The Compensation Debate in the United States
Executive compensation has been a topic of intense media scrutiny over the past several months. The payment of significant bonuses by distressed firms that have received U.S. government assistance has prompted the U.S. Congress to introduce various legislative efforts that attempt to limit or regulate executive compensation. To date, these efforts have been specifically tied to the U.S. government’s economic stimulus programs. However, as the scandals regarding bonuses paid at AIG and Bank of America / Merrill Lynch begin to fade, the focus of the debate has shifted from the amounts paid to senior executives to the connection between compensation incentives and increased systemic risk in the financial system. The Obama administration’s white paper on financial regulatory reform, released on June 17, 2009, specifically makes this link:
“Among the many significant causes of the financial crisis were compensation practices. In particular, incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage. We will seek to better align compensation practices with the interests of shareholders and the stability of firms and the financial system through the fol lowing five pr inciples. First , compensat ion plans should properly measure and reward performance. Second, compensation should be structured to account for the time horizon of risks. Third, compensation practices should be aligned with sound risk management. Fourth, golden parachutes and supplemental retirement packages should be reexamined to determine whether they align the interests of executives and shareholders. Finally, transparency and accountability should be promoted in the process of setting compensation.”
Recent Regulatory Proposals
These principles are reflected in the proposals,1 announced by U.S. Treasury Department on June 10, 2009, for legislation:
- Authorizing the SEC to require non-binding “say on pay” votes on:
- an issuer’s annual executive compensation disclosure in its proxy statement;
- the annual compensation paid to the top 5 executives;
- other specific compensations decisions put forward by the issuer; and
- any golden parachutes.
- Directing the SEC to issue rules:
- requiring compensation committees to meet independence standards similar to audit committees under Sarbanes-Oxley;
- giving compensation committees authority over compensation consultants, the ability to engage outside counsel and other adviser, and to require adequate funding to pay consultants, counsel and advisers; and
- providing standards for compensation consultants and outside counsel.
The Chair of the SEC, also announced2 on June 10, 2009, that the SEC will be considering additional compensation disclosure requirements for public companies regarding:
- how the company and its board manage risk;
- the company’s overall compensation approach;
- potential conflicts of interest by compensation consultants, including disclosure of relationships between consultants and the company and their affiliates; and
- director nominees, including their experience and qualifications to serve on the board or on particular board committees and about why a board has chosen its particular leadership structure.
These new requirements would build on the significant revision to the executive compensation disclosure requirements introduced by the SEC in 2006 and current proposed changes to facilitate greater shareholder involvement in nominating directors.
Potential Impact on Canadian Developments
Although the proposals discussed above are in their early stages and are expected to evolve significantly, their scope suggests that new rules regarding compensation disclosure will likely be enacted in some form in the U.S. The enhanced executive compensation disclosure requirements introduced in Canada last year were substantially modelled on the SEC’s 2006 reforms. We expect that any additional rule-making undertaken by the SEC in this area will be highly influential on the Canadian Securities Administrators. Similarly, the introduction of independence requirements for compensation committees in the U.S. would likely precipitate similar changes in Canada. Although the Canadian Securities Administrators have recently proposed moving towards a less prescriptive approach to independence3 for audit committees than the current rules that are modelled on the U.S. stock exchange requirements and Sarbanes-Oxely, new regulation related to executive compensation is unlikely to stop at the border.
The more immediate impact on Canadian issuers is likely to result from investor and market expectations. The U.S. government proposals echo those of investor advocates in both the U.S. and Canada. For example, the Canadian Coalition for Good Governance’s 2009 Executive Compensation Principles suggest that performance should be assessed based on measurable risk adjusted criteria, matched to the time horizon needed to ensure the criteria have been met. Similarly, there has been a marked increase in “say on pay”4 shareholder proposals in Canada. In April, 2009, the Canadian Coalition for Good Goverance updated its position on “say on pay” and now considers such advisory resolutions as an important part of shareholders’ engagement with boards that should be adopted broadly.
There have also been concrete examples of firms responding to criticism regarding compensation and introducing policies specifically designed to tie compensation to long-term performance. For example, it has been reported5 that Scotia Capital has introduced measures including a three year deferral for the payment of incentive compensation as well as minimum levels of share ownership and bonus claw-backs for senior executives. Similarly, UBS has introduced a new compensation policy6 that includes the payment of variable cash compensation and the vesting of equity compensation over a three-year period, subject to adjustments based on firm performance. The UBS policy will be subject to an advisory shareholder vote in 2009. These types of practices are likely to become more common as a result of the increased focus on compensation incentives.
Canadian directors and management should anticipate that investors will raise concerns regarding compensation and risk management and should be prepared to explain the rationale and logic behind the design of their compensation policies and how they create incentives for performance without encouraging undue shortterm risk. The current compensation discussion and analysis requirements mandate disclosure of the objectives of any compensation program, what the program is designed to reward and performance goals, if measurable, for an issuer’s senior executive officers. Canadian issuers should consider whether specifically discussing how these programs tie to risk management or providing similar disclosure for its other more general compensation programs and policies would proactively address any likely investor concerns.