A common theme among the Obama administration, Congress, investors and regulators is that executive compensation must be refocused on different fundamentals: long-term value rather than short-term profits; financial stability; and management of risks. To date, the Obama administration and its Department of Treasury have not offered much help except to announce the following five principals President Obama’s Financial Regulatory Reform issued by the Department of Treasury on June 17, 2009:
- Compensation plans should properly measure and reward performance;
- Compensation should be structured to account for the time horizon of risks;
- Compensation practices should be aligned with sound risk management;
- Golden parachutes and supplemental retirement packages should be reexamined to determine
- Whether they align the interests of executives and shareholders; and
- Transparency and accountability should be promoted in the process of setting compensation.
Institutional investors through the Council of Institutional Investors Corporate (CII) Governance Policies as updated in October 2008 have better articulated guidelines that the Council has found to be appropriate in most situations regarding executive compensation. These guidelines are instructive to every employer, especially publicly-held companies, but also to tax-exempt organizations as the Treasury appears to be following similar guidelines provided to privately-held companies because bankers and other creditors may follow the guidelines of the CII institutions.
Below is a summary of the CII guidelines regarding executive compensation:
Pay should be for performance that rewards executives for “sustainable, superior performance over the “long-term,” consistent with a company’s investment horizon and generally considered to be five or more years for mature companies and at least three years for other companies. The elements of the pay should be structured to retain and motivate executives to achieve the company’s short- and long-term strategic goals.
Role of the compensation committee is to structure executive pay and evaluate executive performance within the context of that pay structure. In so doing, compensation committees should adopt the following principles and practices:
- Committee composition should be of independent members and should rotate periodically among the board’s independent directors.
- Executive pay philosophy should be approved and announced by the committee identifying the pay components and the desired mix of those components.
- Oversight by the committee should include the pay not only of the CEO, but also of any other employees required by law, as well as of any other highly-compensated employees, including executives of subsidiaries, special purpose entities and other affiliates, as determined by the compensation committee (the “overseen group”).
- Annual review should be performed by the committee of each member of the overseen group with each year’s bonus, severance, incentive award or extraordinary payment being approved by the committee as to fairness and appropriateness in the context of the executive pay philosophy and other company policies and goals.
- Outside advice, including consultants, legal and other advisers, should be sought by the committee when it deems appropriate, including when negotiating contracts with executives.
- Clawbacks should be developed for recapturing unearned bonus and incentive payments that were awarded to senior executives in the event of fraudulent activity, incorrectly stated financial results, or some other malfeasance or cause.
- Peer benchmarking should be used with caution because it is a primary contributor to escalating executive compensation.
Salary, because it is not “at risk,” should be set at a level that yields the highest value for the company at least cost. In general, salary should be set to reflect responsibilities, tenure and past performance and to be tax efficient – meaning no more than $1 million.
Annual bonuses should be based upon well-defined and clearly disclosed performance targets, written in advance and approved by the board. There should be defined performance levels or floors below which no bonus is to be paid and dollar limits on the amount of any bonus that will be paid. Except in unusual and extraordinary situations, the compensation committee should not “lower the bar” by changing performance targets in the middle of bonus cycles.
Long-term incentive compensation also should be based upon well-defined and clearly disclosed performance targets, written in advance and approved by the board with the following limitations:
- Limits on the size of the awards should be set to prevent mega-awards that are disproportionate to performance.
- Performance periods should be no less than three years and should be followed by pro rata vesting over at least two subsequent years.
- Hedging (such as by buying puts and selling calls) should be prohibited by executives if incentive compensation is payable in company stock.
- Shareholder approval should be required of all long-term incentive plans, including equity-based plans, any material amendments to existing plans or any amendments of outstanding awards to shorten vesting requirements, reduce performance targets or otherwise change outstanding long-term incentive awards to benefit executives of publicly-held companies.
Perquisites should not include companies being responsible for paying personal expenses – particularly those that average employees routinely shoulder, such as family and personal travel, financial planning, club memberships and other dues. Employment contracts should be provided to executives only in limited circumstances, such as to provide modest, short-term employment security to a newly hired or recently promoted executive. Such contracts should have a specified termination date (not to exceed three years); contracts should not be “rolling” on an open-ended basis.
Severance should not be payable or paid in the event of termination for poor performance, resignation under pressure, or failure to renew an employment contract. Company payments awarded upon death or disability should be limited to compensation already earned or vested.
Change-in-control payments should be “double-triggered” and payable only (1) after a control change actually takes place and (2) if a covered executive’s job is terminated because of the control change.
Shareholder ratification should be required of all employment contracts, side letters or other agreements providing for severance, change-in-control or other special payments to executives of publicly-held companies exceeding 2.99 times average annual salary plus annual bonus for the previous three years.
Supplemental Executive Retirement Plans or SERPs should not include special provisions, such as above-market interest rates and excess service credits, not offered under plans covering other employees. Stock and stock-option grants, annual/long-term bonuses and other compensation not awarded to other employees and/or not considered in the determination of retirement benefits payable to other employees should not be considered in calculating benefits payable under SERPs.
Post-retirement exercise periods for exercise of stock options should be limited to three-years.
Retirement benefits should not include special perquisites—such as apartments, automobiles, use of corporate aircraft, security, financial planning and other benefits typically paid by other employees as personal expenses.