On October 22, 2009, the US Department of Treasury’s Office of Special Master for executive compensation of companies receiving TARP funds made public letters issued to seven companies (AIG, Citigroup, Bank of America, Chrysler, General Motors, GMAC, and Chrysler Financial), and the Board of Governance of the Federal Reserve issued proposed guidance on incentive compensation policies. The Special Master’s focus is to determine executive compensation by formulaic rule while the Federal Reserve’s focus is that incentive compensation should be determined by director oversight guided by the three principles.

For example, the Special Master’s letter to AIG states that “2009 compensation for AIG’s senior executive officers and most highly compensated employees generally must comport with the following important standards:

• Base salary paid in cash should not exceed $500,000 per year, except in appropriate cases for good cause show . . .
   
• Rather than cash, the majority of each individual’s based salary will be paid in the form of stock units reflecting the value of a “basket” of four AIG insurance subsidiaries . . .
   
• Total compensation for each individual must be appropriate when compared with total compensation provided to persons in similar positions or roles at similar entities. Overall, total compensation must be significantly reduced from the amounts paid in 2008. In AIG’s case, total compensation for these employees will decrease 58% from 2008 levels.
   
• If – and only if – the employee achieves objective performance metrics developed and reviewed in consultation with the Office of the Special Master, the employee may be eligible for long-term incentive awards. These awards, however, must be payable in the form of restricted stock that will be forfeited unless the employee stays with AIG for at least three years following grant, and may only be redeemed in 25% installments for each 25% of AIG’s TARP obligations that are repaid. . . 
   
• Any and all incentive compensation will be subject to recovery or clawback if the payments are based on materially inaccurate financial statements, any other materially inaccurate performance metrics, or if the employee is terminated due to misconduct that occurred during the period in which the incentive was earned.
    
• Any and all ‘other’ compensation and perquisites will not exceed $25,000 for each employee . . .
    
• No severance benefit to which an employee becomes entitled in the future may take into account a cash salary increase, or any payment of stock salary, that the Special Master has approved for 2009.  
    
• No additional amounts in 2009 may be accrued under supplemental executive retirement plans or credited by the company to other ‘non-qualified deferred compensation’ plans…”

The Federal Reserve’s guidance reflects none of these formulaic rules. Instead, states that “arrangement at one firm may not be suitable for use at another firm because of differences in the risks, controls, structure, and management among firms,” and provides as guidance three key principles:

1. Provide employees incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk;
2. Be compatible with effective controls and risk management; and 
3. Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

Even though a majority of the directors of AIG’s board were appointed at the direction of the Treasury, the Special Master’s letter dictates to AIG’s board that it “must take certain additional corporate governance steps,” including granting long-term incentive awards only “as measured against objective performance criteria that the [Board’s Compensation] Committee has developed and reviewed in consultation with the Office of the Special Master.” On the other hand, the Federal Reserve’s guidance recognizes that governing boards are the highest authority in American corporate governance by stating that “the board retains responsibility for ensuring that the organization’s incentive compensation arrangements are consistent with safety and soundness.”

Nevertheless, there are similarities between the Special Master’s letter and the Federal Reserve’s guidance that boards of any organization and their compensation committees should be aware:

• Avoidance of excessive risks. Boards should delegate to a senior officer or group evaluating and managing risks to the enterprise, and these risk-management personnel should have input into the organization’s processes for designing incentive compensation and assessing their effectiveness in restraining excessive risk taking. The board and its compensation committee should receive on an annual or more frequent basis an assessment by management with appropriate input from risk-management personnel of the effectiveness of the design and operation of the organization’s incentive compensation system in providing risk-taking incentives that are consistent with the organization’s safety and soundness. In addition, at least the compensation committee should work closely with any board-level risk and audit committees.
    
• Use of enterprise-wide measures. Both the Special Master’s letters and the Federal Reserve’s guidance favor enterprise-wide measures “that are only distantly linked to the employee’s activities” for avoiding excessive risk taking. The Special Master’s letter to AIG focuses on increases in enterprise net work, capital or surplus through “stock units” or appreciation rights reflecting the adjusted book value of a “basket” of four AIG insurance subsidiary, excluding extraordinary events. The Federal Reserve guidance gives “firm-wide profit” as an example of a measure.
    
• Longer term performance periods. Both the Special Master’s letters and the Federal Reserve guidance focus on longer-term plans than annual bonus plans. The Special Master’s letters states that the period should be three years with cliff vesting unless the employee remains employed until the third anniversary of the date granted.
    
• Deferred payouts. Both the Special Master’s letters and the Federal Reserve guidance focus on deferred payouts. The Special Master’s letters state the payouts should be in 25% installments for each 25% of TARP obligations that are repaid. The Federal Reserve guidance states that the payout should be delayed significantly beyond the end of the performance period to allow for adjustment based upon actual losses or liabilities that are realized after the period.
    
• Not granting exponentially increasing awards. The Federal Reserve Guidance discourages awards having exponentially increasing increments for performance about target because this may motivate employees to take excessive risk in order to reach those targets. The Special Master’s letters approaches this more formulaically by correlating the amount of the award with specified, objective performance criteria that do not diminish long-term value creation.
    
• Forward-looking and backward looking clawbacks. Both the Special Master’s letters and the Federal Reserve guidance include clawbacks, or recovery by the organization of compensation, for risks recognized currently as possibly resulting in future losses or liabilities as well as for currently recognized losses or liabilities that result from risks incurred during past performance periods. The Special Master’s letters require clawback for any award based upon materially inaccurate financial statements or other materially inaccurate performance metric criteria as well as to reduce the amount of any incentive award on the basis of the overall evaluation of the employee’s or the organization’s performance (notwithstanding full or partial satisfaction of the performance criteria).
    
• Disfavor of entitlements. The Special Master’s letters prohibit paying for executives’ personal expenses in excess of an aggregate of $25,000 annually; employer-funded supplemental executive retirement plans and non-qualified deferred compensation unless based upon the executive’s or the organization’s (or a business unit’s) performance; and additional accruals to severance plans after 2009. The Federal Reserve’s guidelines discourage “golden parachutes” or arrangements awarding an employee for departing, or upon a change control of, the organization.

Despite these similarities, a striking difference exists between the Special Master’s approach of formulaic rule and the Federal Reserve’s approach of director oversight guides by some key principles.

Executive compensation is discussed throughout President Obama’s Financial Regulatory Reform issued by the Department of Treasury on June 17, 2009 (the “Regulatory Reform Proposal” or the “Proposal”). The theme throughout is that executive compensation must refocus on the correct fundamentals: Long-term value rather than short-term profits; financial stability, and management of risks.

The theme begins on the first page of the Regulatory Reform Proposal with a finding that that “Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value.” The theme is then developed further by proposing that federal regulators of financial institutions should issue standards and guidelines to better align compensation practices with the correct fundamentals through “five principles”:

1. Compensation plans should properly measure and reward performance;
2. Compensation should be structured to account for the time horizon of risks;
3. Compensation practices should be aligned with sound risk management;
4. Golden parachutes and supplemental retirement packages should be reexamined to determine whether they align the interests of executives and shareholders; and
5. Transparency and accountability should be promoted in the process of setting compensation.

These principles are then expanded to include more than U.S. financial firms: Loan brokers and lenders; investment banking firms securitizing investments; publicly-held companies; and international companies subject to governance by G-20 countries

The regulation of executive compensation included in the June 2009 Regulatory Reform Proposal is more tempered than the regulation imposed in February, 2009 on companies receiving TARP funds (see Corporate Governance Blog posted February 4, 2009 on “U.S. Department of Treasury Guidelines for President Obama’s Executive Pay Limits”). For example, the TARP limitations on the dollar amount of total annual compensation other than restricted stock are not included.

Instead, the Regulatory Reform Proposal includes the more traditional “say-on-pay” empowerment of shareholders. The Proposal says the Obama Administration will work with Congress to pass legislation that will require all public companies to offer an annual non-binding vote on compensation packages for senior executive officers. The Proposal states that such votes “provide a strong message to management and boards and serve to support a culture of performance, transparency, and accountability in executive compensation. Shareholders are often concerned about large corporate bonus plans in situations in which they, as the company's owners, have experienced losses. Currently, these decisions are often not directly reviewed by shareholders – leaving shareholders with limited rights to voice their concerns about compensation through an advisory vote.”

Additionally, the Proposal recognizes the underlying principle of Sarbanes-Oxley: That the first and best line of defense against mismanagement and fraud is oversight by independent directors with advice of independent advisors (see Corporate Governance Blog posted March 30, 2009 with commentary on “A wishful alternative to Geithner’s proposed regulation”). The Proposal would give the SEC the power to require that compensation committees are more independent; compensation committees would have the responsibility and the resources to hire their own independent compensation consultants and outside counsel; and the SEC will create standards for ensuring the independence of compensation consultants, providing shareholders with the confidence that the compensation committee is receiving objective, expert advice.

Although the Proposal does not expressly include the TARP clawback bonuses to executives engaging in deceptive practices, the Sarbanes-Oxley clawback applicable to bonuses of executives of publicly-held companies remains available.

Finally, the Proposal criticizes the commissioned-based compensation of security brokers, originators, sponsors, underwriters, and others being compensated by those subject to the regulatory reform being proposed. The Proposal call for changing such commission based compensation to provide appropriate incentives for participants to best serve the interests of their clients, the borrowers and investor, linked to the longer-term performance rather than only to the production, creation or inception of products.

See Corporate Governance Blog posted on February 26, 2009 on “Cure for the Meltdown Requires Changing Focus” for further information on principle-based compensation similar to that discussed by the Proposal.

The global meltdown in banking and investment banking is a failure to focus on the correct fundamentals.

Focus was on volume and not the quality of that volume. At the best, the focus was on the top line of the income statement and not the bottom-line profit or loss resulting from the volume.

Any focus on an operating statement is, by definition, short term (no more than 12 months). There was apparently no focus given to the liabilities that could, and did, over a longer term result from the lack of quality of the increased volume.

For example, banks focused on the volume of mortgages that they could generate assuming that any losses generated from a lack of quality would be offset by the investment returns on the dollars generated from that volume. When markets declined, investment returns declined. When residential values securing those mortgages declined, the value of those mortgages as an assets became less than their associated liabilities, resulting in a charge to net worth.

Invest banking and brokerage firms focused on fees generated from sale of securities, many of which were bundled mortgages. The brokers or agents selling these securities are compensated by the volume of the securities sold. No one asked, “What happened if the value of the credit securing these mortgages falls?” No one focused on the long term value of these securities. No one considered whether these securities were suitable to the persons to whom they were offered.

To change focus, the incentive and compensation systems must change. The performance standards for the incentive and compensation must include quality, not solely volume. The metrics should include the bottom line profit or loss over a period time, and not the immediate addition to the top line. And the factors considered must be expanded to include stewardship of the balance sheet, especially the longer term impact on ratio of assets to liabilities and the long term effect on net worth or surplus.

Only when we change the focus of the incentive and compensation systems can we refocus global business on the correct fundaments: The long term impact on net worth or surplus.

Compensation committees and executives should heed President Obama’s announced limitations on executive pay of financial institutions. Directors and officers of all organizations – taxable and tax-exempt, public and private – are governed by a duty of care based upon a community standard of what an ordinarily prudent person in a like position would use under similar circumstances. Just as the accounting and control provisions of Sarbanes-Oxley resulted in new standards for all organizations, President Obama’s limitations are likely to result in new standards limiting executive compensation of all organizations.

Heeding these limitations, compensation committees and executives should:

Define “how much is too much.” Obama’s limitations include a ceiling of $500,000 on compensation of executives of financial institutions receiving exceptional financial recovery assistance other than compensation in the form of restricted stock and long-term incentive arrangements. The ceiling is not simply a limit on the tax deductibility of the compensation, but a flat prohibition. Compensation committees and executives exercising due care should discuss “how much is too much” when annually reviewing executive compensation and at least agree to a ceiling.

Replace short-term bonuses with long-term incentive compensation. Obama’s compensation ceiling does not apply to long-term incentive arrangements. Obama’s guidelines state that “an emerging consensus that top executives should receive compensation that encourages more of a long-term perspective.” Compensation committees and executives exercising due care should replace short-term bonus programs with long-term incentive plans based upon performance of the executive and the entity over at least several years (two-to-five years) based upon measurable metrics.

Align Compensation with Sound Risk-Management. The Emergency Economic Stabilization Act and Obama’s limitations compensation arrangements are to be “consistent with promoting sound risk management.” Compensation committees and executives exercising due care should consider value-added compensation models and performance criteria that include balance-sheet items taking into account liabilities and their impact on the entity’s financial condition.

Require clawback provisions for bonuses and incentive compensation based upon manipulated data. Obama’s limitations require clawback of bonuses and incentive compensation if executives are found to have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay. Compensation committees and executives exercising due care should include clawback provisions in employment agreements or otherwise as a condition to payment of compensation. In addition, compensation committees should consider deferring payment for a period of time until the metrics can be assumed to be valid.

Reduce golden parachutes. Obama’s limitations include limiting golden parachute payments to not more than one year's compensation. Compensation committees and executives exercising due care should reduce gold parachutes to an amount that will not unduly encourage executives to impose a change in control except as authorized by shareholders or members.

Reduce promised severance payments. Obama’s limitations assume that boards should not permit any compensatory arrangement that could deter quickly discharging an executive for failure to perform or cause. Compensation committees and executives exercising due care should reduce promises of severance pay to an amount that will not unduly deter the board from discharging the executive for cause or failure to perform.

Adopt policies relating to approval of luxury expenditures. Obama’s limitations include a requirement for boards to adopt entity-wide policies on any expenditures related to aviation services, office and facility renovations, meals and entertainment, holiday parties, and conferences and events. Compensation committees and executives exercising due care should adopt such policies.

Directors and executives of all organizations have a duty to restore confidence in their organizations. They can begin to do so by heeding President Obama’s limitations and imposing similar limits to the compensation being paid by their organizations.

Today, the Treasury Department is issuing a new set of guidelines on executive pay for financial institutions that are receiving government assistance to address our current financial crisis. These measures are designed to ensure that public funds are directed only toward the public interest in strengthening our economy by stabilizing our financial system and not toward inappropriate private gain. The measures announced today are designed to ensure that the compensation of top executives in the financial community is closely aligned not only with the interests of shareholders and financial institutions, but with the taxpayers providing assistance to those companies.

The Treasury guidelines on executive pay seek to strike the correct balance between the need for strict monitoring and accountability on executive pay and the need for financial institutions to fully function and attract the talent pool that will maximize the chances of financial recovery and taxpayers being paid back on their investments. The proposals below, such as emphasizing restricted stock that vests as the government is repaid with interest, seek to strike exactly that balance.

The guidelines distinguish between banks participating in any new generally available capital access program and banks needing "exceptional assistance." Generally available programs have the same terms for all recipients, with limits on the amount each institution may receive and specified returns for taxpayers. The goal of these programs is to help ensure the financial system as a whole can provide the credit necessary for recovery, including providing capital to smaller community banks that play a critical role in lending to small businesses, families and others. The previously announced Capital Purchase Program is an example of a generally available capital access program.

If a firm needs more assistance than is allowed under a widely available standard program, then that is exceptional assistance. Banks falling under the "exceptional assistance" standard have bank-specific negotiated agreements with Treasury. Examples include AIG, and the Bank of America and Citi transactions under the Targeted Investment Program.

As part of President Obama's efforts to promote systemic regulatory reform, the standards today mark the beginning of a long-term effort to examine both the degree that executive compensation structures at financial institutions contributed to our current financial crisis and how corporate governance and compensation rules can be reformed to better promote long-term value and growth for shareholders, companies, workers and the economy at large and to prevent such financial crises from occurring again.

I. COMPLIANCE AND CERTIFICATION:

All Companies Receiving Government Assistance Must Ensure Compliance with Executive Compensation Provisions: The chief executive officers of all companies that have to this point received or do receive any form of government assistance must provide certification that the companies have strictly complied with statutory, Treasury, and contractual executive compensation restrictions. Chief executive officers must re-certify compliance with these restrictions on an annual basis. In addition, the compensation committees of all companies receiving government assistance must provide an explanation of how their senior executive compensation arrangements do not encourage excessive and unnecessary risk-taking.

II. ENHANCED CONDITIONS ON EXECUTIVE COMPENSATION GOING FORWARD:

A. Companies Receiving Exceptional Financial Recovery Assistance:

• Limit Senior Executives to $500,000 in Total Annual Compensation Other than Restricted Stock: Current programs providing exceptional assistance to financial institutions forbid recipients of government funds from taking a tax deduction for senior executive compensation above $500,000. Today's guidance takes this restriction further by limiting the total amount of compensation to no more than $500,000 for these senior executives except for restricted stock awards.
    
• Any Additional Pay for Senior Executives Must Be in Restricted Stock that Vests When the Government Has Been Repaid with Interest: Any pay to a senior executive of a company receiving exceptional assistance beyond $500,000 must be made in restricted stock or other similar long-term incentive arrangements. The senior executive receiving such restricted stock will only be able to cash in either after the government has been repaid – including the contractual dividend payments that ensure taxpayers are compensated for the time value of their money – or after a specified period according to conditions that consider among other factors the degree a company has satisfied repayment obligations, protected taxpayer interests or met lending and stability standards. Such a restricted stock strategy will help assure that senior executives of companies receiving exceptional assistance have incentives aligned with both the long-term interests of shareholders as well as minimizing the costs to taxpayers.
    
• Executive Compensation Structure and Strategy Must be Fully Disclosed and Subject to a "Say on Pay" Shareholder Resolution: The senior executive compensation structure and the rationale for how compensation is tied to sound risk management must be submitted to a non-binding shareholder resolution. There are no "Say on Pay" provisions in the existing programs.
    
• Require Provisions to Clawback Bonuses for Top Executives Engaging in Deceptive Practices: Under the existing programs providing exceptional assistance, only the top five senior executives were subject to a clawback provision. Going forward, a company receiving exceptional assistance must have in place provisions to claw back bonuses and incentive compensation from any of the next twenty senior executives if they are found to have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay.
    
• Increase Ban on Golden Parachutes for Senior Executives: The existing programs providing exceptional assistance to financial institutions prohibited the top five senior executives from receiving any golden parachute payment upon severance from employment, a ban that will be expanded to include the top ten senior executives. In addition, and at a minimum, the next twenty-five executives will be prohibited from receiving any golden parachute payment greater than one year's compensation upon severance from employment.
    
• Require Board of Directors' Adoption of Company Policy Relating to Approval of Luxury Expenditures: The boards of directors of companies receiving exceptional assistance from the government must adopt a company-wide policy on any expenditures related to aviation services, office and facility renovations, entertainment and holiday parties, and conferences and events. This policy is not intended to cover reasonable expenditures for sales conferences, staff development, reasonable performance incentives and other measures tied to a company's normal business operations. These new rules go beyond current guidelines, and would require certification by chief executive officers for expenditures that could be viewed as excessive or luxury items. Companies should also now post the text of the expenditures policy on their web sites.

B. Financial Institutions Participating in Generally Available Capital Access Programs:

The Treasury intends to issue proposed guidance subject to public comment on the following executive compensation requirements relating to future generally available capital access programs.

• Limit Senior Executives to $500,000 in Total Annual Compensation Plus Restricted Stock Unless Waived with Full Public Disclosure and Shareholder Vote: Companies that participate in generally available capital access programs may waive the $500,000 plus restricted stock rule only by disclosure of their compensation and, if requested, a non-binding "say on pay" shareholder resolution. All firms participating in a future capital access program must review and disclose the reasons that compensation arrangements of both the senior executives and other employees do not encourage excessive and unnecessary risk taking. Under the current Capital Purchase Program, the companies were only required to review and certify that the top five executives' compensation arrangements did not encourage excessive and unnecessary risk-taking.
    
• Require Provisions to Clawback Bonuses for Top Executives Engaging in Deceptive Practices: The same clawback provision that applies to companies receiving exceptional assistance will apply to those in generally available capital access programs. Thus, in addition to the clawback provision applicable to the top five executives as under the Capital Purchase Program, a company receiving assistance must have in place provisions to claw back bonuses and incentive compensation from any of the next twenty senior executives if they are found to have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay.
    
• Increase Ban on Golden Parachutes for Senior Executives: Even under generally available capital access programs, the golden parachute ban will be strengthened: Upon a severance from employment, the top five senior executives will not be allowed a golden parachute payment greater than one year's compensation, as opposed to three years under the current Capital Purchase Program.
    
• Require Board of Directors' Adoption of Company Policy Relating to Approval of Luxury Expenditures: This policy will be the same for companies accessing generally available capital programs as it is for those receiving exceptional assistance. There are no guidelines on luxury expenditures under the current Capital Purchase Program.

[These new standards will not apply retroactively to existing investments or to programs already announced such as the Capital Purchase Program and the Term Asset-Backed Securities Loan Facility.]

III. LONG-TERM REGULATORY REFORM: COMPENSATION STRATEGIES ALIGNED WITH PROPER RISK MANAGEMENT AND LONG-TERM VALUE AND GROWTH:

Even as we work to recover from current market events, it is not too early to begin a serious effort to both examine how company-wide compensation strategies at financial institutions – not just those related to top executives – may have encouraged excessive risk-taking that contributed to current market events and to begin developing model compensation policies for the future. Such steps should include:

• Requiring all Compensation Committees of Public Financial Institutions to Review and Disclose Strategies for Aligning Compensation with Sound Risk-Management: The Secretary of the Treasury and the Chairman of the Securities and Exchange Commission should work together to require compensation committees of all public financial institutions – not just those receiving government assistance – to review and disclose executive and certain employee compensation arrangements and explain how these compensation arrangements are consistent with promoting sound risk management and long-term value creation for their companies and their shareholders.
    
• Compensation of Top Executives Should Include Incentives That Encourage a Long-Term Perspective: Over the last decade there has been an emerging consensus that top executives should receive compensation that encourages more of a long-term perspective on creating economic value for their shareholders and the economy at large. One idea worthy of serious consideration is requiring top executives at financial institutions to hold stock for several years after it is awarded before it can be cashed-out as this would encourage a more long-term focus on the economic interests of the firm.
    
• Pass Say on Pay Shareholder Resolutions on Executive Compensation: Even beyond companies receiving financial recovery assistance, owners of financial institutions – the shareholders – should have a non-binding resolution on both the levels of executive compensation as well as how the structure of compensation incentives help promote risk management and long-term value creation for the firm and the economy as a whole.
    
• White House -Treasury Conference on Long-Term Executive Pay Reform: The Secretary of the Treasury will host a conference with shareholder advocates, major public pension and institutional investor leaders, policy-makers, executives, academics, and others on executive pay reform at financial institutions. Treasury will seek testimony, comment, and white papers on model executive pay initiatives in the cause of establishing best practices and guidelines on executive compensation arrangements for financial institutions.