Obama Administration Plan Would Reform Executive Compensation as Part of Vast Overhaul of US Financial Regulatory System
The Obama Administration has proposed to Congress the most sweeping and fundamental regulatory reform of the US financial and securities markets since President Franklin D. Roosevelt’s New Deal. As part of the overhaul of the US financial system, the Administration proposes vast corporate governance reform to regulate systemic risk, enhance transparency and disclosure, and delink executive compensation from excessive risk. A centerpiece of the Administration’s plan, which is in line with the G-20 principles, is to reform compensation schemes to eliminate short-term thinking and excessive risk taking.
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Acting on a broad and growing consensus, the Administration wants legislation and regulation to align executive compensation incentives, particularly variable compensation such as bonuses, with shareholder interests and long-term, firm-wide profitability. Moreover, compensation schemes must become fully transparent. Also, the assessment of bonuses should be set in a multi-year framework in order to spread out the actual payment of the bonus pool through the cycle. Further, bonuses should reflect actual performance and, therefore, should not be guaranteed in advance.
Specifically, boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk; and the timing and composition of payments must be sensitive to the time horizon of risks.
More concretely, the Administration asked Congress to pass legislation mandating a non-binding shareholder advisory vote on executive compensation. The Administration also seeks legislation ensuring the independence of board of directors compensation committees similar to the manner in which the Sarbanes-Oxley Act provided for independent audit committees.
The G-20 principles, to which the US is a signatory, demand that payments not be finalized over short periods where risks are realized over long periods. Also, firms must disclose comprehensive and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies in order to exercise effective monitoring. The inclusion of stakeholders portends a role for shareholder advisory votes on executive compensation, what is popularly known as say-on-pay.
For their part, regulators should assess firms’ compensation policies as part of their overall assessment of their soundness. When necessary, regulators should intervene with responses that can include increased capital requirements. The G-20 also wants the Basle Committee to integrate these principles into its risk management guidance.
Congressional oversight chairs quickly expressed support for the Administration’s legislative proposal. Senate Banking Committee Chair Christopher Dodd said that he strongly supports say-on-pay legislation. More broadly, the senator said that executive compensation has gone completely out of control by rewarding short-term gain and encouraging excessive risk-taking. House Financial Services Committee Chair Barney Frank also supports say-on-pay legislation, but does not think simply mandating independent compensation committees goes far enough. He believes that the legislation should also direct the SEC to set principles preventing companies from providing compensation systems that lead to excessive risk taking.