Today, the House Financial Services Committee held a hearing on “Compensation Structure and Systemic Risk.” This hearing comes one day after the Department of Treasury announced the release of an Interim Final Rule implementing compensation standards for firms receiving TARP assistance. In commenting on the necessity of the hearing, Rep. Carolyn McCarthy stated, “[t]his Committee and Congress should move forward legislation that helps the private sector by providing the tools necessary to create an adequate compensation system that is based on performance principles and not on incentives backed by excessively risky business decisions.” Rep. Andre Carson expressed similar sentiments, and expressed his hope that “industry leaders understand that calls for executive pay reform are not retaliation for our current economic reality, but rather an attempt to usher in a new era of real corporate responsibility.”

Rep. Andre Carson expressed similar sentiments, and expressed his hope that “industry leaders understand that calls for executive pay reform are not retaliation for our current economic reality, but rather an attempt to usher in a new era of real corporate responsibility.”

Panel One

Mr. Gene Sperling, Counselor to the Secretary of the Treasury, U.S. Department of the Treasury  

Mr. Scott Alvarez, General Counsel, Board of Governors of the Federal Reserve System  

Mr. Brian Breheny, Deputy Director of Corporate Finance, U.S. Securities and Exchange Commission

Panel Two

Mr. Lucien Bebchuk, Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, Harvard Law School  

Ms. Nell Minow, Editor and Founder, The Corporate Library  

Mr. Lynn Turner, former Chief Accountant, U.S. Securities and Exchange Commission  

Mr. Kevin Murphy, Trefftzs Chair in Finance, Professor of Business and Law, and Professor of Economics, University of Southern California  

Mr. J.W. Verret, Assistant Professor, George Mason University School of Law

Mr. Sperling, speaking on behalf of the Department of treasury, stated that the Obama Administration does not want to impose caps on executive pay, but compensation must be tailored to encourage “sound risk management and long-term value creation for firms and the economy as a whole.” He articulated the five compensation reform principles that Secretary Geithner laid out yesterday. Those principles include that : (i) compensation plans should properly measure and reward performance; (ii) compensation should be structured in line with the time horizon of risks; (iii) compensation practices should be aligned with sound risk management; (iv) a reexamination of whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders; and (v) promote transparency and accountability in setting compensation.

Mr. Alvarez focused on the activities that the Federal Reserve is developing to enhance and expand supervisory guidance regarding executive compensation to “reflect the lessons learned in this financial crisis about ways in which compensation practices can encourage excessive or improper risk-taking.” Specifically, Mr. Alvarez articulated three key principles that could provide guidance to financial institutions and supervisors to better structure compensation practices. First, compensation packages should be properly aligned throughout the institution. Employees throughout the institution could pose a significant risk; and poorly designed packages may incent a range of employees to engage in risky activity. Second, compensation packages should not reward employees for meeting or exceeding certain thresholds without regard to the risks of the activities or transactions that allowed these targets to be met. Lastly, more should be done to improve risk management and corporate governance as it relates to compensation practices.

Mr. Breheny believed that, “[i]n order for public markets to function properly, it is crucial that shareholders – the owners of the company – be able to make informed decisions about their investments and boards of directors be accountable to shareholders for their decisions.” This process is complicated if shareholders do not have adequate information relating to the company, include executive compensation packages. As such the SEC has focused on requiring institutions to “provide high quality, material and understandable information to investors.” This information must be “straightforward and meaningful” to allow investors to properly assess the information.

In offering suggestions on the role that the government should play in bringing about reforms, Mr. Bebchuk recommended that bank regulators, when assessing the risks posed by any bank, take into account the incentives produced by the bank’s pay arrangements. When these pay arrangements advance risky behavior, regulators should supervise the bank more closely and consider raising its capital requirement.

In his testimony, Mr. Minow provided the following suggestions for executive compensation reform: (i) indexing options and tying option grants to specific performance goals; (ii) banking of bonuses, a kind of escrow to ensure that any adjustments to the financial reports will result in adjustments to the bonus; (iii) limiting severance under any “not for cause” termination; (iv) basing incentive compensation on more than one performance metric; (v) measuring incentive compensation performance over periods of one year or more; (vi) different incentive awards should measure different kinds of performance; (vii) companies should ensure that compensation policies are easy for both executives and shareholders to understand and should avoid multiplication of compensation plans; and (viii) long-term compensation should always make up the majority of total realizable compensation for the most senior executives of the company.

In making his recommendations, Mr. Turner discouraged government involvement in setting compensation either by taxation legislation or by establishing a government overseer of compensation. He stated, “[p]ast attempts at legislating compensation such as through limits on tax deductibility of pay have ha negative impacts on companies and their stock values, and ultimately investors.” Believing that compensation should be determined by transparent free markets, Mr. Turner urged the Committee to pass legislation that would improve transparency, create greater accountability for the oversight of compensation arrangements, and incorporate systemic risk regulation.

Mr. Murphy noted that political pressures to reform executive compensation have increased despite “limited evidence” that the compensation structures were responsible for the excessive risk taking in financial institutions. He went on to state, “[w] hile inappropriately designed compensation structures can certainly encourage risk taking, the risk taking incentives caused by compensation in financial services are small relatives to those created by ‘Too Big to Fail’ guarantees, loose monetary policies, social policies on home ownership, and poorly implemented financial innovations.” He further stated that the restraints currently imposed on TARP recipients will “likely destroy these organizations, unless they can quickly repay the government and avoid the constraints.”

Mr. Varret argued that compensation limits would limit a bank's ability to compete for top talent, which could further worsen the banking crisis. He cited that shortly after yesterday's compensation restriction announcement, reports indicated that Deutsche Bank poached 12 of its highest performing executives and that UBS was hiring financial advisers from institutions that have received TARP firms with compensation increases as high as 200 %. Mr. Varret believed that any pay restrictions might place American banks at a competitive disadvantage.