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:
- Provide employees incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk;
- Be compatible with effective controls and risk management; and
- 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.