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February 5, 2009

A Shot Across the Bow: Obama’s Executive Compensation Changes

Yesterday, on our “Advisors’ Blog” on CompensationStandards.com, I blogged a story about a conversation with a cabdriver about the Wall Street bonuses and how the environment has been altered so much that boards absolutely must change their thinking about executive compensation practices or else face potential societal implications (see this NY Times article).

Recognizing the need for this change, President Obama yesterday announced a new set of Treasury guidelines for those companies seeking government funds. The fact that the President made the announcement and held a press conference on the topic highlights the importance of this matter. Rather than repeat these new restrictions, read the bullets in this press release.

To explain these new restrictions – and how they impact both companies seeking government funds and all companies generally – we are holding a webcast – “TARP II: The Executive Compensation Restrictions” – next Thursday on CompensationStandards.com. Tune in to learn these new developments!

I just posted “Course Materials” from Broadridge for today’s webcast: “How to Implement E-Proxy in Year Two.” Please print them out.

How to Fix the Latest Treasury Guidance

Jesse Brill lays out below how the latest Treasury guidance still needs to be tweaked to accomplish its goals of reining in excessive executive compensation:

The biggest change under the new Treasury guidelines is a $500,000 salary cap. One key aspect of the new $500,000 cap that has not gotten sufficient attention is the unlimited amount of restricted stock and stock options that still can be granted under the latest “restrictions.” Equity compensation is the pay component that has gotten most out-of-line over the past 20 years. It (as well as severance/retirement/ golden parachutes) has caused the greatest disparity between CEO compensation and that of the next tier of executives (and employees generally).

The new $500,000 cap provision does prevent executives from realizing the gains in their equity compensation until after the government is paid back. But there are two major problems with how this applies:

1. It does not apply to past equity compensation. Warren Buffet imposed a similar cap on Goldman Sachs’ executives, but his restriction applies to all the equity held by the top executives. It is not limited just to future grants, as is the case with the new government restriction. So Buffett’s provision wisely requires that the key decision-makers keep all their “skin in the game” until he gets paid off.

2. Although it may help protect the government’s investment, it is short-sighted and fails to protect the shareholders’ best long term interests. The holding period should be the longer of age 65 or two years following retirement. That will ensure that the key executives make decisions that truly are in the long-term best interests of the company (as opposed to decisions aimed at a shorter period – after which an executive could depart, taking all his marbles with him).Note that holding-through-retirement also addresses the major concern about top executives’ unnecessary risk taking.

Holding equity compensation through retirement is perhaps the single most important—and fundamental – fix to getting executive compensation back on track because it also addresses all the past outstanding excessive option and restricted stock grants. And, by requiring CEOs to keep their skin in the game for the long term, it will go a long way to restoring public trust in our companies and our market, which is so important to restoring stability to the markets.

Needless to say, the fundamental hold-through-retirement fix should apply to all companies – not just TARP financial institutions—and can be adopted at the same time that Congress adopts say-on-pay legislation (if such legislation is adopted). (It will have much greater impact and do more good than say-on-pay.) Learn how to implement hold-through-retirement in our “Hold-Through-Retirement” Practice Area on CompensationStandards.com.

Here are three additional points about the $500,000 cap:

1. Just as the $1 million cap was a major cause for the runaway increase in equity compensation over the past decade, the new unlimited opening for restricted stock will further exacerbate the problem. As an example, the typical time vested restricted stock grant does not qualify for the $1 million cap “performance-based” compensation exemption, thus more companies and shareholders will suffer the cost of the lost tax deductions as these very large amounts vest. (So, once again the top executives will benefit at the expense of shareholders.)

2. One reasonable fix to the tax deductibility problem would be to require real performance conditions (in addition to time vesting) upon the vesting of the equity.

3. To address the “unlimited “ new grants problem, do not permit additional grants in situations where the CEO’s total accumulated equity grants exceed the company’s own historic internal pay equity ratios compared to the next tiers of executives within the company.

SEC Chair Schapiro Lays Out Big Changes

As noted in this Washington Post article from Wednesday, new SEC Chair Schapiro intends to make big changes to the Enforcement Division – and quickly. Among other changes, the article notes:

– Rollback of highly-criticized requirement that the Enforcement Staff receive Commission approval before negotiating to impose penalties. This created a huge bottleneck and fines levied have dropped 85% since it was instituted three years ago.

– Beefing up the number of Enforcement Staffers. The number of Staffers has steadily decreased in recent years.

– Reforming an office to focus on identifying and preventing risk in the market. Earlier this decade, then-Chair Donaldson formed such a group – but it was scarcely staffed (umm, with one person) and shut down not too long after it was created.

Good Grief: Here Come the Crazy Ideas

It’s a good thing that Chair Schapiro is acting fast. Congress is out for blood, as became quite clear during yesterday’s House Financial Services Committee hearing on the Madoff scandal. Harry Markopolos is a bit too much for me (here is his written testimony, his oral testimony was beyond self-serving – and here is the SEC Staff’s testimony). With his announcement that he’s about to hand off his investigation of a new mini-Madoff fraud to the SEC’s inspector general, I’ve decided to call him the new “Joe McCarthy.” My favorite quote from him: “3,498 people at the SEC were against me.” Paranoid.

More bothersome than Markopolos was the tone and suggestions of some members in Congress about how to fix the SEC. It looks like plenty of bad ideas might get some traction. For example, the suggestions expressed in this NY Times column entitled “What if Watchdogs Got Bonuses?” from Andrew Ross Sorkin were raised. In the column, Sorkin reports from Davos about a recommendation that regulators get paid bonuses so that they are paid more like their private industry counterparts. Here are few reasons why this is not a good idea:

1. The column posits that paying more will attract smarter people to the government. Although I’m sure existing government staffers would like to get paid more, I can assure you that there are many right now in the government that are plenty smart.

In fact, just as smart as the folks in the private sector – why do you think so many securities lawyers start their career at the SEC? To get trained by the best and brightest. But even in the past five years, Corp Fin has essentially stopped hiring folks right out of law school because so many experienced practitioners were willing to take a pay cut and exit out of the madness that is the law firm lifestyle.

2. The government is not having problems finding qualified people. Right now, a record number of resumes are sitting down at the SEC. The level of unemployed professionals is very high and government service appeals to many who feel that their career has been lacking purpose.

3. The bonus recommendation ignores how most criminals are caught. Referrals lead to the bulk of the SEC’s investigations. This is not unusual in the law enforcement area. Cops don’t show up until they are called (unless they accidentally witness a crime). That’s just the way of the world (unless we develop “pre-cogs” ala “Minority Report“).

How would a bonus program be adminstrated when federal agencies would be working mainly from outside referrals? The payment of bonuses may well disturb the comradery and cooperation that is required between SEC Divisions – and among Staffers within a Division – to make the often years-long effort to bring a solid case. If you’ve ever worked on uncovering a financial fraud, you know how complex and difficult it is to tie the ends, etc. Needle in a haystack stuff.

4. Replicating the poor compensation practices of Wall Street in the public sector doesn’t fix the problem. It’s simply incredible that at the same time policymakers and pundits are decrying bonuses as having motivated executives to engage in improper management practices, they are suggesting that the same apply to the government. How is that supposed to promote objectivity in decision-making? What would you do if you were faced with: “I get a bonus if I bring this enforcement action regardless of how ill-founded it is – and don’t get a bonus if I don’t.”

Most people in government service are not there for the money – so paying them more will not necessarily generate better performance. To the extent those in enforcement are after money, it comes from them earning a reputation as a tough cop who brings good cases and then going into private practice.

The reform focus should be on Wall Street and its ethics. Sure, the government staff could stand to earn some more in base salary so there wouldn’t be pressure to leave when the kids hit school age – but paying the Staff a bonus won’t turn on some magical spigot that will enable the SEC to catch the many criminals out there.

And it certainly won’t stop Wall Street from engaging in practices of the sort that led to the current meltdown. We can’t rely on the government to ensure that people act responsibly and ethically. They can help point us in the right direction and remove outliers from the playing field – but if nearly all the players decide to continue to push the grey areas and not think of the bigger picture, chaos results and even cops can’t help us…

Your Ten Cents: The SEC’s Future

Here is a quick poll to anonymously get your views. You’re allowed to select more than one answer if you wish:

Online Surveys & Market Research

– Broc Romanek