March 16, 2011

New Bank Regulations on Compensation – Well, At Least It’s a Start

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

On March 2nd, the SEC moved forward to adopt a proposal requiring at least 50 percent of annual incentive compensation for executive officers of large financial firms to be deferred for no less than three years.  Stripped to its essence, this proposal is attempting to fix “short-termism” and address the widely popular view that actions motivated by short-term self-interest on the part of those in the financial services industry brought about the near-collapse of our financial system in 2008 and 2009.  In other words, the ones in the financial world who benefitted, despite our deep financial woes, were the ones who also reaped the handsomest rewards.  They did this by taking undue risks in the years leading up to the collapse, and then let the rest of us take the losses and clean up the mess.  It is a modern day “take the money and run” scenario.

While I don’t subscribe to the idea that executive compensation was at the root of the problem, I do believe it played a role.  In an extensive study commissioned by the Council of Institutional Investors, entitled “Wall Street Pay – Size, Structure, and Significance for Shareowners, the authors found that while Wall Street pay was seemingly aligned with shareholder interests through the heavy use of equity-based compensation and long deferral periods, the sheer magnitude of the pay, coupled with excessive focus on short-term growth, was an even more powerful force that divorced the interests between executives and their shareowners.

In attempting to realign bankers’ bonuses with long-term performance, the FDIC became the first agency to implement the Dodd-Frank requirement prohibiting financial institutions from offering any compensation arrangements that could lead to material financial losses for the company.  Under the FDIC proposal, now supported by the SEC, the deferred portion of annual incentive compensation can be paid no faster than on a pro-rata basis (e.g., one-third per year for three years), and the remaining deferred compensation is subject to recoupment if actual losses or other negative performance happens during the deferral period.  Although this proposal must be adopted by all seven of the federal regulatory agencies with authority to implement the rules of the Dodd-Frank Act, this new rule could become effective this year.

So, will the new holdback requirement solve the problem?  Given all that we have learned, the new rule is a start, but doesn’t go far enough in addressing the core issues. It’s a start because the incentive payouts now remain tied to company financial success during the minimum three-year deferral period.  However, they don’t go far enough because the earn-out of these awards in the first place is still tied to short-term performance and the amount earned can still be excessive.

A more holistic solution would be for companies to implement the required holdbacks, but also to:

  • Ensure that a significant portion of compensation (i.e., over half) is earned over multi-year periods (vs. a year at a time)
  • Apply holdbacks to all awards, not just annual awards
  • Ensure that awards paid for any given performance, and in any given performance period, meet industry standards of reasonableness

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As far as reasonableness is concerned, using the Farient Alignment ReportTM may be one place to start.  The Alignment Report is a visual tool that shows whether a company’s CEO Performance-Adjusted CompensationTM is both reasonable and appropriately sensitive to performance given the size, industry, and performance of the organization.  The reason that using a tool like this is advisable is that it relies on 15 years of inflation-adjusted data, reflecting market norms established over long periods of time.  If you think this long-term data base produces a piker’s wage, think again.  For example, we ran our Alignment Report for Goldman Sachs, and it shows that Lloyd Blankfein’s compensation (and that of his predecessor) was reasonable for the company’s size, industry, and performance delivered for all but the 2005 to 2007 time period.  The Alignment Report allows for good compensation for good performance, but also nails any issues.

In general, I am not a fan of government intervention in our free markets.  However, a compensation arms race, like the one that has gone on in banking, serves no good purpose.  I’d like to think that smart companies will not stop with the requirements of the new legislation, but will go on to implement more far-reaching measures that solve the problem of short-termism, support long-term success, and deliver compensation that is truly reasonable.  And who knows . . . if enough companies act smartly, perhaps we can avoid an arms race, pay reasonably, pay only if performance is sustained, and stave off the need for yet another round of legislation.

Robin A. Ferracone is the Executive Chair of Farient Advisors LLC, an independent executive compensation and performance advisory firm that helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders.  Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com.

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