The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISUSA-style pay as the “highest common denominator” (where by “highest” we mean in termsof generosity not efficiency). However, while we would not advocate full convergence to theUSA model (which has its own problems), we believe that movement “towards” the USAfocus on pay for performance would be good for shareholders on both continents.Our calls for less rather than more regulation is not meant to indicate support for thestatus quo, but rather the reality that increased intervention is much more likely to makethings worse rather than better. We perceive major problems with European-style executivepay packages, and are especially concerned with the lack of alignment between CEO andshareholder interests. <strong>The</strong> solutions to these problems will best emanate from boards ofdirectors and compensation committees, and not from the governments. Ourrecommendations for European firms include:• Boards should increase the percentage of compensation paid in the form of restrictedstock, performance shares, or stock options. To the extent the new elements are largelyadded on top of existing compensation plans (i.e., without reductions in base salaries orbonuses), they should come in the form of performance shares or performance-vestingoptions. Restricted shares are appropriate when the grants are accompanied by areduction in base salaries.• Boards should encourage executives to exchange part of their base salaries for restrictedshares, offered at a reasonable discount.• If stock options are granted, the exercise date should be specified in advance and not leftto the discretion of the executive.• Boards should enforce stock ownership guidelines or provide incentives for executives tohold equity well past the time when restricted shares vest or options become exerciseable.• To the extent feasible, bonus formulas should provide for symmetric rewards andpenalties. Symmetric rewards can be facilitated by reducing base salaries whileincreasing target bonuses: bonus payouts “below target” even when positive constitutepenalties for poor performance.• Some portion of annual bonuses should always be deferred to allow for recovery ofrewards if and when there is future revision of critical indicators on which the rewardswere based or received. (While especially relevant for financial companies, thisrecommendation can be applied to all companies.)-123-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS• Similarly, some portion of annual bonuses should be paid in shares that are subject toforfeiture if and when there is future revision of critical indicators on which the rewardswere based or received.• Even if not mandated by the government, Boards should make disclosures of individualcompensation packages (including details on grants and holdings under equity-basedplans) as recommended by the European Commission.Given the recent financial meltdown and controversies involving the “bank bonussector,” the banking sector warrants special consideration:• Our recommendations for boards to impose symmetric rewards and penalties (includingthe imposition of “negative bonuses” through deferred payments, bonus banks, and bonuspayments in the form of stock) is especially critical in banking, since the scope ofmanipulating short-run vs. long-run performance metrics is arguably higher in this sector.• Similarly, our recommendations for boards to introduce and enforce “clawback”arrangements allowing for recovery of ill-gotten rewards is also especially important forthis sector.However, we believe that calls for especially stringent reforms or punitive taxes onbanking bonuses are misguided and ultimately counter-productive:• While we conclude that it is “especially important” for banks to have bonuses that aremore “symmetric,” deferred, performance-contingent, and paid in restricted shares aswell as cash – coupled with smaller base salaries (as a percentage of total pay) and higherbonus opportunities – we also find that banking CEO pay in both the USA and Europeare already are better-aligned with our recommendations compared to CEOs in othersectors.• While it is a fact that pay in the banking sector over the past two decades has increasedrelative to pay in other sectors, we also recognize that there is no direct empiricalevidence (and not for a lack of trying) that this either the level or structure of pay inbanking was an important factor leading to the financial crisis.• Moreover, while there are arguments (albeit little evidence) that the level of CEO payreflects CEO influence over their own pay levels, compensation levels and structures forbanking employees well below the top executive levels are clearly set in a competitivemarket, reflecting the highly specialized skills in understanding and trading inincreasingly complex derivative instruments. Overall, regulating compensation in-124-
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