July 19, 2010
Dodd-Frank Forum: Executive Compensation & Incentive-Based Compensation
Posted by Christine Hurt

In every Congressional session in recent memory, legislation has been proposed to somehow curb executive compensation.  Two narratives are commonly used:  (1) executives should not receive pay without performance and (2) the difference between employee compensation and executive compensation should not be as large as it is.  Both of these arguments are hard to counter.  It's hard to argue that anyone should be paid more than they deserve, and falling back on traditional concepts of enforcing arms-length bargains just isn't that catchy.  And who wants to argue for income disparity?  That doesn't win you a lot of friends, either.  However, most of these proposals just languished until the 2008 Financial Crisis, when bill writers dusted off old executive compensation legislation and inserted the words "systematic risk" a few times.  Now we have a third narrative:  incentive-based compensation created a system that rewarded excessive risk-taking.  This isn't just bad for the individual companies, so we can't just leave it to them to rework their bonus structures.  This type of excessive risk-taking is bad for the system, so we must regulate it.

So, everyone's favorite part of the executive compensation protest finds a home in the Dodd-Frank Bill, in Subtitle E of Title IX -- Investor Protections and Improvements to the Regulation of Securities.

Say on Pay

First, under Section 951, shareholders must receive information and get the right to vote on executive compensation at least once every three years in a separate resolution.  (However, once every six years, shareholders have the right to vote on whether this compensation vote should take place more frequently.)  Of course, the big catch is that this vote is nonbinding.  So, the corporation is going to spend a lot of shareholder money hiring lots of compensation experts and legal experts to create these executive compensation packages and disclose them in proxy materials, just so the same shareholders can vote on the packages, a vote which has only signalling value.

Pay Without Performance

Then, under Section 953, publicly-held corporations must also disclose every year to shareholders how executive pay is connected to executive performance.  Charts and graphs may be used.

Intra-Firm Income Disparity

Also, under Section 953, this annual disclosure must include (1) the median of all "total compensation" of all employees except the CEO; (2) the CEO's total compensation and (3) the ratio of (1) to (2).  (As an aside, I'm not sure if taking out the CEO's compensation in (1) is meaningful given the definition of "median" and the number of employees in most publicly-held corporations, but that's just an aside.)


Our old friend Sarbanes-Oxley provided that in the event of an accounting restatement, that CEOs and CFOs would have to reimburse the company for any bonus or other incentive-based compensation (including stock options) earned during a 12-month period after the erroneous financial statements were certified.  Dodds-Frank expands this to any executive officer returning incentive-based compensation received up to three years before the date of the restatement.  However, this clawback is not an SEC enforcement mechanism; the clawback rule is required to be a policy of each company's compensation structure.

My problem with most regulation of executive compensation is that it is regulating where the streetlamp is shining.  We know who an executive officer is and who it isn't -- it's a discrete group.  But the great bulk of the risk-taking is done by nonexecutives.  The real players who have a lag in between their being compensated on projects and the fulfillment of those projects (investments, trades, etc.) are generally not executives.  The traders who were in line to get multi-million bonuses in 2008 and 2009 and who were lambasted in the press were not executives.  But, this is an easy bone to throw at the clawback contingency.

We Hate Speculators and Those Who Would Bet Against Us

Section 955 requires ocmpanies to disclose employees and directors who engage in hedging investments regarding company stock.  So, never mind when employees' retirement accounts are frozen and they can't sell company stock even when everything is going to heck in a handbasket.  They can't hedge, either.

Systematic Risk

Under Section 956, the "appropriate federal regulators" will promulgate new rules for "covered financial institutions" to disclose their inecentive-based compensation arrangements so that these appropriate federal regulators can determine whether their compensation arrangements for executives, employees and directors is "excessive" and whether they "could lead to material financial loss."  Because if a company can't see that all flags are pointing toward material financial loss, I'm pretty sure that appropriate federal regulators can.

And just before you thought that all these "Improvements to the Regulation of Securities" were mere disclosure items, nonbinding votes and window dressing, wait.  These appropriate federal regulators will also promulgate new rules for covered financial institutions that will prohibit these compensation arrangements that "encourage inappropriate risks."  Now, if we only had a good rule that told us when compensation was excessive and when a risk was inappropriate. 

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