Ask the Expert: Executive Compensation

David Swinford, president of Pearl Meyer & Partners, addresses the implications for executive compensation in the financial meltdown and recently passed Emergency Economic Stability Act.

Q: What effect is the economic crisis having on boards? How is it changing their priorities?

A. Directors are refocusing on a few specific areas. Many are looking at how to deal with pay for underperformance and how to properly compensate top executives until their companies can make money again. Another area is retention. Right now, there is less competition for executive talent across many industries, so a company that wants to invest ahead of the turn of the cycle can effectively recruit by, for example, offering stock options to people who are holding underwater options in their own companies. Going forward, Directors also will be focusing a lot more on risk management in a broader sense. Directors need to get a better handle on risk – not just how much risk the incentive plan encourages, but how much risk the company has actually taken on. It’s quite obvious that a lot of directors, and not only at financial services firms, didn’t fully understand their organizations’ level of risk. Think about the companies that didn’t see their major investments in Lehman paper as a potential problem down the road.

There’s no question that a new Congress and a new Administration will pay close attention to executive pay as they deal with the deficit and our tax issues. I think we may even see a “shareholder bill of rights."

                                                       --David Swinford, Pearl Meyer & Partners

Q: What are the implications for executive pay in the rescue package?

A: Clearly, the most intellectually interesting concept is the provision that prohibits unduly risky incentive plans at companies that participate in the bailout plan. The law limits executive compensation at companies that Treasury invests in, either by purchasing troubled assets or buying equity or preferred debt. But Treasury will first have to define “unduly risky.” It is intellectually interesting because it addresses the danger that incentive plans that don’t have governors will send people off in directions that aren’t so good. As we see in the current crisis, some companies had created unlimited upside for profits through the design of new financial products that no one really understood. The result was runaway incentive programs. Other pay restrictions related to parachutes and deductibility limits will have only a minor impact on pay program design.

Q: What about the expansion of clawbacks?

A: Right now, SOX stipulates the right to a clawback when there is fraud or a restatement of earnings , but only for the CEO and CFO. The EESA expands that concept to include all named executive officers in the proxy. What’s not clear is how big a mistake needs to be made for a clawback to be allowed. Also, SOX limited clawbacks to 12 months, while under the bailout plan clawbacks at companies that sell assets to the Treasury are unlimited.

Q: The EESA also prohibits golden parachutes, right?

A: Yes and no, depending on the extent of Treasury’s involvement with the company. If a “direct purchase” is made, then all parachute payments are prohibited as long as Treasury holds the position. In an “auction purchase” situation, however, current parachute commitments may be honored, but no new ones may be adopted. Exactly how this rule will apply to the healthy banks in which Treasury is investing is being worked out as we speak.

Q: What are the other pay implications for non-financial firms raised by the law?

A: There is general agreement in Congress that imposing at least some limits on executive compensation is appropriate. Even the Administration, which previously supported unrestrained executive pay, gave in on this point very quickly. All of these areas are now vulnerable to change. There’s no question that a new Congress and a new Administration will pay close attention to executive pay as they deal with the deficit and our tax issues. I think we may even see a “shareholder bill of rights,” possibly including the Say on Pay concept that was part of the original bailout package, but was dropped before passage.