On Friday, the House Financial Services Committee held a hearing entitled "Executive Compensation Oversight after the Dodd-Frank Wall Street Reform and Consumer Protection Act". Committee Chairman Barney Frank (D-MA) began the hearing by arguing that incentive compensation in the financial sector prior to the financial crisis was not rationally set but instead encouraged imprudent risk-taking. Rep. Frank stated that incentive compensation should be structured such that employees are "not incentivized to take risk excessively." Ranking Member Spencer Bachus (R-AL) followed by noting that the regulators faced a difficult task in setting rules governing executive compensation. In a brief two-hour hearing, the panelists uniformly stated the need for rules restricting incentive structures which reward imprudent risk, but few details on what such rules would look like were offered by the regulators.

Witnesses testifying before the committee were:

Panel One:

  • Scott Alvarez, General Counsel, Board of Governors of the Federal Reserve System
  • Meredith Cross, Director, Division of Corporation Finance, U.S. Securities and Exchange Commission
  • Marc Steckel, Associate Director, Division of Insurance and Research, Federal Deposit Insurance Corporation

Panel Two:

  • Martin Baily, Senior Fellow, The Brookings Institution
  • Darla C. Stuckey, Senior Vice President - Policy & Advocacy, Society of Corporate Secretaries and Governance Professionals

The first panel consisted of regulators empowered by the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") to regulate executive compensation. Mr. Alvarez began by noting "[i]ncentive compensation is an important and useful tool for attracting and motivating employees to perform at their best. At the same time, poorly designed or implemented compensation arrangements can provide executives and other employees with incentives to take imprudent risks that are not consistent with the long-term health of financial organizations." He pointed out that the recent incentive compensation guidance issued by the federal banking agencies revolves around three principles: "(1) incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk; (2) these arrangements should be compatible with effective controls and risk management; and (3) these arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors." He recognized that "time will be required to implement all the improvements that are needed, given firms’ relatively unsophisticated approach to risk incentives before the crisis, the unavoidable complexity of compensation issues, and the large numbers of employees who receive incentive compensation at large banks."

Ms. Cross recounted the SEC's involvement in the development of disclosure rules related to executive compensation and noted that the SEC is currently working to implement the provisions of Dodd-Frank. She then proceeded through each of the relevant Dodd-Frank provisions requiring SEC rulemaking and the timing for each rulemaking. Without providing specifics as to any rule, Ms. Cross indicated that rulemaking for relevant Dodd-Frank provisions will occur as follows: rules related to Section 951 requiring shareholder say on pay votes will be issued in time for the 2011 proxy season; with respect to Section 957, which requires national securities exchange rules to prohibit brokers from voting uninstructed shares on significant matters, rules for the New York Stock Exchange have already been amended to prohibit voting on certain matters; the SEC anticipates proposing rules related to Section 952 for compensation committee independence in the near future; rules related to Sections 953, 953 and 955 will be proposed by July 2011; and, finally, the SEC is working with other federal regulators to implement Section 956 relating to incentive-based compensation disclosure requirement for covered financial entities.

Mr. Steckel described how inappropriate risk incentives contributed the recent financial crisis. According to Mr. Steckel, the FDIC does not advocate for any caps on compensation and believes that a "one size fits all" approach would not work. Instead, incentive based compensation programs should be aligned with the long-term interests of the institution. Mr. Steckel suggested that two features would help to protect the deposit insurance fund: Boards and senior management must take primary responsibility for ensuring that incentives are aligned with the long term interests of the company; and portions of compensation should be subject to meaningful look back mechanisms.

During questioning, each regulator reiterated that they were not in favor of compensation caps, but instead were working toward aligning incentives to avoid inappropriate risks. Rep. Bachus voiced a concern that regulators not micromanage the compensation programs for institutions. The regulators uniformly stated that their involvement with compensation will be to ensure consistent, rational principles are applied and not to manage the pay for individual employees.

To begin the second panel, Mr. Bailey argued that Dodd-Frank provides a valuable framework for regulation of financial institutions but that the level of pay for executives and other risk-takers should not be regulated;, instead, a portion of each executives' compensation should be withheld at the time it is earned and invested in cash-equivalents. This would be paid out to the executive over five years provided the company does not require government assistance or become bankrupt. Claw-back provisions should not be used because they are unworkable.

Ms. Stuckey focused on specific suggestions for the SEC to consider in each of its rulemakings. For instance, she suggested that the SEC adopt a similar model as used for TARP for say on pay rules given the short timeframe before the 2011 proxy season and that the influence of proxy advisory firms, which use a "one-size-fits-all" model be carefully considered. With respect to Section 953(a), which requires disclosure of the relationship between pay and performance, she suggested the SEC allow flexibility so that compensation committees can explain their compensation decisions, when compensation is "actually paid," and when and how performance is measured. She also focused on how clawbacks should operate and the need for flexibility in allowing boards to determine whether and how to recoup compensation from employees.