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.