The End of Comp as We Know It?

The
government stops short of saying it wants to cap executive pay, but
signals an ongoing effort to influence broad change across all public
companies.

David McCann
- CFO.com | US

June 12, 2009

The Obama Administration's principles for executive compensation
reform, announced on Wednesday by Treasury Secretary Timothy Geithner,
may lack the teeth of pay limits imposed earlier on companies receiving
federal bailout money. But several aspects of the government's stated
intentions suggest significant changes ahead in executive compensation.

Perhaps most notably, the administration apparently plans to apply
reforms to all public companies, not just those in the financial sector
or those receiving assistance in the form of federal funds.

Geithner did emphasize that the government's goal of better aligning
compensation practices with sound risk management and long-term value
creation was "particularly [important] in the financial sector." But he
noted that he is working on the matter with Mary Schapiro, chairman of
the Securities and Exchange Commission chairman, whose oversight
encompasses all public companies.

Plus, in announcing plans to make a pair of compensation-related
legislative proposals, the government made no suggestion that the laws,
if they are passed, would not apply across the board.

One of those proposals — a requirement that compensation committees
be as independent from company management as audit committees currently
are required to be under the Sarbanes-Oxley Act — by itself could cure
most of the problems created by executive pay programs, according to
John Martini, head of the executive compensation practice at the law
firm Reed Smith.

Most large public companies, though fewer small ones, already
require that compensation committees be composed entirely of outside
directors. But what's important about the proposed law is that the SEC
would have to establish standards for ensuring that any compensation
consultants or outside counsel that comp committees use are independent
from company management. Companies would have to make sufficient funds
available to the board to pay for the services.

In theory, that could eliminate widely criticized conflicts of
interest whereby the same outside experts who help executives draft
policies governing their own pay also consult with compensation
committees on making final decisions on executive compensation.

"It's a phenomenal idea, and probably the most important concept to
come out of this [government involvement in compensation]," said
Martini. "It will largely fix the compensation problems we have seen.
It is difficult [right now for an advisor to management] to say that
the CEO is making too much money. Compensation committees will be much
more comfortable and get much more candid advice if they have
completely independent consultants and counsel."

Another attorney, Ken Raskin, head of the executive compensation,
benefits, and employment practice at White & Case, said he's the
first one to suggest that an agreement he's drafted with an executive
be sent to the compensation committee for vetting before it's brought
to a vote. But he agreed that the proposed legislation is on the mark.

Of course, attorneys and consultants are far from bias-free on this
issue. If management and the compensation committee have separate
advisors, that means more work for the advisors. "Well, that's true,"
said Raskin. "Obviously that would be an effect of this.
Notwithstanding that, it is simply a best practice for the compensation
committee to divorce itself from the company in making these decisions."

The other legislative proposal would require companies to give
shareholders an advisory vote on executive compensation packages.
That's something President Obama promoted during his campaign, and it
is currently required of recipients of federal bailout funds.

The two attorneys took separate sides on the matter. "Shareholders
are not properly equipped to evaluate pay practices," said Martini,
"nor is it likely that they will ever become so in the future."

Raskin, though, argued that institutional investors with a big stake
in a company are likely to delve into the details of compensation
proposals until they fully understand them. He noted that the law as
described by the government would not impose any requirements on
corporations other than to permit the non-binding vote — but a "no"
advisory vote may have the same effect as a binding disapproval. "The
administration is focusing more on public embarrassment than
restrictions," Raskin said.

The two proposed laws were mentioned in the fifth of five principles
that Geithner put forth, namely that there should be transparency and
accountability in the process of setting compensation.

The first principle, that  compensation plans should properly
measure and reward performance, could cause broad change in the way
executive pay packages are structured, should the government opt to
move beyond the principle to regulation or legislation. Geithner said
that performance-based pay "should be conditioned on a wide range of
internal and external metrics, not just stock price." Martini called
that statement "not completely unexpected, but radical nonetheless."

There has been some pull-back recently in the prevalence of stock
options within the total executive compensation mix, but it remains
common for bonus packages to be mostly equity-based. That is unlikely
to change, absent new rules.

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