Executive Compensation Reform Legislation Should Be Guided by Financial Stability Board Principles

Based on the final communiqué of the G-20 leaders and their pledge to pass legislation reforming compensation regimes as part of financial regulatory reform, it is very probable that US legislation reforming executive compensation will be based on principles concomitantly set forth by the Financial Stability Board. That is because the G-20 endorsed the compensation principles of the new Financial Stability Board, formerly the Financial Stability Forum. The Board, with a strengthened mandate, now includes all G-20 countries, and the European Commission.

It is almost certain that the legislative overhaul of US financial regulation will include significant reform of executive compensation. In a letter to President Obama, Senator Christopher Dodd and Rep. Barney Frank pledged to work together in a bicameral and bipartisan effort to pass legislation reforming the regulation of the nation’s financial markets by the end of the year. Senator Dodd is Chair of the Banking Committee, and Rep. Frank is Chair of the Financial Services Committee. The oversight Chairs said that as part of financial reform they will draft legislation comprehensively reforming corporate governance and executive compensation. They promised to work with the Administration to ensure a new corporate governance framework focused on strict accountability and the promotion of long-term value. One of the most consistent criticisms of current executive compensation is that it favors short-term performance and contributes to excessive risk taking.

According to the G-20, the legislation must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, firms' 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.

Payments should not be finalized over short periods where risks are realized over long periods, said the communiqué, and 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 in the communiqué portends a role for shareholder advisory votes on executive compensation.

For their part, regulators will 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.

Compensation regimes must be viewed in the broader context of sound corporate governance and effective risk management. Governance is more likely to be effective if the firm’s stakeholders, particularly shareholders, are engaged with compensation. In order for them to be engaged, they must be informed. Disclosure must go well beyond the compensation details of a few senior officers.

The Financial Stability Board said that relevant disclosure should include the general design philosophy of the compensation system and the manner of its implementation, as well as a sufficiently detailed description of the manner of risk adjustment and of how compensation is related to actual performance over time. There should also be disclosure of compensation outcomes for employees at different levels or in different units sufficient to allow stakeholders to evaluate whether the system operates as designed, and summaries of results of internal and external audits.

In addition, the Board recommends an annual non-binding shareholder advisory vote on executive compensation. In cases where the shareholders do not approve the compensation, the firm would be expected to consult, make material changes, and provide explanations why proposed compensation is aligned with shareholders’ interests.

The Board views golden parachute arrangements that generate large payouts to terminated staff and that are not sensitive to performance or risk as prudentially unsound. Such arrangements create a “heads I win, tails I still win” approach to risk, said the Board, which encourages more risk taking than would likely be preferred by the firm’s shareholders or creditors. Similarly, golden handshakes that reimburse unvested compensation foregone at the employee’s former firm are a difficult problem. If employees are routinely compensated by a new employer for accumulated unvested bonuses, or for vested bonuses still subject to clawback, in a manner that removes the employee’s exposure to risks imposed on the old employer, the incentive effects of the principles will be reduced. Also, multi-year guaranteed bonuses are not in line with the principles.

With regard to risk management, three principles focus on making compensation sensitive to risk outcomes: First, compensation must be symmetric with risk. This means that compensation systems should link the size of the bonus pool to the overall performance of the firm. Employees’ incentive payments should be linked to the contribution of the individual and business to such performance. Bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.

Second, compensation payout schedules must be sensitive to the time horizon of risks. Payments should not be finalized over short periods where risks are realized over long periods.

Third, the mix of cash, equity and other forms of compensation should be consistent with risk alignment. It is not obvious that more equity and less cash always increases the employee’s incentive to align risk with the firm’s appetite. The mix is likely to differ across employees and to involve a smaller cash component the more senior the employee.