjecting Private Funds to SEC Registration and Oversight

Posted by John G. Finley, Simpson Thacher & Bartlett LLP, on
Thursday, February 12, 2009
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This post from John G. Finley is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.

A bill introduced in the Senate on January 29, 2009 would generally require private funds to register with the U.S. Securities and Exchange Commission and impose other regulatory requirements, including the filing of information for public disclosure such as the identity of investors and the value of fund assets. The “Hedge Fund Transparency Act” (the “Bill”) was introduced by senior senators Carl Levin (D-MI) and Chuck Grassley (R-IA). Despite the name of the Bill, it applies to all types of private funds and not just hedge funds.

ALL TYPES OF PRIVATE FUNDS REGULATED
Unlike recent unsuccessful regulatory efforts focused only on the hedge fund industry,[1] the Bill would apply to nearly all types of private funds. Aside from certain de minimis exclusions (e.g., funds with assets of less than $50,000,000), all hedge funds, private equity funds and other private funds would be subject to the new regulations through proposed amendments to the definition of an investment company in the Investment Company Act of 1940 (the “Investment Company Act”). Traditionally, private funds have relied on exemptions from the definition of an investment company under the Investment Company Act pursuant to §3(c)(1) (exempting any issuer whose securities are privately placed and owned by no more than 100 investors) and §3(c)(7) (exempting any issuer whose securities are privately placed and owned exclusively by “qualified purchasers”). The Bill proposes to amend the definition of “investment company” by deleting those two exemptions in their entirety, moving them to become the new §6(a)(6) (formerly §3(c)(1)) and §6(a)(7) (formerly §3(c)(7)). The text of the replacement sections would remain largely the same, with the notable differences that funds falling under these sections would now be considered “investment companies” and any “large investment companies” (funds with assets of $50,000,000 or more) would be required to meet certain registration and reporting conditions in order to be excluded from the onerous regulatory requirements otherwise imposed on investment companies required to register under the Investment Company Act (i.e., mutual funds).

PROPOSED REPORTING REQUIREMENTS
The Bill would impose the following registration and reporting requirements on any private fund relying on §6(a)(6) or §6(a)(7) with assets of $50,000,000 or more:

• Registration with the SEC

• Maintenance of such books and records as the SEC may require

• Cooperation with the SEC in regard to any request for information or examination

• The filing of an electronically-searchable “information form” at least once a year to be made publicly available by the SEC and to include information such as:

  • the names and current addresses of each natural person who is a beneficial owner of the fund, any company with an ownership interest in the fund and the primary accountant and primary broker of the fund,
  • an explanation of the structure of ownership interests in the fund,
  • information on any affiliation that the fund has with another financial institution,
  • a statement of any minimum investment requirement,
  • the total number of investors, and
  • the current value of the assets of the fund and any assets under management by the fund (apparently on an aggregate basis rather than on an investment-by-investment basis).

The Bill’s requirement of public disclosure of the names of private fund investors is likely to spark debate. The policy rationale for providing public disclosure of the names and addresses of investors in private funds is unclear and raises significant privacy concerns, especially for entities used in personal planning contexts.

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Is Investor Protection the Top Priority of SEC Enforcement?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, February 11, 2009
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This post comes to us from Stavros Gadinis, who is a Post-graduate Fellow at Harvard Law School.

A paper I recently posted on SSRN, “Is Investor Protection the Top Priority of SEC Enforcement? Evidence from Actions Against Broker-Dealers,” provides the first empirical account of SEC enforcement efforts against the firms at the center of the current market turmoil: investment banks and brokerage houses. It suggests that the SEC favors defendants associated with big (listed) firms compared to defendants associated with smaller firms. Moreover, the paper finds tentative support for the hypothesis that SEC officials favor prospective employers.

The paper uses a new dataset of all SEC actions against broker-dealers in 1998, 2005, 2006, and the first four months of 2007. It presents systematic data on the types of violations the SEC pursues, the typical sanctions it imposes, and the enforcement venues (courts and administrative proceedings) and settlement patterns in its actions. More importantly, the paper investigates whether the SEC treats large and well-known investment houses more favorably than small broker-dealers. Because the SEC may choose to pursue a broker-dealer by either filing a civil lawsuit or by initiating administrative proceedings before an administrative law judge, the paper first explores the factors that determine the agency’s choice of venue. Courts are a worse forum for finance professionals, since, conditional on a finding of violation, a court is more likely than an administrative law judge to ban defendants from the securities industry. The paper finds that, for the same violation and comparable levels of harm to investors (proxied by disgorgement awards), big firms and their employees are more likely to avoid courts and face administrative proceedings instead.

The paper then turns to administrative cases, which the SEC controls more directly than court cases. Again, the paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are less likely to receive a ban from the securities industry, compared to small firms and their employees. Some theories could justify the differential treatment of large and small firms, on the basis of systemic risk considerations or concerns about unduly penalizing entire firms because of limited violations. However, no public policy justification exists for the preferential treatment of individual employees in large firms.

Despite controls concerning violation types and levels of harm, it is possible that big firms’ conduct is systematically less reproachable than small firms’ conduct, because of better compliance systems, higher quality personnel and sophisticated clients. To address these concerns, the paper presents qualitative evidence on a subset of cases where these concerns would be greatest: cases involving a failure to supervise subordinates. It finds that small- and big-firm violations are so similar in terms of fact-patterns, types of supervisory failures, and specific omissions, that they are virtually indistinguishable from a law enforcement perspective.

Finally, the paper tentatively links the above results with concerns about the post-SEC career trajectories of agency officials, who find employment in big firms’ compliance departments or in premier law firms. The paper shows that big firms headquartered in favorable locations receive lower sanctions than big firms around the country, indicating that SEC officials may respond to future employment prospects. The paper also provides some evidence that variation in the quality of legal representation between big and small firms cannot account for the observed differences in sanctions, because these differences persist even for cases where both big and small firms are likely to hire outside counsel.

The paper is available here.

Madoff – Could it Have Happened in the UK?

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, February 11, 2009
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This post is by Michael Raffan and Andrew Marsh of Freshfields Bruckhaus Deringer LLP in London.

This post outlines what the alleged Madoff fraud involved and how it was able to happen. It looks at relevant aspects of the US regulatory system and draws attention to some similarities in the UK system.

The Madoff debacle
Bernard Madoff’s alleged Ponzi scheme is reported to have cost clients $50bn. His business was run through Bernard L Madoff Investment Securities (‘Madoff’), based in New York. For years it appeared that Madoff was consistently making large returns from a sophisticated investment strategy involving purchases of equities hedged by out-of-the-money put-and-call index options. It now seems that those returns were fictitious and that payments to investors were being financed from the proceeds of new investments.

Not a hedge fund story
Initially the press reported this as a hedge fund story, no doubt because of Madoff’s purported complex investment strategy. But it seems that Madoff did not establish a hedge fund as an investment vehicle. Instead, it simply managed clients’ investment portfolios on a segregated, client-by-client basis. Indeed, Madoff seemed particularly keen to minimise the number of legal entities involved. It not only managed the accounts as discretionary investment manager, it also executed the trades itself as broker and acted as the custodian of clients’ cash and investments.

Ironically, it would have been much harder to maintain a fraud if Madoff had operated a hedge fund. Although hedge funds are typically established in less heavily regulated jurisdictions, they generally use an independent administrator, third party brokers and a custodian (often a prime broker) that is not itself the investment manager. The need for frequent reconciliations between the various confirmations, statements, reports and records of these entities makes concealment of fraud much more difficult.

Madoff and the regulatory system in the US
Inevitably, questions are being asked about whether the Madoff debacle has shown up deficiencies in the US regulatory system. The US system clearly distinguishes between broker dealers on the one hand and investment advisers (including discretionary investment managers) on the other hand. Madoff operated both types of businesses, which it carried out on separate floors of the same building. Initially it was registered only as a broker dealer. It claimed that its discretionary investment management activity did not require it to register as an investment adviser because it was remunerated only by trading commissions, rather than by a percentage of assets under management or profits.

Following various allegations of potential fraud, a Securities and Exchange Commission (SEC) enforcement investigation was launched in 2006. Although this failed to find any evidence of fraud, Madoff was found to be in breach of the investment adviser registration requirement. Madoff then registered as an investment adviser (in addition to its broker dealer registration) in September 2006. Madoff’s investment advisory business therefore became subject to the SEC’s regular inspection regime for investment advisers in 2006. But no inspection had in fact been carried out before the firm’s collapse.

Does any of this suggest that changes are needed to the US regulatory system? Clearly the SEC’s failure to detect fraud in its 2006 investigation suggests that there may be lessons to be learned about how such investigations should be conducted. But it is difficult to tell at this stage how far the SEC was at fault in this respect. If Madoff had been required to register as an investment adviser much sooner, there would have been a greater chance of detecting problems earlier. However, it is much more difficult to detect fraud when one or a few individuals are able to maintain control over books and records without any independent examination of whether the transactions in those books and records are real. It also appears that SEC investigators lacked the financial sophistication to understand that Madoff’s financial results were highly suspect – even though a number of commercial banks and brokerage houses harboured suspicions about this business activity and therefore refused to deal with Madoff.

One of the most interesting aspects of this case is that the concentration of investment functions in one place is not prohibited under the US regulatory system. There is nothing to prevent an investment adviser from acting as custodian, broker and administrator. This is the case even for ordinary retail and unsophisticated investors. By contrast, regulators have long recognised the importance of segregation of functions within a firm to prevent, for example, the same individual from performing both trading and settlement functions. The fact that no such requirements apply at the level of the firm itself allows opportunities for fraud if the firm is institutionally corrupt.

Could it happen here?
The simple answer is ‘yes’. Importantly, the UK system is the same as the US’s in allowing investment management, execution and custody to be performed by the same entity firm, even for retail clients. The more flexible Financial Services Authority (FSA) system based on ‘risk‑based’ regulation may have led the FSA to keep a closer eye on the firm’s operations, but that would of course have depended on the FSA having identified the firm as being higher risk in the first place. The job of assessing a firm’s risk profile is a difficult one, which seems deceptively easy only with hindsight. In the light of the Madoff experience it seems likely that the concentration of investment functions in a single firm will rank more highly as a risk factor with the FSA.

Areas for Enhanced Board Focus

Posted by Ira M. Millstein, Weil, Gotshal & Manges LLP, on
Tuesday, February 10, 2009
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This post is based on a client memo by Ira M. Millstein, Holly J. Gregory and Rebecca C. Grapsas of Weil, Gotshal & Manges LLP.

Recent events in the financial markets and the ensuing economic turmoil has shattered the trust of investors, regulators and Main Street in financial institutions and the capital markets on a global scale. The crisis has heightened focus on the importance of risk management at all corporations and has encouraged a fresh look at the role of the board in risk oversight. Although the manner in which a board fulfills its risk oversight responsibilities is a matter of business judgment, directors should bear in mind that conduct will be judged by investors, regulators, the media and others with the benefit of 20-20 hindsight. There is benefit to be had in going beyond the standards of care set by Caremark and its progeny, which require board oversight of an effective compliance and reporting system. Remembering that “best practices” provide a zone of comfort with respect to avoiding director liability, we set forth below ten areas for the board to enhance its focus in 2009 in light of the current environment. They are all related in some respect to enhancing the board’s ability to oversee management’s efforts to identify and avoid, mitigate or manage risk, with the caveat that specific actions to be taken will vary for each company.

1. Apply judgment in tailoring governance structures and processes to the current needs of the company. Remember that adopting a one-size-fits-all check-list approach to corporate governance is fundamentally inconsistent with effective governance. Care should be taken to avoid bowing to pressures to adopt practices that may not be in the company’s interest, while at the same time actively considering the viewpoints of key shareholders on appropriate matters. Boards should tailor their governance practices and structures to the company’s unique needs. The Key Agreed Principles to Strengthen Corporate Governance of U.S. Public Companies published in October 2008 by the National Association of Corporate Directors with support and input from The Business Roundtable and the International Corporate Governance Network (available here and briefly outlined in the Appendix to this document) reflect an effort to distill and articulate fundamental principles-based aspects of governance on which there is broad consensus. The Key Agreed Principles capture the current baseline consensus among boards, managements and shareholders about a range of effective governance practices. Their articulation may help improve the quality of discussion and debate about those governance issues that have not yet gained consensus, and also serve as a touchstone for boards in tailoring governance and avoiding a rote approach. We urge boards to gain familiarity with the Principles and consider them in tailoring their own governance structures and practices to meet the needs of their respective companies.

2. Take a fresh look at board composition and director competency. While a board is more than the sum of its parts, it requires key skill sets and experiences to be positioned to provide and oversight of risk and compliance. The nominating/corporate governance committee should review with rigor the composition of the board and determine whether the board is comprised of people with the optimal mix of experience given the business, circumstances and nature of the risks facing the company. The right mix of competencies will change over time as the company evolves and care needs to be taken to avoid a mindset of “permanent tenure” for directors. The board should use the evaluation process (as well as term/age limits where appropriate) to refresh itself periodically. It is not enough to pull together a distinguished group of men and women if those directors do not have the expertise necessary to understand the fundamentals of the company’s business as the business changes over time and the attendant risks. Given the emphasis on independent directors, boards need to take special care to ensure that persons on the board have industry specific expertise and distinct sources of information about the intricacies of the business and related risks. The board should consider ways to ensure that it is not simply dependent on management for its understanding of the business and the industry. The nominating/corporate governance committee should ensure that company-specific director education and orientation programs are presented to the full board periodically, especially programs that address risk oversight and risk management generally, providing directors with the opportunity to learn about specific risks affecting the company and changes in business conditions and legal standards that may impact on risk.

3. Consider implementing some form of independent board leadership. The ability to exercise effective oversight may be compromised where the board lacks any defined leadership for the independent and non-management directors. Management has natural conflicts and blind spots — in monitoring CEO performance, providing risk oversight and evaluating the strategic plan. The long-range trend is toward a separation of the chair and CEO positions, with an independent director filling the chair role, and that trend is likely to accelerate as shareholders seek assurances that the board is strongly positioned to provide objective judgment in its review of management decisions in key areas. The board — and in particular the independent directors assisted by the nominating/corporate governance committee — should evaluate whether to appoint a separate independent chairman or a strong lead director to assist the board in fulfilling its oversight responsibilities, and should explain its choice to shareholders. For companies that combine the roles of CEO and chairman, expect increased pressure from shareholders to separate the positions or at a minimum create a strong lead director position with an appropriate range of responsibilities. Indications are that independent board leadership will be a “hot button” issue for shareholders during the 2009 proxy season.

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Risk and The Chief Legal Officer: Expanding Exposure

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Tuesday, February 10, 2009
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This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

My firm has prepared a memo entitled “Risk and The Chief Legal Officer: Expanding Exposure,” which addresses what we believe is expanding exposure facing Chief Legal Offices (CLOs) of US public companies. The first two sections briefly address the two key underpinnings of this phenomenon: (1) increasing focus on the CLO as a central player in the fight for improved corporate governance and legal/ ethical compliance; and (2) an increasingly complex legal environment, with the prospect of more legislation and regulation.

The third section provides the distilled practical guidance of a large number of Skadden lawyers from a broad range of relevant practice areas, developed in response to a basic question: “Based on your personal experience, what do you think would be particularly valuable for a CLO of a public company to know about the CLO’s risk exposure today and how best to manage it?” Our guidance comes in the form of a series of intentionally pithy headline observations, followed by some important elaboration on each. Broadly speaking, our guidance relates to the two basic areas of CLO risk management — responding to a potential or actual problem which arrives on the scene and dealing in advance with preventative measures. Some points clearly fall into one category or the other; a few are relevant to both.

While targeted for CLOs of U.S.public companies, the memo may be of interest to CLOs of many non-U.S. public companies, as well.

The memorandum is available here.

Executive Compensation: What Obama’s Plan Means

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, February 10, 2009
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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.

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Back to Purchasing Troubled Assets

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, February 9, 2009
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Editor’s Note: This post is by Lucian Bebchuk of Harvard Law School.

The plan proposed by Treasury Secretary Paulson last September focused on the government’s purchasing “troubled assets” from banks and other financial institutions. Critics (including myself) stressed the huge difficulties that would be involved in the government’s placing a value on troubled assets and the risk that the government would overpay for purchased assets, and the administration abandoned its plan to purchase troubled assets in favor of directly infusing TARP funds into financial institutions.

At the time, I put forward, in an article (available here) as well as a WSJ op-ed piece (available here), an alternative plan to Paulson’s for government-funded purchases of troubled assets. Under the approach I put forward last fall, if the government were to provide capital to get additional liquidity for the market for troubled assets, it should invest funds through a multi-buyer competitive process that uses private parties with appropriate incentives.

According to news reports, the new administration is working on a plan that would involve purchasing troubled assets. This time, however, the administration seems to be considering involving private parties. The WSJ reported yesterday that “Treasury Secretary Timothy Geithner is considering a plan to help purge banks of their bad bets by partnering with the private sector to buy troubled assets, according to people familiar with the matter.” Similarly, the New York Times reported on Saturday that the administration is considering providing capital to, or assuming some of the risks of, private investors purchasing troubled assets.

Appropriately designed, a plan based on multi-buyer competitive process that uses private parties with appropriate incentives can provide the necessary liquidity to the market for troubled assets while maintaining the market pricing that is essential to avoid overpaying for troubled assets. Here is a brief description of (one version of) the proposal I put forward last fall:

Suppose that Treasury believes that the market for troubled assets is not functioning properly due to lack of liquidity and that the introduction of buyers armed with $250 billion could bring the necessary liquidity to this market. The Treasury could establish, say, 25 funds with a capital of $10 billion each. The funds could be funded with TARP funds as well as with some borrowed funds from the Fed.

The key is to have the funds managed by private mangers with appropriate incentives. Each fund should be run by a manager verified to have no conflicting interests. The manager would be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess return (over the yield on treasury securities) generated by the fund during its period of operations.

This system would not equire Treasury officials to place any value outside a market context on troubled assets. It would be effective because:

(1) The competition among these 25 funds would prevent the price paid for the mortgage assets from falling below fair value, and

(2) The fund managers’ profit incentives would prevent the price from exceeding fair value.

For the above approach to be effective, it needs to be appropriately designed. The devil is in the details. Thus, if Treasury does elect to proceed with a scheme involving the use of private parties for purchasing troubled assets, it will be important to study carefully the details of the design it chooses. Given that purchasing troubled assets is back on the table, I am planning to write again on the subject when more information becomes available, and any comments or suggestions would thus be most welcome.

Moral Hazard and Managerial Compensation

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, February 8, 2009
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This post comes from Robert A. Miller and George-Levi Gayle of Carnegie Mellon University.

In our recently accepted American Economic Review paper entitled Has Moral Hazard Become a More Important Factor in Managerial Compensation? we estimate a model of moral hazard with data spanning a sixty-year period in order to investigate how well two specific channels explain secular changes in managerial compensation and to assess their relative importance. First, contracts reflect heterogeneity across firms, such as their size, capital-labor ratios, the sectors they belong to, and the dispersion of their financial returns. Consequently, changing the heterogeneity across firms induces changes in the aggregate level and variability of compensation. Second, the optimal contract is a function of the preferences and risk attitudes of managers. Changing those preferences also affects the probability distribution of compensation across executives.

The data for our empirical analysis are drawn from two samples that collectively span approximately sixty years from 1944 with a fifteen year break at 1978. The firms and their managers are selected from three industrial sectors, aerospace, chemicals, and electronics, broadly representative of all publicly traded corporations. Our empirical framework accommodates changes in the processes determining firm size and returns by separately estimating models of managerial compensation for the two samples and by parametrically allowing for the effects of changes on the contracts within each sample.

The welfare cost of the moral hazard is a compensating differential paid to risk-averse managers to hold insider wealth and accept non-diversifiable risk that realigns their incentives to those of the stockholders, who do not price risk from an individual firm’s abnormal returns because of their portfolio choices. We find that the welfare cost of the moral hazard associated with employing CEOs has increased by an estimated factor of more than twenty times in the aerospace and electronics sectors and six fold in the chemicals sector. Subtracting the welfare costs of the moral hazard from the expected compensation paid to top executives, we obtain, for each of the six categories, the average certainty equivalent wage which equates the supply and demand for managerial services for a given firm. The overall increase in the sixty year period is 2.3, the same as the increase in national income. Therefore our results attribute all the difference between the rate of increase in managerial compensation and the rate of increase in national income to the rising welfare cost of the moral hazard. We find the main reason this welfare cost steeply rose, is that large firms pay a higher risk premium than small firms to align the incentives of managers with their shareholders, and average firm size increased significantly over this period.

The full paper is available for download here.

More on the Administration’s Compensation Guidelines

Posted by Broc Romanek, TheCorporateCounsel.net, on
Saturday, February 7, 2009
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This post is from Broc Romanek TheCorporateCounsel.net. The Administration’s compensation guidelines are available here, and a valuable outline of the guidelines by Davis Polk & Wardwell is available here. Earlier posts on the compensation guidelines on this blog are available here and here.

Related to the recent op-ed piece from Professor Bebchuk regarding the new Treasury executive guidelines, here are key fixes to those new guidelines recommended by Jesse Brill, Chair of CompensationStandards.com:

One key aspect of the Obama Adminstration’s new $500,000 cap that has not gotten sufficient attention is the unlimited amount of restricted stock and stock options that still can be granted under the latest “restrictions.” Equity compensation is the pay component that has gotten most out-of-line over the past 20 years. It (as well as severance/retirement/ golden parachutes) has caused the greatest disparity between CEO compensation and that of the next tier of executives (and employees generally).

The new $500,000 cap provision does prevent executives from realizing the gains in their equity compensation until after the government is paid back. But there are two major problems with how this applies:

1. It does not apply to past equity compensation. Warren Buffet imposed a similar cap on Goldman Sachs’ executives, but his restriction applies to all the equity held by the top executives. It is not limited just to future grants, as is the case with the new government restriction. So Buffett’s provision wisely requires that the key decision-makers keep all their “skin in the game” until he gets paid off.

2. Although it may help protect the government’s investment, it is short-sighted and fails to protect the shareholders’ best long term interests. The holding period should be the longer of age 65 or two years following retirement. That will ensure that the key executives make decisions that truly are in the long-term best interests of the company (as opposed to decisions aimed at a shorter period – after which an executive could depart, taking all his marbles with him).Note that holding-through-retirement also addresses the major concern about top executives’ unnecessary risk taking.

Holding equity compensation through retirement is perhaps the single most important—and fundamental – fix to getting executive compensation back on track because it also addresses all the past outstanding excessive option and restricted stock grants. And, by requiring CEOs to keep their skin in the game for the long term, it will go a long way to restoring public trust in our companies and our market, which is so important to restoring stability to the markets.

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Reactions to Bebchuk on the Administration’s Compensation Guidelines

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, February 7, 2009

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The Administration’s compensation guidelines are available here, and a valuable outline of the guidelines by Davis Polk & Wardwell is available here.

In response to Lucian Bebchuk’s post from yesterday, Bernard Sharfman writes:

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.”

Another reaction has come from David Wilson, who writes:

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.

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