I am a senior partner and founder of Compensation Advisory Partners LLC (“CAP”), a boutique consulting firm that specializes in providing independent executive compensation advice to compensation committees of boards of directors of public and private companies. Our clients range from Fortune 50 companies to mid-sized firms operating in a variety of different industries. I have been an executive compensation consultant for more than 25 years. For more than 15 years, I have specialized in working with boards and company management teams in the financial services industry. Recently I have worked closely with several TARP participants and their compensation committees to interpret and apply TARP regulations to “covered employees’” and to manage the companies’ overall compensation programs.
Design of compensation structures that attract and retain executives, align with long term success, and discourage excessive risk-taking
The design of effective compensation programs is a multi-faceted process that begins with the company’s business strategy and specific goals, identifies the talent necessary to reach these goals and then determines how pay, formalized into an articulated compensation philosophy or set of guiding principles ( i.e. pay-for-performance), can be structured to support the desired outcomes.
As part of this process, the competitive universe is defined and reviewed, including an examination of the mix of compensation components — fixed vs. variable, short-term vs. long-term, and cash vs. equity. Setting and calibrating the level of pay for a commensurate level of performance and selecting the right measures to evaluate short-term and long-term results are critically important steps in the pay design process.
A relatively new, but essential, component of the pay design process involves evaluating the potential for excessive risk-taking. Compensation committees are actively involved in risk assessments. Companies have responded to TARP, SEC, Treasury guidance and current Federal Reserve/regulatory reviews by developing processes that integrate risk management with human resources and finance in incentive compensation design and retrospective reviews. Where the potential for undesirable risk-
taking or an inappropriate focus on short term results (at the expense of the firm’s long term welfare) is identified, corrective measures including mandatory deferrals of compensation, claw backs, adjustment to metrics, etc. – are being introduced.
Most financial services firms emphasize long term performance in their compensation programs for senior executives. The majority of pay for a CEO and other proxy reported executives is based on performance that extends beyond one year. Firms use a variety of vehicles – stock options, restricted stock and long term performance plans– that contain vesting requirements or performance periods of at least 3-5 years. Properly designed to align sustained long term financial goals with value creation for shareholders, these plans can be effective in rewarding as well as in attracting and retaining talented executives. In addition, most banks have significant stock ownership guidelines and/or share retention requirements that require executives to hold a high proportion of the shares they receive from company plans over their careers.
Special Master’s compensation determinations
EESA and Treasury’s Interim Rules (TARP Standards for Compensation and Corporate Governance) imposed numerous limitations on TARP recipients and more stringent rules on the seven firms that received “exceptional assistance”. The Special Master’s role was to evaluate and set pay levels within the limitations and consistent with the principles provided by the Interim Rules. Working within these constraints, the Special Master crafted an approach that could be applied across all seven firms. In summary, the program includes: (a) significantly reduced cash compensation, with salaries generally kept below $500,000 and no cash bonuses permitted; (b) proportionately large grants of “salary stock” – i.e., shares that are vested but restricted from sale for at least two years; and (c) awards of restricted stock, predicated on performance, with a minimum 3-year vesting period. As a practitioner, here are several observations:
- As a result of the limitations in the Interim Rules, only a modest amount (at most 1/3) of each employee’s compensation was actually based on performance – the portion that was provided in restricted stock. Existing pay programs would have had a far larger amount conditioned on performance.
- Compensation paid was fixed. Salary and salary stock were paid bi-weekly. The dollar value of the salary stock was set in advance. The number of shares varied based on the stock price at the end of each pay period.
- Having executives who are substantially invested in company stock is an appropriate program objective. Having the right balance between cash and stock, and the appropriate performance objectives for each is critical. Executives at TARP firms were significant shareholders who lost the value of their investments along with those of other shareholders. While delivering compensation in stock reinforces a long term focus, it does not guarantee the existence of a pay-for-performance program or a culture that properly evaluates individual risk-taking.
- Company performance for many financial service firms was abysmal in 2009 and is just beginning to recover now. Compensation committees are well aware of shareholder sentiments and regulatory scrutiny. In this environment, it is doubtful that the pay-for-performance programs that were in place would have been as generous as what TARP allowed. By their own terms, cash bonuses would have been reduced or non-existent (as many were in 2008) and equity awards would have been apportioned more appropriately
- The Special Master’s actions may have supported the public interest and attempted to lower the tension between Wall Street and Main Street, but most companies would not view them as a model for effective incentive compensation.
Impact of TARP restrictions on the ability of firms to recruit and retain
TARP participants and the seven firms receiving “exceptional assistance” were tainted. At the beginning of the financial crisis, their stability was questionable. Would the firms survive? How long would the government’s involvement last? What would the organization look like after? This instability affected existing employees, as well as potential new hires. Very quickly, being associated with a TARP firm was a “negative” on an executive’s resume.
I have had more direct experience with recruiting issues among TARP participants outside of the Special Master’s direct oversight. For these firms, the possibility of recruiting new talent at the highest levels in the firm was viewed as virtually impossible. If they could locate appropriate talent, pursuing candidates and getting approvals was too time consuming. Between the negative impression of TARP banks and the relatively inflexible pay programs, they chose to promote from within or “manage” until they repay their obligations. For companies under the Special Master’s oversight, and the other TARP banks the opportunity to discuss special needs was available.
From a retention perspective, initially, alternative positions for TARP executives were not readily available. Now as the market improves and companies emerge from TARP, we will see more turnover and companies will need to rethink how to keep their talent.
Special Master’s determinations as a useful model for corporate executive compensation structures in the future
Some aspects of the Special Master’s approach and the regulations will serve as a model. The importance of identifying and minimizing ‘unnecessary or excessive risk’ in the design and evaluation of incentive arrangements will remain a critical design principle for financial firms. This was further confirmed in June when the Federal Reserve, joined by the Office of the Comptroller of the Currency, the Federal Deposit Insurance and the Office of Thrift Supervision, issued its final guidance and the disclosure of risk assessments in proxy statements was extended to all companies with the SEC’s endorsement in late 2009.
Other practices that are consistent with the TARP regulations have become synonymous with “good governance” practices for companies outside of TARP and are likely to endure. These practices include
the introduction of clawbacks, limitations on perquisites, prohibition of accrual of benefits under supplemental retirement or non-qualified deferred compensation programs, and prohibitions on ‘gross-up’s on perquisites or severance arrangements. TARP companies were the first companies required to conduct say-on-pay votes that are now mandatory under the Dodd Frank Wall Street Reform and Consumer Protection Act.
Compensation Structures to meet the “Public Interest Standard”
The principles behind the “Public Interest Standard” – mitigation of risk, ensuring pay-for-performance both in make-up and timing, retaining program competitiveness, recognition of individual value to the enterprise, and appropriate balance between elements offered — are valid objectives. Compensation committees and management are capable of weighing these objectives and they will as part of the regulations. Companies are not “one-size-fits-all’; compensation plans are not “one-size-fits-all.” It is critical that programs be structured to reinforce each company’s strategic objectives and that Committees be empowered and held responsible for making these decisions.
The “exceptional assistance recipients”, given the public’s high level of investment and appropriate concern over potential repayment, required additional oversight. If overall compensation and current cash was the area of greatest concern and political consternation, negotiated reductions in the aggregate levels of cash and total compensation, related to performance, would have been more effective. Selecting the ‘20 highest’ paid executives (plus the NEOs) and imposing a program that fundamentally guarantees a minimum level of compensation is not pay-for-performance.
Compensation Structures for distressed companies or a ‘turnaround’ situation
Attracting a management team to a turnaround or distressed company utilizes the same elements of compensation as healthy companies with some tailoring of its features depending upon the severity of the company’s condition. A company in crisis with little time to generate results, would structure its programs differently from one that may have severe problems but a reasonable period of time to demonstrate progress. The elements of pay and emphasis placed on them, operating as a business tool, would reflect these realities. For example, the compensation structure for a company with little time would rely heavily on annual incentives (payable in cash/stock) to support the often very short-term objectives necessary to survive. Although long term incentives, performance based and payable in stock, would be part of the program, when survival is that questionable, it is unlikely to be the primary focus of the program. If recovery is less questionable, but a matter of strategy, economic conditions and the right leadership, a more balanced program with greater focus on long term incentives would be appropriate. The vesting schedule for the equity, the magnitude of the award, etc. would be tailored to the appropriate time frames and competitive market. The board would also have to determine if any
employment contracts were necessary and the related provisions. Attracting executives to a turnaround situation requires a careful calibration of the risk/reward aspects of the compensation program. Initially pay may be low(er) with considerably more opportunity placed on the long term and the ‘upside’. It is important to ensure that the program cannot enrich executives if their efforts end in failure. If the team is successful, the pay-off should be significant but aligned with the value created for shareholders.