“Modest” Reform Proposals for Executive Compensation

By now, all of us are more than familiar with the controversies swirling around the subject of executive compensation - the $161.5 million golden parachute Stan O'Neal received when he exited Merrill Lynch, the $165 million in retention pay and bonuses paid to AIG employees, and the $3.6 billion in eleventh hour payments to employees made by Merrill Lynch just before its acquisition by Bank of America. As Goldman Sachs Chairman and CEO Lloyd Blankfein recently acknowledged, the compensation practices that led to these – and other – pay outs "look self-serving and greedy in hindsight."

We are also aware of the public anger provoked by executive compensation of this magnitude, particularly at companies that are receiving TARP funds. This anger has driven ham-handed, emotional and perhaps unconstitutional efforts by Congress to claw back money already paid out through tax levies, specifically targeting some of these companies and employees.

The outcry is quite understandable given the hundreds of thousands of people who are losing their jobs each month. However, what is oftentimes missed amid the resulting brouhaha is what got us here in the first place - a significant breakdown in corporate governance at many of the companies that made these payments. To paraphrase Judge Stanley Sporkin's famous question from a few years back about the outside lawyers and accountants who were involved with Lincoln Savings & Loan: Where were the boards of directors and their compensation committees?

Somewhere along the line, independent directors forgot that they were supposed to be truly independent of management, and that they were supposed to represent the best interests of the owners of their companies - the shareholders - and not just line the pockets of senior management in good times and in bad.

How this state of affairs came about is fairly obvious. Many independent directors became too cozy with management, and there was little or no incentive for them ever to stand up to management and their compensation demands. After all, when you are making a significant amount of money each year as a director of a public company, the last thing you want to do is to rock the boat and get thrown overboard. Not surprisingly, boards and their compensation committees did not operate as an effective check on executive compensation, and the salary and benefits arrangements that resulted were not on arm's-length terms.

Usually, boards attempt to justify the compensation packages given to management on the grounds that they were recommended by compensation consultants. And, of course, we have all heard the oft-voiced concern that if companies do not pay well, they will not be able to attract and retain the best talent.

Wall Street’s Lake Wobegon effect

What the first justification fails to recognize is the inherent conflict of interest that compensation consultants face. Just like rating agencies and real estate appraisers, they realize that if their recommendations are too “low”, they will not be hired for next year’s review. As a result, pay consultants do their best to justify senior executive compensation packages that keep up with the Joneses. Add to that tendency the Lake Wobegon effect, which is the notion that since all of the company’s senior executives are “above average,” they deserve even more than the Joneses, and it is easy to see how executive compensation has spiraled out of control in recent years.

The idea that most senior executives are hired guns who will flee their companies at the first offer of higher pay is also largely a fallacy. How many examples are there of corporate executives switching jobs just or primarily for the money? Practically all high-level job changes are due to other factors such as the attractions of greater responsibilities, running a larger company, or having a position that is higher up on the corporate ladder at the new company. And what ever happened to loyalty to one’s company and being willing to take a “home team discount”? Are senior executives really that mercenary and only looking out for themselves? If so, perhaps their companies would be better off if executives left for “greener” pastures.

It is clear from all the recent examples of excessive executive compensation that many boards of directors and compensation committees have fallen down on the job. The result is a near-complete disconnect between how much top executives are paid and their companies’ financial health and performance over the long-term. In the process, many directors seem to have lost sight of their primary responsibility – to enhance shareholder value.

There is no single answer as to how we get boards of directors and their compensation committees back on track when it comes to deciding how much senior executive should be paid. However, a number of steps should be given serious consideration in order to avoid the need for Congressional legislation, which, as more than one prominent observer has noted, will be inherently suspect in the current environment. What is required, at a minimum, are (1) increased board independence, (2) greater shareholder involvement, (3) increased transparency and disclosure, and (4) better alignment of the interests of executives and directors with shareholders. How might these objectives be best achieved?

Increased Board Independence

One thing we have learned since Sarbanes-Oxley was enacted in 2002 is that just because a director satisfies the independence requirements imposed by the statute does not mean that he or she is truly independent from management. There is probably no good way to get inside a director’s head to find out just how independent he or she will be vis-à-vis senior management. It is also probably not a good idea to scrutinize a director’s personal life in an attempt to ascertain whether, for example, their spouses are good friends, they were fraternity brothers or sorority sisters in college, or they belong to some of the same clubs or are involved with the same charities.

That being said, several things can be done to make boards and compensation committees more independent from management:

• No management involvement in director and committee membership selection. In addition to requiring that the board’s nominating committee consist entirely of independent directors, which is largely the case today, management (including all inside directors) should be precluded from having any input, formal or informal, into the selection of committee members or director nomination decisions made by the nominating committee.
• Composition of the compensation committee. Similarly, the board’s compensation committee members should be selected only by the board’s independent directors. Moreover, individuals who are currently senior executives of other companies should be excluded from compensation committee membership. In order for the compensation-setting process to be more arm’s-length, it would be preferable not to have a CEO from another company on the committee thinking, “What would I want to be paid if this were my company’s compensation committee?”
• Term limits on independent directors. If a director knows that he or she will roll off the board after, say, six years, this knowledge will reduce the incentive that the director might otherwise have to curry favor with senior management in order to ensure continued board membership with all the accompanying compensation, perks, and status. Admittedly, if the limits imposed are for too short a period of time, this could backfire and actually further entrench management and/or weaken independent board members by making them, in effect, lame ducks. Also, it could be difficult to square this solution with better alignment of the interests of management, directors, and shareholders. Still, the idea is worthy of serious consideration. If requiring lead audit partners rotate off audit engagements after five years, as required under Sarbanes-Oxley, helps enhance auditor independence and improve audit quality, term limits could also work with directors.

Providing independent directors with more independence from management should reduce the likelihood that independent board members will be predisposed to do management’s bidding on executive compensation and other matters and will empower boards to ask the “tough questions” about new business strategies, risk management, and other matters that, in many cases during the current financial services crisis, appear never to have been asked.

Greater Shareholder Involvement

Perhaps the best litmus test as to whether an executive’s pay is excessive is the collective opinion of the company’s owners, its shareholders. At least in theory, they are the ones who should best know whether or not senior management and the board have done a good job in enhancing shareholder value. All they have to do is to look at their brokerage account and 401k statements and check stock prices online to see how their companies are performing over the long run.

Besides, what harm is there in having more feedback from shareholders on how they think their companies are being run, in addition to having the opportunity to vote on director elections, unless directors and senior management really do not value their opinions? Limiting shareholder participation in corporate governance to voting on directors and significant corporate transactions and having the now largely theoretical right to bring derivative actions against boards does not go far enough. What else should be done?

• Give shareholders a say on executive pay. Letting shareholders vote up or down on what a company’s top five executives are paid, over time, will serve to rein in executive compensation and severance packages that, in recent years, have spiraled out of control. The knowledge that shareholders will have the opportunity to vote will be in the back of directors’ minds and will help them remember that they are working for the company’s owners and not executive management when negotiating compensation arrangements. Also, a positive vote by shareholders will better insulate boards and executives who receive large pay packages from shareholder derivative actions as well as criticisms leveled by Congress and various activist groups. Conversely, a negative vote will serve as a much-needed reality check for the parties concerned. Just because executives are contractually entitled to what they receive and the payments made are “legal” does not mean they are fair or appropriate. Too often, boards and their compensation committees get lost amongst the myriad of executive benefit plan trees. Say on pay will provide them with a perspective that will better enable them to see the entire forest.
• Appoint or elect a shareholder Ombudsperson. While measures such as separating the positions of Chairman of the Board and CEO and appointing lead directors have had a beneficial impact in terms of reducing the incidence of imperial CEOs, they still have not gone far enough in giving company owners a voice at the table. Perhaps what is called for is an independent shareholder Ombudsperson whose sole responsibility is to look out for the best interests of large and small shareholders alike. The Ombudsperson could serve as the main communications channel between shareholders and the board between annual meetings. Shareholders could voice their company performance and corporate governance concerns to the Ombudsperson. Also, the Ombudsperson could take the lead role in negotiating compensation arrangements on behalf of companies.
• Give shareholders better access to the proxy statement. The current state of director election affairs is somewhat akin to holding a political election where only one party is permitted to run advertisements. Shareholders should more easily be able to nominate and vote for opposing slates of director candidates through increased proxy access, especially in situations where their companies have not performed well since the prior annual meeting. A number of complex issues remain to be resolved (e.g., whether only large shareholders can propose directors), but the playing field needs to be more level when it comes to election and re-election of directors proposed by board nominating committees.

Increased Transparency and Disclosure

As anyone who has looked at a monthly credit card statement lately knows, more disclosure does not necessarily mean better disclosure. If shareholders are to be enfranchised and given a meaningful say on pay, they need to have better information regarding the compensation their companies are paying senior management.

• Simplify Proxy Statement Disclosure of Executive Compensation. The SEC’s Regulation S-K executive compensation disclosures have become so complicated in recent years as to make it very difficult, if not impossible, for shareholders to answer the basic question: How much did senior management make last year in base salary, cash bonuses, vested restricted stock, exercised stock options, and perks? All the additional charts and detailed information on executive compensation are fine for those who have time to connect the dots, but there also needs to be an executive summary section that is uniform for purposes of comparisons so that shareholders wanting a simple answer to the question of “how much did they make last year” do not get buried in an avalanche of information.
• Provide More Information on Compensation Consultant Recommendations. Shareholders need to know what advice compensation consultants are giving their board of directors, and what the rationale is for that advice. If the consultants are making recommendations based on what other companies are paying their executives, what companies are those and why are those comparisons appropriate? More disclosures as to how consultants arrive at their compensation recommendations and compensation committees arrive at their compensation decisions will inject much-needed transparency into the process, will rein in boards’ tendencies to set executive compensation at excessive levels, and will give shareholders a better basis on which to evaluate board compensation decisions for themselves.

Better Alignment of Executive, Director and Shareholder Interests

Too often recently, senior management compensation has been based largely on a company’s annual earnings. As a result, executives are motivated to take excessive risks in order to increase short-term profits at the expense of the long-term health of their companies and to the detriment of their shareholders. When their companies do ultimately blow up, executives are frequently rewarded with extremely generous severance packages. It is “heads I win; tails shareholders lose but I still do OK”, plain and simple. Several basic executive compensation reforms are needed to address the underlying moral hazards involved.

• Pay Executives and Directors Mostly in Stock. As FDIC Chairman Sheila Bair and others have advocated, to better align management and shareholder interests, senior executives as well as directors should receive the bulk of their compensation in the form of long-term restricted stock and stock options. If the company does well under their stewardship, they will reap the appropriate rewards; if not, they will receive much less. Poor subsequent performance should also trigger compensation clawbacks, and no re-pricing of previous stock option grants should be permitted.
• Base Executive Pay on a Company’s Risk-Adjusted Returns on Equity. Executives should not be judged and compensated based just on earnings in the abstract, but rather on how much their companies earned relative to the risks – investment, operational and other – that were taken to produce the earnings. If a company earns oversized profits in a particular period but does so by taking excessive risks, management compensation should be adjusted downwards accordingly. Similarly, if a company is profitable but underperforms its peer group, that factor should be taken into account as well.
• Executives Should Not Receive Severance Payments in Bad Times. Under the Federal Deposit Insurance Act’s golden parachute provisions, banks and bank holding companies that are in a troubled condition or are expected to become troubled are prohibited from making any severance payments to senior management. The logic behind the law is unassailable: departing executives should not be rewarded for failure. Going forward, companies would be well-advised to include similar golden parachute language in their severance agreements prohibiting senior managers who leave (either voluntarily or involuntarily) when their companies are experiencing financial difficulties from receiving any severance payments unless and until their companies return to financial health.

Excessive executive compensation is an issue that is going to be with us for some time. Boards and their compensation committees are now beginning to get the message that it is no longer business as usual when it comes to paying their top officers. Some companies, too, are starting to adopt compensation reforms, although perhaps not quite as sweeping as those recommended above. However, too many other companies, boards, and executives still fail to grasp the significance of this issue to the public at large and to the Congress.

Companies’ failure to improve corporate governance and change common executive compensation practices could end up being costly, not only to shareholders but also to senior management itself. If reforms in this area are not instituted voluntarily, Congress could attempt to “solve” the problem itself. Given how the new executive compensation restrictions imposed by Congress have significantly dampened industry enthusiasm for participating in Treasury’s TARP program, this would almost certainly be the worst outcome for everyone.

Author Bio

John Buchman is General Counsel and Corporate Secretary of E*TRADE Bank, a $46 billion asset bank subsidiary of E*TRADE Financial Corporation located in Arlington, VA, and is a member of the adjunct faculty at The George Washington University Law School. Prior to joining the Bank in November 2000, John worked as a banking attorney in Washington both in private practice and with the government.