Treasury Secretary Timothy Geithner has proposed sweeping legislative changes that will affect executive compensation and corporate governance practices of public companies. The proposed changes, if adopted, would mandate shareholder say-on-pay and impose stricter independence standards on compensation committees of public companies.
On June 10, 2009, Treasury Secretary Timothy Geithner proposed sweeping legislative changes designed to impose standards on and promote transparency in the executive compensation practices of public companies. If adopted, the proposals will affect the executive compensation and related governance practices of virtually all domestic public companies across all industries. In a public statement accompanied by two fact sheets, Secretary Geithner proposed major reforms in shareholder say-on-pay and the independence of compensation committees. This statement, combined with other recent statements by lawmakers and the Securities Exchange Commission, continue the recent upward trend in intense focus on the structure of executive compensation.
Principles for Executive Compensation
Secretary Geithner outlined a number of broad-based principles on which future legislative and regulatory directives will be based:
- Compensation should be tied to long-term value creation. Toward this end we can expect that:
- Compensation practices that set the performance bar too low will be discouraged
- Benchmarks that measure performance relative to peers (as opposed to in isolation) will be favored
- Performance measures that apply a wide range of internal and external metrics, not merely stock price, will be preferred.
- Compensation should take into account the time-horizon of the risk. In other words, there should not be short-term rewards for performance that could result in long-term risks. Companies are encouraged to manage behavior with a mind to long term risks, not only in the executive suite, but also to those at other key levels of the company. Techniques for matching the risk time horizon include:
- Requiring executives to hold stock for a long time (e.g., until termination of employment or beyond)
- Performance-based compensation with multiple-year performance periods
- Compensation practices should be aligned with sound risk management. This will require a significant new dimension in risk assessment and management in many companies.
- Risk managers will need to have the stature and authority to advise the compensation committee on risks and rewards of applying various metrics to performance-based compensation.
- It is expected that compensation committees will be required to perform and report “risk assessments” of executive pay packages. This is an outgrowth of the requirement that TARP recipients conduct a formal, internal risk assessment so as to avoid compensation packages that encourage unnecessary and excessive risks. The SEC staff has been urging for more than a year that all companies voluntarily adopt this approach. An examination of recent proxies shows that some companies have attempted to meet this goal by varying the metrics used to measure long- and short-term incentives. It appears that a more formal analysis will be required once new requirements are fully articulated.
- The future of enhanced severance benefits and SERPs (supplemental executive retirement plans) is uncertain. Secretary Geithner has called for an examination of whether such programs provide incentives for value-enhancing performance and thus align executives’ interests with shareholder interests, or whether they provide rewards even when the shareholders lose value.
- The process of setting compensation should be more transparent and there should be greater accountability of those who set it. This includes legislative initiatives to strengthen compensation committees and to permit shareholders to vote on executive pay, as discussed more fully below.
Shareholder Say-on-Pay Proposal
For any company listed on a national securities exchange, federal legislation to be proposed would:
- Authorize the SEC to require public companies to include in annual proxy statements a shareholder resolution requesting non-binding approval or disapproval of disclosed executive compensation (including the currently required narrative in the Compensation Disclosure and Analysis and the quantitative amounts payable to executives.)
- Give shareholders the right to a non-binding vote on annual compensation for the top five named executive officers. This includes all types of compensation described in the CD&A and the summary compensation table. In addition to this required shareholder vote, companies will, if they choose to, have the opportunity to ask shareholders views on specific compensation decisions.
- Give shareholders the right to cast a non-binding vote to approve or disapprove golden parachute compensation in proxy solicitation materials prepared for shareholder meetings to vote on a merger, acquisition or other possible change of control.
Compensation Committee Changes
For any company listed on a national securities exchange, legislation to be proposed would impose on the compensation committee standards similar to those imposed on audit committees under the Sarbanes-Oxley Act. These changes would require the SEC to:
- Issue rules requiring members of the compensation committee to meet standards for independence similar to those for audit committee members.
- Give compensation committees the power to engage counsel and other advisors and require companies to establish funding to engage and adequately compensate advisors employed by the compensation committee. Compensation consultants would report directly to (and be answerable only to) the compensation committee, which would be directly responsible for the appointment, compensation, retention and oversight of any compensation consultants it retains.
- Establish standards for ensuring the independence of compensation consultants and outside counsel to be used by the compensation committee.
It is not clear whether these proposals will require (as is the case of audit committees) that the compensation committee include and identify publicly a member who is a “compensation expert” or mandate the use of outside advisors.
The statement makes it clear that these proposals are intended to be broad-based principles intended to discourage excessive risk taking and set forth standards on approval of compensation without capping compensation or requiring any particular compensation structure. The proposals are, at this point, without much detail. It remains to be seen whether or how Congress will take up these issues but given the potential impact on all public companies, public companies have an interest in following these proposals.
In addition to this statement from Secretary Geithner, the SEC Chairman announced on June 10, 2009 that the SEC is actively considering a package of new proxy rules that would focus on greater disclosure regarding risk management, overall compensation approach, potential conflicts of interest of compensation consultants and director nominees. The SEC proposed rules in May 2009 which would permit certain shareholders to nominate directors. While these rules are only proposed, the combination of a right to nominate directors and a non-binding say-on-pay vote would give shareholders a much stronger role in corporate governance.
Executive compensation has already drawn significant scrutiny in Congress this year, and the Treasury proposal will undoubtedly bring new focus on this debate. Only one day after its release, the House Financial Services Committee held a hearing on executive compensation and systemic risk. Though no legislation has yet been proposed by the House, Chairman Barney Frank (D-MA) has indicated his desire to move an executive compensation measure prior to the August congressional recess. In the Senate, Sen. Charles Schumer has already introduced S. 1074, the Shareholders Bill of Rights Act of 2009, which includes say-on-pay provisions. With the Senate actively engaged on debate on climate change, health care reform, and a Supreme Court nomination, it is unclear when it may consider S. 1074 or other executive compensation legislation.
What To Do Now
Compensation committees will want to be aware of the regulatory environment before taking any action on executive compensation. The legislative and regulatory scrutiny of executive compensation substance and procedure in public companies is likely to intensify even more for the rest of this year and in the future. Since these new proposals may mature into “best practices” before formal legislative action occurs and in any event may be effective for the 2010 proxy season, compensation committees should work with their advisors, before renewing or adopting new incentive, equity or retention plans, contracts or arrangements, to assess, among other things, whether the right array of performance measures, performance periods, and stock holding requirements is in place, and whether the arrangement reflects a real understanding of the company’s business and the risk and reward characteristics of each element of compensation. In particular, all public company compensation committees may wish to assure that their decision making processes include analysis of compensation plan design in the context of enterprise risk.