Last week, we updated you on the Treasury’s new rules for compensation arrangements by recipients of federal aid under the Troubled Assets Relief Program (TARP). Also on June 10, 2009, Treasury Secretary Timothy Geithner issued a statement outlining guiding principles related to executive compensation to be used to further align executive compensation practices with the interests of shareholders. These principles are so-called “best practices” on compensation matters that are supported by Treasury and are not legal requirements or regulations (at this time). As such, they are not specific to entities that are recipients of TARP assistance but are applicable to all companies. In addition, Treasury made clear that it will not be capping pay or setting forth specific prescriptions on how non-TARP companies must set compensation. However, Treasury outlined two specific legislative agenda items for action by Congress which would require (i) nonbinding annual “say-on-pay” votes for all public companies and (ii) greater compensation committee independence for all companies listed on national securities exchanges.  

TREASURY’S EXECUTIVE COMPENSATION “BEST PRACTICES”  

The following summarizes the Treasury position on executive compensation:  

  • Use Performance-Based Compensation. Compensation should be based upon performance metrics that support long-term value creation and are set in a manner that does not reward performance which lags the performance of peers. Generally, performance-based pay should be conditioned on a variety of metrics and not just stock price.  
  • Align Long-Term Risk With Long-Term Compensation. Institutions should pay top executives in ways that tightly align their interests with the long-term success of the firm since the mismatch of short-term gain and long-term risk has contributed to the current financial crisis. Compensation must therefore have a long-term component (whether through long holding periods of company stock or other designs suited to the needs of the company).
  • Emphasize Risk Management in Developing Compensation Programs. All compensation committees should conduct and publish risk assessments of pay packages to guard against imprudent risk taking. Risk managers must be provided with the tools needed to improve the relationship between compensation incentives and risk taking.  
  • Re-examine Golden Parachutes and Supplemental Retirement Packages. Institutions should re-examine golden parachutes in place in order to ensure that these enhance the long-term value of the firm and still serve to align executive’s interest with that of shareholders and do not reward executives even when shareholders lose value. Similarly, institutions should examine supplemental retirement packages in order to make sure that these programs also incentivize performance and align executive interests with those of shareholders.  
  • Increase Transparency and Accountability In Setting Compensation. Many practices that encouraged risk taking might have been subject to greater scrutiny if compensation committees had greater independence and shareholders had greater clarity on the terms and conditions of such programs. Current disclosures often failed to make clear in a single place the total “walkaway” compensation owed to executives, including all of the components thereof.  

Much of the Treasury set of principles are already considered in some form or aspect by many corporate executive compensation planning programs. However, the affirmative guidance and clear adoption announced by Treasury should serve to focus both compensation committees and executives on these areas of compensation as likely targets for regulatory scrutiny and rulemaking in future.  

SAY-ON-PAY” NOW AGENDA ITEM FOR OBAMA ADMINISTRATION AND TREASURY  

As part of Treasury’s statement on compensation, it called for Congressional action which would require non-binding annual say-on-pay votes to be held by all public companies.  

This legislative initiative was outlined by Treasury to provide the following:  

  • Increase Board Accountability. Say-on-pay is designed to provide shareholder perspective to directors in designing compensation.  
  • SEC Required Vote. Any legislation passed should authorize the Securities and Exchange Commission (SEC) to require all public companies to have an annual non-binding “say-onpay” vote approving or disapproving executive pay packages for the top five executives, including all compensation covered in the Compensation Discussion and Analysis.
  • Permissive Votes On Specific Compensation Decisions. Institutions would be allowed, but not required, to solicit shareholder views on specific compensation decisions or programs, including categories of pay.  
  • Specific Vote On Golden Parachutes. Shareholders are to be given the right to cast a nonbinding vote related to golden parachute compensation disclosed in proxy solicitation materials prepared for shareholder meetings related to a merger, acquisition, or other transaction that may involve a change of control of the company.  

The foregoing, if enacted into legislation, would seem to extend the say-on-pay requirement that was applied to TARP recipients under the American Recovery and Reinvestment Act of 2009 (ARRA) to all public companies with the additional requirement that a separate vote be required with respect to golden parachute compensation.  

MORE REQUIRED INDEPENDENCE FOR COMPENSATION COMMITTEES  

Treasury and the Obama administration are also calling for legislation to increase the independence of compensation committees for all companies listed on national securities exchanges (similar to what Sarbanes-Oxley did for audit committees).  

Under this legislative initiative compensation committees would (i) have to meet heightened standards of independence analogous to what is required for audit committee members under Sarbanes-Oxley; (ii) be empowered to use outside consultants and legal counsel which report directly to the compensation committee; and (iii) be sufficiently funded to utilize these powers. In addition, the SEC will be directed to establish standards for independence of compensation consultants and outside counsel used by compensation committees subject to these rules.  

These compensation committee standards, if passed, could require changes in composition and functioning of certain compensation committees. In addition, these changes (like the changes made by Sarbanes-Oxley) could also increase the compliance costs to public companies listed on national securities exchanges.  

FUTURE EXECUTIVE COMPENSATION DEVELOPMENTS

In the coming days and weeks there will be substantial discussion and activity in the area of executive compensation triggered by these proposals as well as the recently released Treasury interim final rules on compensation applicable to TARP recipients under ARRA. It is clear that Treasury and the Obama Administration are set to make executive compensation topics the focus of future legislation which could bring potentially impact the compensation practices at all public companies in the United States. We will continue to monitor these ongoing developments and issue updates as new developments arise.