[Senate Hearing 112-477]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-477




                               before the

                            SUBCOMMITTEE ON

                                 of the

                              COMMITTEE ON
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             SECOND SESSION




                           FEBRUARY 15, 2012


  Printed for the use of the Committee on Banking, Housing, and Urban 


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                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director
              William D. Duhnke, Republican Staff Director
                       Dawn Ratliff, Chief Clerk
                     Riker Vermilye, Hearing Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor


     Subcommittee on Financial Institutions and Consumer Protection

                     SHERROD BROWN, Ohio, Chairman

            BOB CORKER, Tennessee, Ranking Republican Member

JACK REED, Rhode Island              JERRY MORAN, Kansas
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MIKE JOHANNS, Nebraska
DANIEL K. AKAKA, Hawaii              PATRICK J. TOOMEY, Pennsylvania
JON TESTER, Montana                  JIM DeMINT, South Carolina
HERB KOHL, Wisconsin                 DAVID VITTER, Louisiana
KAY HAGAN, North Carolina

               Graham Steele, Subcommittee Staff Director
         Michael Bright, Republican Subcommittee Staff Director
                    Kara Stein, Legislative Counsel


                            C O N T E N T S


                      WEDNESDAY, FEBRUARY 15, 2012


Opening statement of Chairman Brown..............................     1

Opening statements, comments, or prepared statements of:
    Senator Corker...............................................     2


Kurt Hyde, Deputy Special Inspector General for the Troubled 
  Asset Relief Program...........................................     4
    Prepared statement...........................................    26
Lucian A. Bebchuk, William J. Friedman and Alicia Townsend 
  Friedman Professor of Law, Economics, and Finance, Harvard Law 
  School.........................................................     5
    Prepared statement...........................................    32
Robert J. Jackson, Jr., Associate Professor of Law, Columbia Law 
  School.........................................................     7
    Prepared statement...........................................    37
Michael S. Melbinger, Partner, Winston & Strawn, LLP.............     9
    Prepared statement...........................................    44




                      WEDNESDAY, FEBRUARY 15, 2012

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
       Subcommittee on Financial Institutions and Consumer 
                                                    Washington, DC.
    The Subcommittee met at 2:10 p.m., Room SD-538, Dirksen 
Senate Office Building, Hon. Sherrod Brown, Chairman of the 
Subcommittee, presiding.


    Chairman Brown. The Subcommittee will come to order. Thank 
you. At least three fourths of the witnesses, thank you for 
joining us. Mr. Jackson we think we might have made a mistake 
in notifying him of time. So, we think he will be here by 2:30 
but we will proceed and my special thanks again to Senator 
Corker, the ranking Member, who has been terrific to work with.
    I apologize at the outset. I will do the opening statement. 
Senator Corker will do his. We will start the questioning. I 
have a Federal judge nominee from Toledo, Ohio, that I need to 
introduce in the Judiciary. I will go down for half an hour and 
come back and Senator Reed will preside too and Senator Corker 
will be here through part of that.
    So, thank you all for this. I will make a brief opening 
statement and then introduce Senator Corker and then introduce 
the witnesses.
    In 1933 the Pecora Commission, as we know, investigating 
the causes of the 1929 stock market crash calls its first 
witness, Charles Mitchell, the CEO of what is now Citibank.
    His testimony revealed he had paid himself and his top 
officers millions of dollars from the bank in interest-free 
loans. As a result of this testimony, Mr. Mitchell was 
    We are here today to examine his successors in the role 
that what we think excessive and risky compensation packages 
played in causing the financial crisis.
    During the 1970s, average compensation for a CEO was about 
30 times the average pay of a production worker in his company. 
By 2007, CEO compensation had increased to nearly 300 times 
that of the average worker.
    According to Thomas Philippon of NYU and Ariell Reshef of 
the University of Virginia, workers in the financial sector are 
paid a 40 percent wage premium above their counterparts in 
other industries.
    In 2007, major Wall Street banks paid an estimated $137 
billion in total compensation, roughly $33 billion in year-end 
bonuses alone. A significant portion of this compensation has 
come in the form of stock options that both encourage risk-
taking and provide banks with special tax loopholes that 
Senator Levin and I have sought to close.
    In part because of these payment schemes, the largest banks 
engaged in risky activities and took on leverage as high as 30 
to 1 or 40 to 1.
    Mr. Jackson, thank you for joining us and we are sorry if 
the mixup was ours on the times. So, sorry about that.
    The evidence suggests that bank executives were not being 
paid based upon the merits of their work unless there is merit 
to creating the financial crisis that we have lived through.
    The average total compensation for CEOs in some of the 
largest TARP recipients, the average compensation was 
approximately $21 million.
    A study by Linus Wilson of the University of Louisiana at 
Lafayette shows that CEOs of banks that received emergency debt 
guarantees from FDIC were paid an average of $4\1/4\ million 
more than CEOs of banks that did not receive FDIC support.
    Is it any wonder that Federal Reserve Chairman Bernanke 
says that banks compensation practices led to misaligned 
incentives and excessive risk-taking contributing to bank 
losses and financial instability.
    So, today we ask what, if anything, has changed in terms of 
Wall Street pay; what, if anything, can be done to rein in the 
excess and dangerous incentives. It is not so much just that, 
you know, you might argue they are overpaid. It is the 
incentives that this seems to bring that help bring our economy 
to the brink of collapse.
    The Dodd-Frank Act provides a framework for reforming pay 
practices at Wall Street megabanks. Title IX of Dodd-Frank 
enacts important corporate governance reforms to address 
compensation practices including disclosure in, quote, say on 
    Section 165 provides the Fed with authority to impose risk 
management standards or other prudential necessary for large 
complex financial companies.
    It appears that significant tools exist for regulators to 
put an end to the ``heads I win, tails the taxpayer loses'' 
compensation packages. I look forward to hearing and our 
witnesses' comment on any and all of this as we analyze this.
    And I will hand it over to Senator Corker.
    Thank you, Bob.


    Senator Corker. Thank you, Mr. Chairman, and I thank all of 
you for being here. I know we have looked at your testimony in 
advance and I am sorry. This is really unusual what is 
happening today.
    But on the issue of compensation, I know that in Dodd-Frank 
we actually put in place a lot of provisions to deal with 
compensation at financial institutions. It is my understanding 
that that is being complied with and it is working.
    I know personally on the claw back provisions I was very 
involved in ensuring that those kind of things took place so I 
am not sure exactly what the problem is now because it seems 
that we kind of dealt with that during the legislative process 
when we looked at some of the incentives that the Chairman is 
referring to.
    But I hope in your comments that if you are considering 
something in addition to what has already been put forth that 
you will help us think through what we do with the auto 
industry which obviously received a whole lot of money that 
looks like it is never going to be paid back, the real estate 
industry that we subsidize hugely in this country, maybe 
realtor fees, appraiser fees. Maybe you can help us with some 
of the wind companies that receive huge subsidies from the 
Federal Government.
    So, as you think about these issues, I hope it will not be 
only focused on the financial industry in the context of just 
the big reach that the Government has as it relates to 
providing certainly a lot of help to a lot of industries; and I 
say that obviously slightly rhetorically, if you get my point.
    But I look forward to your testimony and I am glad to be 
    Chairman Brown. Well, Senator, I get your point so that is 
good. Thank you, Bob.
    Let me introduce the witnesses and we will begin the 
testimony and about halfway through I will step out and then 
come back and Senator Corker and Senator Reed will be here 
    Kurt Hyde is SIGTARP's Deputy Inspector General, Special 
Inspector General for Audit. He began his Government career as 
an audit manager for the GAO and later was detailed to the U.S. 
House of Representatives Commerce Committee's Subcommittee on 
Oversight Investigation, on which I sat, which was one of the 
most interesting subcommittees in the House, where he 
investigated property and casualty insurance company failures.
    He also served as Deputy Assistant Inspector General for 
Audit at the Resolution Trust Corporation, charged with 
unwinding failed S and Ls.
    Lucian Bebchuk is the William Friedman and Alicia Townsend 
Friedman Professor of Law, Economics, and Financial and 
Director of the Program on Corporate Governance at Harvard Law 
    His research focuses on corporate governance, law, finance 
and the law and economics. He served as a consultant to the 
Treasury Department's Office of the Special Master on Executive 
    Robert Jackson, Associate Professor at Law at Columbia 
where his research emphasizes empirical study of executive 
compensation and corporate governance matters. Before joining 
the faculty in 2010, Professor Jackson served as an advisor to 
senior officials at Treasury and the office of Special Master 
for TARP executive compensation.
    Before that, he practiced in the executive comp department 
of Wachtell, Lipton, Rosen and Katz.
    Michael Melbinger is a partner in the law firm of Winston 
and Strawn and global head of the firm's executive compensation 
and employee benefits practice. Mike practices exclusively in 
the area of executive compensation and employee benefit issues 
for corporations, partnerships, executives, boards of 
directors, and by fiduciaries.
    He is also an Adjunct Professor of Law at Northwestern 
University School of Law and was commenting on Chicago weather 
    Thank you to all of you. And if you will begin Mr. Hyde, 
thank you very much for joining us.


    Mr. Hyde. Thank you, Chairman Brown, Ranking Member Corker. 
I am honored to appear before you today on behalf of SIGTARP. 
The subject of financial sector pay packages is important and 
timely and I commend the Committee for examining it.
    SIGTARP recently issued a report on employee compensation 
at seven companies whose TARP assistance stood out as 
exceptional. They were Bank of America, Citigroup, AIG, and the 
auto companies, General Motors, Chrysler, Chrysler Finance, and 
Ally Financial.
    The legislation approving TARP contained important limits 
on compensation for TARP recipients. SIGTARP reported that 
after major TARP recipients paid billions in bonuses for 2008, 
the President announced a cap of $500,000 on cash salaries at 
TARP exceptional assistance companies. Congress set limitations 
on compensation for TARP recipients and Treasury created a 
special master charged with setting pay for TARP 25 employees 
at the seven companies.
    After analyzing the special master's decisions, SIGTARP 
found that the special master could not effectively rein in 
excessive compensation at those companies because he was under 
the constraint that his most important goal was to get the 
companies to repay TARP.
    Although generally the special master limited cash and made 
some reductions, the special master approved total compensation 
in the millions with 49 individuals receiving told compensation 
of more than $5 million from 2009 through 2011.
    Former Special Master Kenneth Feinberg said that he was 
pressured by the companies and by Treasury to let the companies 
pay executives enough to keep the company's competitive.
    The TARP companies proposed TARP high pay packages based on 
historical pay, failing to take into account the position that 
they had gotten themselves into that necessitated taxpayer 
bailout. Rather than view their compensation through the lens 
of partial Government ownership, they argued that the proposed 
pay packages when necessary to retain or attract employees.
    AIG which, according to the Special Master Feinberg, 
constituted 80 percent of his headaches and actually proposed 
cash salary raises for the top 25 employees.
    The special master set pay based on what he called 
prescriptions including that they should be at the 50th 
percentile for similarly situated employees and that cash 
salaries should generally not exceed $500,000, with any 
additional compensation paid in stock or long-term incentives.
    SIGTARP found that the special master awarded cash salaries 
greater than $500,000 to 11 individuals in 2009 and 22 
individuals in 2010 and 2011.
    The special masters determinations are not likely to have a 
long-lasting impact at the companies. Bank of America and 
Citigroup exited TARP in part to escape OSM's compensation 
restrictions. Only AIG, GM, and Ally remained under those 
restrictions, and OSM will set 2012 pay for these coming up in 
    One conclusion of SIGTARP's review is that regulators 
should take on an active role in monitoring factors that could 
contribute to another crisis. Federal regulators have stated 
that executive compensation practices were a contributing 
factor to the financial practice because it encouraged 
excessive risk-taking.
    Financial institutions should reform their compensation 
practices to restrain excessive risk-taking that could threaten 
the safety and soundness of the institution or that could have 
systemic consequences. However, for the seven companies 
reviewed by SIGTARP, in only a few rare instances did the 
companies take it upon themselves to limit pay.
    Federal banking regulators are our monitoring compensation 
using a principals-based approach focusing on the limiting 
risk. In October 2011, the Federal Reserve reported progress by 
the largest institutions in reforming compensation but that 
significant progress remains.
    In addition, the Dodd-Frank Act requires regulations on 
compensation. However, many of these regulations are not final 
and their effectiveness remains to be seen. The regulators 
strength and leadership in this area is critical.
    Chairman Brown, Ranking Member Corker, and Members of the 
Committee, thank you again for this opportunity to appear 
before you and I will be pleased to respond to any questions.
    Chairman Brown. Thank you very much, Mr. Hyde.
    Professor Bebchuk.

                       HARVARD LAW SCHOOL

    Mr. Bebchuk. Chairman Brown, Ranking Member Corker, 
distinguished Members of the Subcommittee, I am honored to be 
testifying today on this important subject.
    This is discussed in detail in my written testimony. There 
is a basis for concern that pay structures have contributed to 
the financial crisis. To help bring about desirable 
improvements and pay structures, regulators should strengthen 
the proposed rules that they issued last April in ways that I 
will presently discuss.
    The focus of my comments will be on compensation of senior 
executives. This compensation is especially important because 
senior executives not only make key decisions but also 
influence the setting of incentive compensation for others in 
the firm.
    One problem with past practices is that they have provided 
excessive incentives to focus on the short term. Executives 
were rewarded for producing short-term gains even when doing so 
created an excessive risk of an implosion later on.
    To illustrate, a study that I coauthored with colleagues 
documented that notwithstanding the 2008 meltdown of Bear 
Stearns and Lehman Brothers, the top five executives of these 
two firms took enough compensation off the table during 2000 
through 2007 so that their bottom line for that period of 2000 
through 2008 was decidedly positive and substantially so.
    Going forward, regulators should ensure that equity-based 
compensation, the principal components of incentive 
compensation for senior executives will be tied to long-term 
results. Such regulations would serve both financial stability 
and the long-term interest of shareholders.
    In my view, it is important for regulators to require firms 
to separate the times that options and restricted shares can be 
cashed from the time in which such shares and options vest. 
Firms should require executives to hold equity incentives for a 
fixed number of years after vesting. Firms should also adopt 
aggregate limitations that would restrict the fraction of the 
executive's portfolio of equity incentives that could be 
unloaded in any given year.
    In addition, regulators should require financial firms to 
adopt robust limitations on hedging and derivatives 
transactions that senior executives could use to reduce the 
extent to which they would lose from a decline in the firm's 
stock price. Executives should not be able to use such 
transactions to undo the incentive consequences of the pay 
structure that was set for the executives.
    Another feature and a separate feature of pay arrangements 
that has produced excessive risk taking incentives is the 
exclusive focus on shorter interest. Payoffs to financial 
executives have not attempted to internalize consequences that 
losses could impose on parties other than shareholders such as 
preferred shareholders, bondholders, depositors, or the 
Government as the guarantor of deposits. This gave executives 
incentives to pay insufficient attention to tailor risks and to 
the possibility of very large losses.
    To address these problems, regulators should adopt rules 
that would induce firms to make the incentive compensation of 
senior executives depend significantly on long-term payoffs to 
the banks nonshareholder stakeholders and not only on the 
payoffs of shareholders.
    To this end, firms could tie executive payoffs not only to 
stock price increases but also to increases in the value of 
other securities such as preferred shares and bonds.
    In seeking to induce firms to go in this direction, 
regulators should recognize that the risk-taking incentives 
that are optimal from the shareholders' perspectives and that a 
shareholder regarding both would seek would likely be excessive 
from a social perspective.
    Thank you. I look forward to your questions.
    Chairman Brown. Thank you.
    Professor Jackson, welcome. Thank you.

                    LAW, COLUMBIA LAW SCHOOL

    Mr. Jackson. Chairman Brown, Ranking Member Corker, and 
distinguished Members of the Subcommittee, thank you so much 
for the opportunity to testify today about incentive pay at 
America's largest financial institutions.
    We have learned from hard experience, I think, that 
bankers' pay is a source of concern for all Americans, and so I 
welcome your invitation and am honored to be here today.
    The financial crisis brought into sharp relief the dangers 
associated with bankers' incentives, and in 2010 Congress 
responded with the Dodd-Frank Wall Street Reform and Consumer 
Protection Act which included, as you mentioned today, several 
important new rules on executive pay.
    Many of those rules, like the ``say on pay'' provisions 
that give shareholders a voice for the first time in setting 
executive compensation, have been the subject of quite 
considerable public debate.
    But the most expansive pay-related provision in Dodd-Frank 
has received much less attention. That provision, Section 956, 
gives nine Federal agencies including the Federal Reserve, the 
FDIC, and the Securities Exchange Commission unprecedented 
authority to ensure that bonus practices at our largest banks 
never again endanger financial stability.
    In Section 956, Congress and the Administration gave 
Federal regulators the broad powers they will need to ensure 
that bonuses do not again threaten the safety and soundness of 
America's financial system.
    Now, last April the agencies proposed rules to implement 
these important provisions, and unfortunately the proposals 
fall a good deal short of the rigorous oversight of pay that 
Congress has authorized.
    In this testimony, I am going to provide three reasons why 
the Subcommittee should not expect this to change bonus 
practices at America's largest banks, and I am going to give 
four suggestions for reform that would help ensure that bonus 
structures never again give bankers reason to preserve long-
term value creation, to give bankers reason to pursue long-term 
value creation rather than short-term profits like those that 
led to the crisis.
    First, although the rules require bankers to receive their 
bonuses over time so that more can be known about the risks 
they have taken before they get paid, these rules apply only to 
a few top executives. Yet, one of the few clear lessons from 
the crisis is that bankers who are not executives can cause a 
great deal of systemic damage.
    None of the employees at the American International Group's 
Financial Products Division, the unit that contributed to the 
system's collapse, was an executive, for example, nor was the 
Citigroup trader who are more than 100 million in bonuses in 
the years running up to the crisis.
    If those bankers were doing today exactly what they did 
before the crisis, the key rules under Section 956 would not 
apply to their bonuses.
    Now, Congress and the Administration understood that these 
bankers' bonuses are important, and that is why the Treasury 
Department's rules on executive compensation and the Congress's 
rules on executive pay at TARP firms apply to well beyond the 
executive suite. But unfortunately the Section 956 rules do not 
and so bonuses remain unregulated for key risk-takers in our 
financial system.
    So, my first recommendation is that these new rules on 
bankers' bonuses should apply to all risk-takers, not just 
executives. Now, that is not to say that executives' incentives 
are not important. They certainly are.
    But the agency's rules for executives under 956 are no 
different than the ways that banks have paid executives for 
many years. Indeed, as I pointed out in my written testimony, 
the evidence on executive pay shows that large banks required 
executives to defer more pay between 2002 and 2006 than the 
rules would require today; and in many ways, the rules lag 
behind pay practices that banks are using right now to address 
    For example, the rules do not prohibit hedging, that is, 
the use of derivatives to undermine bankers' incentives. Many 
large U.S. banks have prohibited executives from hedging for 
years and the evidence shows that if they are allowed to do so, 
they will.
    Perhaps the most prominent example of hedging involved CEO 
Hank Greenberg of AIG who hedged about $300 million worth of 
stock in 2005 and avoided millions of dollars in losses when 
the firm collapsed in 2008.
    That is why the Office of the Special Master at Treasury 
has prohibited hedging at all the firms under its jurisdiction, 
but the rules under 956 do not stop executives from doing that.
    So, my second suggestion would be that these rules should 
be changed to regulate executive pay in a way that does more 
than the current bank practices already do.
    Finally, the last problem with these rules is that the way 
the rules are arranged, banks are entitled to make two key 
decisions that should not be left to the banks: first, picking 
out the individuals who take the risks that threaten the 
system, and the second, deciding how those bankers should be 
paid. Neither decision should be left to the banks.
    As I point out in my written testimony, at the height of 
the crisis just six of America's largest banks had more than 
1.3 million employees, 4,500 of whom received bonuses greater 
than $1 million in that year. It is hard to identify in that 
massive group exactly who was taking the risk that endangers 
our system.
    But the regulators have left the decision to identify those 
individuals to the banks themselves and, more importantly, they 
have left the decision as to how those bankers should be paid 
to the boards of directors of banks.
    The problem with that is that the boards of directors of 
banks owe their duties to the shareholders of the banks and, as 
Professor Bebchuk has pointed out, shareholders will want banks 
to take excessive risks from a social point of view.
    The last problem with the proposed rules is that they do 
not require banks to disclose detailed information about bonus 
structures. The current rules only require a qualitative 
disclosure rather than a quantitative disclosure. Because 
regulators need to know the numbers to understand bonus 
compensation at America's banks, I suggest the rules be changed 
to require quantitative detail on that subject.
    Thank you, again, for the opportunity to testify today. I 
will be pleased to answer your questions.
    Chairman Brown. Thank you, Professor Jackson.
    Mr. Melbinger. Thank you.


    Mr. Melbinger. Chairman Brown, Ranking Member Corker, and 
Members of the Subcommittee, thank you for the opportunity to 
address the subject of compensation practices at financial 
institutions including, hopefully, the creation of appropriate 
pay-for-performance and building the right structure for 
incentive compensation.
    As you know, my name is Mike Melbinger. I chair the 
employee benefits and executive compensation practice at the 
international law firm of Winston and Strawn. We represent 
companies and the boards of directors, and I have done that for 
29 years.
    I appeared today on behalf of the Financial Services 
Roundtable. The Roundtable is a national trade association that 
represents 100 of the Nation's largest financial service 
    In my oral testimony today, I would like to highlight just 
the three key points on the topic of today's hearing that are 
elaborated upon in my written testimony.
    The first and I think most important point that I want to 
make is that large financial institutions have embraced 
principles of safety and soundness and profoundly changed their 
compensation policies and practices since 2008.
    Like everyone else, they learned important lessons from the 
financial crisis. Boards and management at these institutions 
have taken those lessons very seriously. They have taken the 
new rules very seriously and they are working very hard to 
comply with them and to improve their practices.
    But they have also transformed their compensation practices 
and policies not just in response to lessons learned but also 
in response to the Dodd-Frank Act, the 2010 interagency 
guidance, the proposed interagency guidance under Dodd-Frank, 
and also I do not want to discount pressure from institutional 
investors and their advisers like to ISS, Glass Lewis, the 
large pension funds.
    The second point I want to make is that financial 
institutions have made both directional and attitudinal changes 
in their compensation practices, dramatically in most cases.
    In my testimony, my written testimony, I cite a survey of 
the Roundtable of its membership taken last year in which 100 
percent of the institutions reported that since 2008 they have 
significantly revised their compensation practices.
    Other findings of the survey which I think are borne out by 
nearly daily reports in the press over the last 12 months, are 
that overall levels of compensation in the industry are down. 
Annual bonuses have come down. Perquisites and benefits and 
contractual protections like golden parachutes, SERPs, things 
like that, are down. And these findings are similar to the 
Federal Reserve Board study that was mandated by Dodd-Frank 
that was mentioned a minute ago.
    The third and last point I would like to make is that 
financial institutions today have actually taken on the role of 
thought leaders in corporate America on issues such as pay-for-
performance and mitigating the potential risks created by 
incentive compensation.
    Now, in my experience nearly every public company in 
America has worked to improve its practices, compensation 
practices since 2008. But no other industry has had the focus 
and, frankly, the regulatory push that the financial industry 
has had in this director.
    So, for decades aligning executive pay with company 
performance has been a very important objective of compensation 
committees and boards of directors of both financial 
institutions and public companies but it is not that easy.
    I think that we all agree, however, that one effective way 
to align pay for performance is to design plans that avoid 
paying for short-term gains at the expense of true long-term 
performance; and in this area again, financial institutions are 
now leading the way. The world has changed for them 
    For this, Congress and the regulators deserve substantial 
credit. For example, Section 165 of Dodd-Frank was alluded to 
earlier, requires large financial institutions to establish a 
separate board-level risk committee. All the financial 
institutions have done that, establish a board-level committee.
    And risk oversight has become a major component of the role 
of boards and management, particularly in executive 
compensation. But in this area they are ahead of the curve, and 
it is like shareholder ``say on pay'', which was a financial 
institutions only provision that through Dodd-Frank has now 
spread to the rest of corporate America. I think that is where 
we are going with board-level risk committees, and that is why 
institutions are a bit out front.
    With that, I will conclude. Again, I appreciate the 
opportunity to provide his statement to the Subcommittee for 
its consideration and would be happy to respond to any 
questions on compensation the Subcommittee Members may have.
    Senator Reed [presiding]. Thank you very much. Senator 
Brown has to go to Judiciary to introduce a nominee or a 
witness and I would like to recognize the Ranking Member for 
    Senator Corker. Thank you, Mr. Chairman. I appreciate it 
and I thank each of you for your testimony, and for what it is 
worth I think the emphasis that each of you have made on long-
term success and compensation being based on longer-term versus 
short term results I just could not agree more with, and I 
thank you for that testimony.
    And as I said in my opening comments, what we are hearing 
throughout the industry is that regulations that were passed 
during Dodd-Frank that so many of us were involved in and 
especially in this area supported, maybe not other provisions, 
it sounds like that in the industry it is working and that 
people are transforming the way they are looking at incentive 
    Mr. Jackson, I know you were alluding to some of the 
rulemaking and I know that that is different than maybe what 
the industry is actually doing itself and I think what you said 
was is that, you know, we passed these laws, you wish the 
regulators would be a little more stringent in what they are 
putting out but that does not necessarily mean at this point, 
and we all know this can change. It does in cycles.
    At this point are you seeing anything in the actual 
industry in itself that is different than what Mr. Melbinger 
just said?
    Mr. Jackson. I think it is too soon to tell. I think Mr. 
Melbinger's testimony, his written testimony in particular, 
points to a survey of the financial institutions that indicates 
that some attitudes are changing, and that is important. No 
doubt about it, and you are right, sir; the law that you passed 
absolutely enables the agencies to change compensation 
practices in the industry.
    But I think my answer to you, Senator, would be that we 
should not leave it to the banks to do this, and there are two 
reasons why.
    First, the shareholders of the banks have reason to take 
excessive risk because their failure is insured by the 
Government both as the insurer of deposits and as a source of 
bailout financing.
    Second, we have evidence from just a few years ago that, if 
left to their own devices, the banks will engage in practices 
that turn out to involve substantial risk.
    So, even though I am encouraged to learn that things may be 
changing in the industry, I think one lesson from the crisis is 
that we should not leave it to the banks to monitor themselves 
when it comes to compensation, and I am afraid that the current 
rules do just that, sir.
    Senator Corker. It is interesting. I think most people on 
this Committee would dispute the notion that you just mentioned 
about the bailout component. I think one of the things we tried 
to do is ensure that if an institution failed there was a 
resolution authority to actually take it out and I think that 
is in place; and while it is not in perfect, hopefully what you 
just said would not be the case.
    I do not know if you want to speak, professor, regarding 
what was just said.
    Mr. Bebchuk. Sure. A couple of points. One is I agree what 
you just said, Senator, that the future about bailouts might be 
very different and importantly so.
    However, we would all agree that financial institutions 
still have important possible externalities over the 
environment even with the reforms that have happened; and as 
long as there are systemic externalities, we have to be 
concerned that firms would not do what is optimal systemwide.
    So, in the same way that we cannot count on firms to make 
the right choices with respect to capital levers so that we 
restrain their choices, we have to understand that compensation 
choices can create risks in the same way that capital lever 
choices do and, therefore, we need to monitor and regulate 
    Second, you are right, Senator, that some firms have been 
improving but looking at the landscape, we see many firms where 
some arrangement that Mr. Melbinger said are good and people 
generally will recognize them to be good, many firms still do 
not have.
    So, many firms still do not have a prohibition on hedging 
by executives, and it is very hard to see any reason why this 
should be allowed.
    Similarly, you said that everything should be tied to the 
long term. There is a very big variation and many firms that do 
not do it in a substantial way.
    Senator Corker. Listen. I know my time is up here in just a 
few seconds but I do thank you for your testimony.
    I think we have to be careful. You know, populism is 
running pretty rampant right now, and that can really damage 
institutions. I know, you know, this is the political season 
and we talk a lot about the one and the 99 and all of those 
kind of things and people paying their fair share.
    But I would just like to emphasize that people like you 
that are opinion leaders that come out and testify, and you 
have done a very good job today, that we can carry this so far 
that we actually damage these institutions, and the folks that 
actually have the ability to lever these institutions actually 
move out into unregulated areas where they are not compensated 
this way.
    So, I would just ask that all of those who care about the 
safety of our financial system, I think some very good points 
have been made today, that is taken into account that populism 
can drive a lot of talent out that we want to see in the 
financial system.
    And I would agree, Mr. Professor, that if we had a systemic 
crisis in this country, the resolution authority that has been 
put in place probably would not work and we would be trying to 
figure out what in the world we are going to do with our 
financial system.
    So, I appreciate your comments and, Mr. Chairman, I thank 
you for leading me go first. I appreciate it.
    Senator Reed. Thank you so much, Senator Corker.
    Thank you, gentlemen, for your excellent testimony and for 
your both written and oral testimony.
    There is another aspect perhaps, Professor Jackson, 
following on your comments about why rulemaking is important. I 
think it dovetails on what Senator Corker also talked. It is 
the proverbial prisoners' dilemma, that is, at the height of 
this controversy we were asking financial executives why they 
were paying so much money, they would say, well, we just have 
to keep the talent. We are being driven, et cetera.
    So, unless we have a comprehensive set of rules, there will 
always be that temptation to say we know this is a crazy 
compensation package but, you know, we have got to keep the 
person here.
    Is that another factor that we have to consider?
    Mr. Jackson. Absolutely, Senator, I could not agree with 
you more. I think retention of these employees, particularly 
those who are overseeing systemically important decisions, is a 
very difficult challenge. It is one that the Office of the 
Special Master at Treasury faced and still faces, I think, and 
it is a very important challenge for these firms.
    What I would say about that is that makes the issue of 
rulemaking all the more important, Senator, because the 
lawmakers have an opportunity to guide the industry with 
respect to these practices which would give us more sort of 
comprehensive solutions that would make it more difficult for 
employees to move their capital from one firm to the other.
    I think we have to balance that consideration, as your 
question suggests, with the knowledge we all have that one size 
does not fit all, and I am not at all opposed to flexibility, 
but what we see in the existing rules, I think, is so much 
flexibility that I cannot really imagine what practices would 
change directly in response to these rules.
    As I pointed out in my written testimony, the current 
executives of banks were deferring more compensation in 2003 
than they are required to defer under the current rule under 
956. When I read the statute that you passed, Senator, it does 
not seem to me like that is what it requires.
    Senator Reed. Let me ask both Professor Bebchuk and 
Professor Jackson and if Mr. Melbinger wants to comment also 
    We are in an international economy and, again, another sort 
of looking back I will not say nostalgically looking back, is I 
can recall in the early 2000s where there was suggestions that, 
well, you know, if you do not let us do all of these things, 
pay these levels of compensation, more deregulation, we are all 
going to London. Now, I think the British have taken an even 
more aggressive posture toward regulation.
    So, I think, Professor Bebchuk, Professor Jackson, you 
might have some insights on what Great Britain and other 
countries are doing which makes frankly our efforts seem rather 
    Professor Bebchuk, do you have comments?
    Mr. Bebchuk. The Europeans go further than what we have 
done and I think it would be useful to, in this case, to look 
across the Atlantic and learn from their lessons.
    One thing that I do want to stress is the fact that there 
is competition would be a reason for us to be careful not to 
reduce pay levels too much, but it is never a reason to pay 
people in an inefficient way, in a way that produces risk-
taking incentives. That is never the case.
    Senator Reed. Professor Jackson.
    Mr. Jackson. I think there is no doubt at all that the 
British and the European Parliament has been more stringent 
than our regulators have been with respect to rules, and I want 
to point to a very specific way in which they are more 
stringent. That is what I think is most important.
    As I mentioned in my testimony, with respect to executive 
compensation there has been change over time, and I think many 
of the changes that Mr. Melbinger refers to in his testimony 
have to do with top executives' pay.
    For the folks who run these firms, they have had to 
disclose their pay for years. They are frequently the subject 
of public attention. I am not quite so concerned about their 
    What is critical is the few risk-takers under that level 
who make big decisions that can affect our systemic safety 
like, for example, the folks who worked at AIG Financial 
Products. No executives there but we learned the hard way how 
dangerous their decisions can be. Ditto for the Citigroup 
trader I mentioned in my testimony.
    The Europeans have made absolutely clear that for those 
individuals their risk-taking and their incentives, their 
bonuses will be subject to the same stringent rules that apply 
to executives.
    Our regulators have made a different decision. What they 
have said is that identifying who those people are and setting 
their pay is left to the banks; and in that way, among many 
others, I think our regulations are much less likely to prevent 
incentives for excessive risk-taking than those overseas.
    Senator Reed. Mr. Melbinger, any comments on this line of 
    Mr. Melbinger. Well, you are certainly correct that back in 
2000 going to a foreign-owned bank was a very viable 
alternative in the competitive marketplace. Nowadays it is 
still a risk of folks going across the street to a competitive 
institution or an unregulated entity, but I think our 
differences of opinion are very slight.
    We also agree that the Government should not be setting pay 
in a one-size-fits-all, but it should be focusing on improving 
practices. We are onboard with that.
    Senator Reed. Let me specifically raise the issue about 
hedging. As both Professor Jackson pointed out specifically is 
that I think most shareholders would be a little bit unnerved 
if they thought that someone was being hugely compensated with 
stock, their stock basically, was on the same time hedging it.
    Is that something that explicitly should be addressed in 
the rules from your standpoint as it apparently is not being 
    Mr. Melbinger. Well, there is a specific requirement in 
Dodd-Frank that institutions, well, all public companies 
disclose their hedging policies.
    Senator Reed. I am talking about individual executives, I 
    Mr. Melbinger. You mean whether it should be prohibited? 
Well, I think actually even in Professor Jackson's, I do not 
mean to put words in your mouth, but he think he pointed out 
that most institutions already have put in place those kinds of 
    Senator Reed. Which can be removed too. I mean that goes to 
the whole point about if we are going to have sensible rules 
that apply to everyone not just the most scrupulous 
organizations but all organizations, then I would think this 
notion of hedging at least disclosing the fact that while you 
are being compensated in this stock of the company that you are 
working for and presumably doing everything you can to drive 
the value up, you are betting it might or at least taking into 
consideration it might go down.
    Is that your point? Would you share that?
    Mr. Melbinger. Disclosure, yes.
    Senator Reed. Professor Jackson, disclosure, is that 
    Mr. Jackson. Well, I think disclosure is helpful, and I 
think Section 955 of Dodd-Frank, the section you mentioned 
earlier which requires disclosure, is helpful.
    That applies to all public companies, and it is not clear 
to me why we would want shareholders to have to sift through 
this detailed disclosure and discover exactly whether 
executives are engaged in this kind of hedging.
    Moreover, disclosure of a policy, which is what 955 
requires, is not the same, as you suggested earlier, Senator, 
as requiring individuals to show us that they have hedged.
    So, I do not think I would be satisfied actually with the 
disclosure requirement. I think it is clear that there is no 
sensible reason why shareholders or bank regulators, to be 
sure, would want bankers to be in a position to hedge their 
risk with respect to the stock of these companies.
    Senator Reed. Before I recognize Professor Bebchuk for his 
comments, I have the distinct impression from your last comment 
is that your opinion is that even regulators do not know who 
might be hedging against the stock of the company that they 
work for and are being compensated. Is that true?
    Mr. Jackson. Yes, sir. They have no way to know; and as I 
suggested in my testimony, one of the ways in which the rules 
are, I think, disappointing is the disclosure that the banks 
must provide to the regulators themselves.
    So, in the provision 956, Congress has said clearly that 
the regulators can ask anything they want to know about 
incentives at large banks; and I would think that the existence 
of hedging would be one of the things they want to know on an 
individual case-by-case, banker-by-banker basis.
    But instead, all the disclosure rules require is a written 
description, an essay about pay practices at the company; and 
so, in this way I think the disclosure rules fail to give 
regulators the type of information you are describing.
    Senator Reed. Professor Bebchuk please.
    Mr. Bebchuk. Yes, I agree with you, Senator, that we should 
not just stop at disclosure policies but just have as part of 
the agency's regulation a general requirement that firms do not 
allow hedging because, even though usually we like to say one 
size does not fit all, this is one of the rare instances in 
which there is really no good reason; and I do not know of 
anyone who has come up with a reason, why any company should 
allow a kind of general freedom for executives to hedge in an 
engaging derivative transactions because what those 
transactions do, they simply undo whatever the firm is setting 
in place.
    So, the firm is spending money to create some incentives 
and then the executive has the freedom to undo in a way that 
the company might not be fully aware of what those incentives 
are trying to accomplish.
    So, there is very little reason to allow this to happen.
    Senator Reed. Thank you.
    Mr. Hyde, you have had a lot of experience at the SIGTARP 
in terms of a lot of these issues. Can you give us your 
impression in terms of where we are with the regulations?
    And I share, I think, the sense of urgency, at least I have 
heard on some members of the panel that these regulations have 
to be strengthened, adopted quickly. Would that be your 
    Mr. Hyde. Right. We do think that. You know, I think the 
devil is in the details and I think it is important that the 
regulations do come out, that they are evaluated as to how they 
are performing.
    One of the things there is that there may be, you may have 
an intended objective with that regulation; but actually when 
they are put in place, they are not getting that intended 
    I just want to add a few things to this last discussion on 
    Senator Reed. Yes.
    Mr. Hyde. I personally do not believe that hedging, I mean, 
that disclosure is enough. I do think that if you look at AIG 
and AIGFP, it was the executives in AIGFP or the employees 
within AIGFP that caused a substantial problem for AIG. It was 
not the executives that would be reporting under disclosure of 
    So, we have got to get further down into the bowels of the 
corporation in order to assess what the risks are within that 
corporation and whether there are employees that are going to 
be putting that institution at risk.
    Senator Reed. Very good. There is another issue that comes 
up in the context of these proposed regulations and that is 
that some people have suggested in comments at least that I am 
aware of that the calculation of the senior executive pay vis-
a-vis the median pay is too complicated, et cetera; and I 
wonder if you have any opinions with respect to whether that is 
too complicated or whether, your comment.
    Mr. Hyde. Right. We did not look at that. I mean, I know 
that has just come out there; and again, I go back to what is 
the intent there and are you meeting that intended purpose of 
it; and I think we have got to, it is important for the 
Government to look at that; but we did not look at that here in 
these companies.
    Senator Reed. Professor Bebchuk, Professor Jackson, do you 
have any comments on sort of the technical aspects of this? Is 
it too complicated?
    Mr. Jackson. I think you are referring, Senator, to Section 
953(b) of the Dodd-Frank Act, which requires disclosure of the 
ratio between the amount of the CEO's compensation and the 
median employee of a large public company. I know there has 
been a great deal of debate about the cost of implementing such 
a rule.
    My intuition and my sense from talking to folks in the 
industry is that those costs are very real and that they raise 
serious implementation problems for the statute.
    My own sense is that they could be overcome, but what will 
be required is that the SEC have some flexibility about the way 
that the rule should be implemented.
    So, for example, some commentors have proposed that perhaps 
the company could be sampled to figure out the approximate 
median compensation rather than the exact median compensation. 
Or perhaps, some elements of pay could be included or excluded 
from the calculation to make the calculation more manageable.
    I think if the SEC engages in a careful cost-benefit 
analysis that limits the work the firms have to do, the rule 
could provide valuable information. They could comply with the 
letter of the law but still make it manageable for firms to do 
this without spending too much on it.
    Senator Reed. Anyone else, Professor Bebchuk, Mr. 
    Mr. Bebchuk. I think this is one area where regulators 
should definitely accommodate the industry. It is one of the 
issues on which the precision is not going, I mean, there are 
some things that would make this reporting limited in its 
precision anyway; and therefore, I would support making an 
effort to kind of require making this calculation in a way that 
would economize as much as possible on cost implementation.
    Senator Reed. Anyone else in this disregard? Mr. Melbinger.
    Mr. Melbinger. I agree.
    Senator Reed. Thank you. Let me raise a final topic. I am 
anticipating Senator Brown's arrival momentarily. I know he has 
    But we recently saw, and this is a related point because 
there is at least a possibility that whatever regulation is 
proposed it will be challenged in court.
    And most recently the Circuit Court of Appeals in 
Washington, DC, rejected the SEC rule with respect to proxy 
access for investors to nominate a director based on sort of an 
interesting logic.
    So, I wonder if you have looked at the case, Professor 
Jackson, if you have a view, or Professor Bebchuk, not only 
about that but also what the agencies have to do now in order 
to be sure that their well thought out regulations are upheld.
    Mr. Jackson. I think I would make three points about that, 
Senator. First, I have read the opinion and what the DC Circuit 
has said, very clearly I think, is that the SEC is responsible 
for assessing the cost and benefits of any new rules including 
those that you have instructed them to enact in the Dodd-Frank 
    And I think as far as it goes, that is unobjectionable, of 
course. I mean, there is a relevant statute that requires the 
SEC to take account of costs and benefits.
    The question is the level of precision with respect to 
which the court should demand the SEC to undertake that 
analysis, and there is some debate about that. The DC Circuit 
opinion describes it.
    But the first thing I would say is I would expect over time 
the courts to recognize the necessary imprecision of the study 
of costs and benefits and to accommodate the SEC's best efforts 
to undertake that work.
    So, I think, first, the SEC should not expect every opinion 
to look like that proxy access opinion that you were referring 
to earlier.
    Second, I think in order to engage in the kind of very 
precise cost-benefit analysis that the DC Circuit has 
described, the SEC needs people who can do it; and for that 
they need budget, sir. They need to hire substantial staff so 
that they can engage in the work that they have been asked to 
do by the DC Circuit; and my intuition about reading the 
opinion is that this kind of work would be very difficult.
    It is the kind of empirical work I do in my own research 
and it is challenging; and I think the SEC will need additional 
resources to do it.
    The third thing I would say is that to the extent the SEC 
has an opportunity to promulgate a rule on a temporary basis 
and observe its costs and benefits and use that as a way to 
answer the DC Circuit and its concerns about costs and 
benefits, it should explore that.
    Scholars have been saying for some time actually that a 
rule could be issued temporarily to see what happens in the 
markets in response to costs and benefits, and the SEC can use 
that information in its work.
    It has not yet done that and I can understand why. But I 
think the proxy access opinion should give the SEC a moment to 
think hard about whether that is a strategy they should pursue.
    Senator Reed. Professor Bebchuk, do you have any comments? 
I know you have probably looked at this also.
    Mr. Bebchuk. Yes. I hope that the court's going forward 
will recognize that this is an area of the law where some 
predictions are just impossible to make with precision, and 
this would not be an issue that can be solved by diligence and 
good faith effort because as financial economists we know that 
if you have an arrangement that is new, has not happened, your 
ability to predict with precision its future consequences is 
just going to be limited.
    So, had we demanded this, we would not have had probably 
the rules on insider trading because before we had those rules, 
it would have been very difficult to access with precision all 
the costs and benefits.
    So, I think this is an area where we want regulators to do 
the best job they can, but in the end we will have to count on 
them making some policy judgments that are not going to be able 
to rely with perfectly precise predictions.
    Senator Reed. Thank you, very much.
    The Chairman has returned.
    Chairman Brown [presiding]. Thank you, Senator Reed, and I 
appreciate the patience of all of you and, Mr. Melbinger, I am 
sorry, I did not hear you orally but I have certainly looked 
that your testimony. I am sorry for the rudeness of walking 
    The prospective Federal judge has now been introduced. I 
know not a big thing but a big thing for our State. So, thank 
    I have a series of questions and I will obviously go beyond 
the 5 minutes but I wanted to ask you about several things.
    The title of this hearing is pay-for-performance. It seems 
clear that Government support and, as we have had in other 
testimony in August, Professor Ed Kane suggested that 
regulators should track the level of Government support 
subsidies that Wall Street receives. We know that larger banks' 
access to capital is less expensive than a community bank in 
Coldwater or Mansfield, Ohio.
    So, as I was saying, that the hearing title is pay-for-
performance. It is clear that Government support both prevents 
trillion dollar institutions from failing in many ways and 
gives them funding advantages that, say, the large six bank 
whose assets range from 800 billion to 2.2 trillion they have 
funding advantages that unfairly boost their performance based 
on advantages they have especially access to cost of capital.
    My question is this. I will start with Mr. Hyde, if you 
want to answer. Is the level of Government support, either 
explicit or implicit, something that regulators should consider 
when evaluating the appropriateness of executive pay packages?
    Mr. Hyde. Well, I think absolutely. I think it is important 
to do that. The Government put in quite a bit of money, I mean 
a huge amount of money into a lot of these institutions; and 
so, rightly so they should be looking at the executive 
compensation that they are getting. They should be thinking 
about all the different types of support that they are getting 
and whether that is going to help and how much, how much they 
really need.
    So, I think it is important. I want to add that it was not 
just the top institution certainly that we are giving explicit 
support but it was a number of institutions that were in fact 
getting it, and I just think it is an important topic to look 
    Chairman Brown. Professor Bebchuk, would you comment on not 
just direct Government subsidies they got through TARP but 
advantages they get on the capital markets as a result of their 
size and our unwillingness in this body, it seems to me, to do 
something about the sheer size of these institutions?
    Mr. Bebchuk. I completely agree, and in some things I 
stressed in my written testimony and in some academic writings.
    The way I would think about this is that when we talk about 
pay for performance, in many cases outside the financial sector 
it is clear what performances. It is performance for the 
    In the case of financial institutions, it is important not 
only how executive decisions affect the bottom line for the 
shareholders but also for others that contribute capital, and 
that the debt holder is the preferred shareholder and it is 
also the Government as the guarantor, either explicit or 
implicit, of deposits.
    So, that is an important element of performance and that is 
why it is important to count executive performance not just by 
looking at the narrow metric of shareholder payoffs but the 
kind of broader metric of looking at the effect on those other 
    And in my testimony I kind of provided ways in which this 
can be done.
    Chairman Brown. Professor Jackson, your comments on sort of 
either approach to that question about Government direct or 
less direct subsidy and its effect on what you believe the 
regulators' response should be.
    Mr. Jackson. So, I absolutely agree with both Mr. Hyde and 
Professor Bebchuk that these benefits that the firms obtain 
that you have described should be included in the way 
regulators think about compensation packages, and I would offer 
another thought for your consideration on this point, Senator.
    One thing that stock compensation tends to do, particularly 
stock options, is it rewards rising tides. So, as markets 
generally increase, the rise of stock prices generally result 
in very substantial payments to executives, and that is 
particularly true with respect to stock options because they 
are very leveraged bets on the increase in the value of the 
    To the extent that we are concerned that the financial 
industry as a whole is benefiting from the kind of subsidy you 
have been describing, one way to address that problem might be 
to only pay executives for relative increases in the value of 
their stock as opposed to, say, their competitors' stock, and 
to punish them for decreases in the value of their stock as 
opposed to their competitors' stock, because this would be a 
practical way to get at the issue that you are describing.
    Unfortunately, stock-based compensation at public firms, to 
my knowledge, generally does not do this. One reason is a 
provision of the tax code that makes it administratively 
difficult, but another reason is that the culture of stock 
compensation over the years has just developed in a way to 
reward rising tides. And I think to the extent that we want to 
get serious about taking account of the subsidy that the 
industry is benefiting from, we might want to think about this 
kind of relative analysis of how firms are performing when we 
decide how to reward executives, rather than just rewarding 
them for stock prices rising more generally.
    Chairman Brown. Thank you, Professor.
    Mr. Melbinger, any comments?
    Mr. Melbinger. I am a compensation guy. So, the access to 
capital is a little out of my wheelhouse, but I think I can say 
the financial institutions accept the additional level of 
scrutiny to which and regulation to which they are subjected 
because of their financial role in the system.
    We are not arguing against Dodd-Frank. Quite the contrary, 
I think Dodd-Frank pushed institutions to make these critical 
changes to their compensation programs.
    Chairman Brown. Mr. Melbinger, if I could just follow up a 
little bit on that.
    When you are looking at compensation questions for 
executives at particularly the largest banks that do have that 
cost of capital advantage, if I could term it that, and you 
compare that to others, their chances of success are a bit 
higher because they have that access to less expensive capital.
    Is that a consideration that you should make in your 
recommendations to those boards on executive compensation that 
their chance, as you could argue these big banks are too big to 
fail, these executives in some sense are in a better position 
to succeed than an executive that might not have this sort of 
indirect subsidy on less expensive capital.
    Mr. Melbinger. I think the way that institutions address 
that is to compare their performance relative to their peers 
and, when they set pay levels, to compare pay levels relative 
to their peers.
    Chairman Brown. And their peers are a very small number of 
banks in this case.
    Mr. Melbinger. At the very highest levels, yes.
    Chairman Brown. Thank you for that.
    Let me take a different approach. I mentioned in my opening 
statement that the financial sector workers are paid higher 
than their counterparts in other industries.
    A Bloomberg editorial, certainly no left-leaning 
publication, argued erasing that compensation gap that did not 
exist 30 years ago would cut the typical banks' operating 
expenses by almost 20 percent.
    That is just about enough to raise the capital ratio from 5 
to 10 percent without increasing lending rates, without 
impairing shareholder profits.
    Give me your thoughts about the tension between excessive 
bonus pools and equity funding, if you will, and how you see 
that fitting together, any of you.
    Mr. Hyde. I think there does need to be a hard look at the 
amount of bonus payment and how that bonus payment is. I think 
in our audit what we found that the executives were coming to 
the table in 2009, for example, were coming to the table 
requesting excessive pay; and they were also requesting AIG, 
for example, it was requesting, for some group of employees 
requesting 550 percent increases in pay. For other groups of 
employees, 120 percent increase.
    One of the things that they wanted was to have stock that 
was immediately sellable and so it was not going to be tied to 
a long-term performance.
    So, I think it is important to have the compensation, have 
that looked at and have it tied to long-term performance which 
would I think in turn equate to return of investment.
    Chairman Brown. Mr. Melbinger, do you agree that what Nobel 
prize-winning economist Joseph Stiglitz pointed out that 
excessive bonus pools do, in fact, and this again may not be 
quite in your wheelhouse and certainly deflect if it is, but 
that excessive bonus pools can drain from a bank's equity base?
    Mr. Melbinger. That is something I guess I have read in the 
press but I have never seen any studies or really frankly read 
that study.
    Chairman Brown. Good.
    Professor, would you like to answer that?
    Mr. Bebchuk. Sure. I mean, basically you can think about 
the aggregate pie that comes in the financial firm, and in the 
end it is going to be divided between the employees and the 
    So, to the extent that the employees and the executives 
especially are taking a larger slice of it, there is less that 
is going to be left for the shareholders.
    Chairman Brown. Would you argue then that excessive 
compensation actually can threaten the safety and soundness of 
financial institutions?
    Mr. Bebchuk. I think that what financial economies are most 
concerned about is that the size of the financial sector is in 
terms of its slice of total earnings and in terms of the talent 
that it attracts might create some distortions.
    Most financial economies would not be for regulating pay 
levels but they have been watching the trends over time in 
terms of the slice of the financial sector occupies within the 
economy, and then also the slice of it that goes to financial 
    The concern is that it distorts the allocation of talent 
and that it leads to too much taking of rents.
    Chairman Brown. Does excessive compensation then mean that 
there is less money to lend for those institutions in a 
significant enough sense to measure?
    Mr. Bebchuk. I do not think people have tried to measure 
it, but I am sure there is going to be left less to those that 
provide the capital. Yes.
    Chairman Brown. Professor Jackson, your comments on any of 
    Mr. Jackson. I think you have raised a very important 
point, Senator. I will tell you why.
    Around the time of the financial crisis, it became clear 
that many of the largest firms, right at the end of 2008, paid 
out very, very large cash bonus compensation at a time when 
they were so short on cash that, as you know, the Federal 
Government had to provide TARP funding to keep them liquid.
    So, I think it is very clear actually that, under certain 
circumstances, this cash that goes out the door for 
compensation can make the capital base of the institution much 
less stable; and I want to say that that is why so many of us 
who are thinking about this issue are so insistent that firms 
should give out stock that is locked up that individuals cannot 
sell over time, because this gives the firm a base of patient 
capital that the firm can lend, as you point out, or can just 
use to ride out these difficult times that these financial 
institutions often face.
    And I guess one thing that is troubling about the new rules 
that we have is that they do not require this kind of holding 
mechanism that would require cash to be held in the firm and 
keep it solvent over time.
    One thing to remember when you think about financial 
institutions in this country is that for a very long time they 
were partnerships, and partnerships, like a big firm that has 
locked up equity, has patient capital--and these financial 
institutions are not partnerships anymore.
    For that reason, this kind of cash going out the door in a 
large public company can create exactly the kind of situation 
your question raises.
    So, I think it is a very important issue.
    Chairman Brown. Let me ask another question of all four of 
    John Reed, the former Citigroup CEO, testified before the 
full Banking Committee in support of the Volcker rule. He cited 
in his words, quote, a dominant business philosophy focusing on 
shareholder value as a contributing factor to the crisis.
    What we have seen in the last 30 years in this country a 
very different and evolving and changing manufacturing sector 
and financial services sector.
    Thirty years ago finance was roughly one sixth of our 
economy, of our GDP, a little less than that I believe; and 
manufacturing was 26, 27, 28 percent of our GDP 30 years or so 
    Today that has pretty much flipped, that the manufacturing 
is only about 10 percent of our GDP. Financial services is a 
much higher percent, more than double that.
    Finance, you were using the word partnership and you could 
have used that is different sense too. Finance was more of a 
partner to local businesses and its purposes was not financial 
services as much as lubricating the rest of the economy, as you 
    So, as Wall Street shifted its focus from activities that 
allowed institutions to grow with its customers, that trading 
were firms sometimes bet, as you know, against their own 
clients. Today financial services, it could be argued, is a bit 
of an end in itself rather than a means of supporting growth in 
other sectors.
    So, my question to all four of you is: Should factors such 
as the growth of the broader economy or the success of an 
institution's clients factor into the measurement of 
appropriate compensation?
    Is that one of the places that regulators and analysts of 
executive compensation and people like Mr. Melbinger should 
consider as they discuss compensation levels?
    Do you want to start this one, Mr. Bebchuk?
    Mr. Bebchuk. I think that, you know, it is part of what I 
recommended in my writings, in my testimony. I would like to 
see the payoffs to which executives are tied broadened to 
include other contributors of capital and the risk of the firm.
    I would not go further than that and look at the effect of 
the bank on the economy. That will be both difficult to measure 
and I am not sure that conceptually it is the right thing.
    But I think it is clear to me that it is important to 
broaden the objective to include at least the effects on all of 
those that contribute capital to the firm which includes, and 
in this way to take more fully into account the effects of the 
choices of the executives on the risk of the firm.
    Chairman Brown. Other comments on that?
    Mr. Jackson. I think your question raises two separate 
points that are worth discussing. First, as Professor Bebchuk 
points out, the idea that we want to incorporate the 
performance of the bank's clients and the performance of those 
to which it is lending money into performance measures I think 
is quite clear and uncontroversial for the reason that Mr. 
Bebchuk has given.
    And what I think the industry has been learning over time, 
and I wonder whether Mr. Melbinger would agree, is that these 
kinds of performance measures are something about which you can 
learn, that you can sort of figure out over time exactly how to 
measure these kinds of things.
    I think the industry has been working hard to understand 
the types of performance measures they are using and I think 
those practices have improved over time, although, as I said at 
the outset of my testimony, not because of the rules the 
regulators have issued but instead because of the initiative of 
the industry.
    The second point I think I would make is that the 
measurement of these things can actually be quite challenging; 
and so it is difficult to understand, for example, the 
contribution that a bank is making to the communities in which 
it lends.
    It is difficult to understand exactly each lending decision 
the bank has made. It is difficult to translate those decisions 
into the performance of the senior folks whose incentives we 
are often focused on in these discussions.
    I think one thing the regulators should be doing is to help 
banks study that question. So for example, to the extent that 
you care about how a bank is lending in the local economy or 
how its auditors are performing, you might find that out by 
getting data about exactly who is making lending decisions, how 
they are being paid, and what the relationship is between those 
two things.
    And that is why it is so important that the rules under the 
Dodd-Frank Act require better disclosures than are in the 
proposed rules, because all of that kind of information--who 
does the lending, who makes the decision, and how do they get 
paid--all of that stuff is obscured in the disclosure that the 
regulators would require, because those disclosures only 
require generalized essays about pay-for-performance.
    Chairman Brown. Thank you. Do you want to add something, 
Mr. Melbinger?
    Mr. Melbinger. Yes. Well, in my experience, compensation 
committees are always interested in best practices and open to 
new ideas. So, this is certainly not something that I would 
reject out of hand at all. I too would have concerns about 
measurement of it; but, again, new ideas are always welcome at 
the comp committee.
    Chairman Brown. Thank you.
    Let me do one more question and then thank you again for 
joining us.
    Professor Jackson, you mentioned partnership structure. 
Talk to me, and this question is aimed at you but any of you 
who would like to weigh in on this.
    Are there ways we can re-create any of the incentives that 
were associated with the partnership structure perhaps by 
putting more of executive's wealth at risk would be one way of 
doing it, I assume. Give me any thoughts you have on how we 
could sort of re-create that situation where, which would 
probably be safer for the financial markets.
    Mr. Jackson. It is very challenging, of course, because the 
deal we make when we have partnerships become public companies 
is that, in exchange for being able to raise capital, we allow 
the separation of who owns the firm and who is running it, and 
that is just a fundamental compromise that we strike when we 
allow companies to be public companies.
    And the growth of our financial institutions has 
significantly aided the growth of our economy. So, it is hard 
to say it is a bad thing that the firms are no longer 
    But the question that you are asking is how do we get back 
to those incentives, and I think the answer is that we can or 
we can at least get close.
    I think the way to do it would be to require the people who 
run these firms, as you say, to put wealth at risk; and the way 
I would suggest doing that is by having them be paid in stock 
that is then locked up for a significant period of time.
    And let me say that many of the members of Mr. Melbinger's 
organization actually already do this. The Office of the 
Special Master at the Treasury Department has required that 
those firms do it. It is not that it is impossible. It is just 
that it is challenging.
    And if you do it, as I mentioned earlier, you will have the 
kind of capital that the employees are keeping in the firm just 
like a partnership.
    Let me add one more thought about something I would not 
suggest that we do, a proposal that I have heard a little bit 
about which would be to suggest that the people that run these 
firms should be held personally liable for the liabilities of 
the firms, that we should break through the liability shield 
that is created by the corporate form.
    I think that is a bad idea. And the reason I do is, first 
of all, we have another solution that is less intrusive, that 
is more intuitive, and that is more likely to align incentives 
in a way that a partnership would. But much more importantly, 
although we want to manage the risk that banks take, we do not 
want to make the people who run them so risk averse that they 
do not lend into our economy, especially at a time like this 
where communities need active financial institutions.
    So what I would say is there is a way to do it and it is 
just to pay them in stock that is locked up over time; and that 
makes it puzzling, really, that the rules that have been issued 
under Section 956 do not have a requirement along those lines, 
and I would not go further to the more extreme proposals I have 
just described.
    Chairman Brown. Thank you.
    Anybody else want to comment on those ideas, Professor 
    Mr. Bebchuk. The recommendations that I made with respect 
to the limitations on unwinding of equity incentives and that I 
would like to see incorporated into the final rules of the 
regulators would go exactly in the direction that you 
suggested, Senator Brown.
    So, under what I think is a desirable state of affairs 
there is a clear separation between vesting and when you can 
sell your stock. So, vesting would mean that you have earned 
the stock. It belongs to you, and, therefore, it cannot be 
taken from you but that does not mean that the terms of the 
security are ones that allow you to sell it right away. The 
security can belong to you but you might be able to sell it 
only over a long period of time.
    And it is also important and that again would push us 
closer to this partnership award is that we have clear 
restrictions that say whatever is your portfolio of equity 
incentives you cannot sell in any given year more than 10 
percent or some other fraction.
    The reason is that there are many executives that are ones 
that stayed sometime in the firm. They might be in a situation 
in which most of their portfolio is one that is completely free 
to unload at any point in time and that gives them the wrong 
frame of mind. It does not make them feel like a partner. It 
makes them feel like someone who can exit at any time based on 
the short-term price. And, therefore, if we have aggregate 
limitations on unwinding, it would make them more like 
    The last point I would make about this is that if you look 
at Goldman Sachs which is the firm that people often think 
about when they think about the partnership model, if you look 
at the proxy statement you see that they actually have very 
substantial limitations on unwinding that are much better than 
those that many of the peers right now have.
    They require their executives to retain a very large 
percentage of all the equity that is given to them. My hope is 
that the regulators would push other companies to go in that 
direction as well.
    Chairman Brown. Thank you. Mr. Hyde.
    Mr. Hyde. Yes. I would agree with both Professor Jackson 
and Professor Bebchuk. I think it is important to do that. I 
think hearing the delinking of their vesting requirements and 
how when it is actually being, when they are actually selling 
it I think that is important.
    I also think shifting away from cash compensation or some 
sort of heavy, short-term compensation to one that is more 
long-term compensation, these are the things that I believe the 
special master was trying to do at Treasury and with these 
seven exceptionally assisted institutions.
    Chairman Brown. Thank you.
    Thank you all for joining us today. Your comments were 
very, very helpful. Thank you for that.
    Some Committee Members may have comments or questions that 
they want to direct at you in the next 5 days. We will keep the 
record open for 7 days. So if you would respond to them if they 
have questions and we may follow up too. If you have any 
remarks that you want to add, you certainly can do that and be 
in touch with Committee staff. So, thank you again for joining 
    The Subcommittee for Financial Institutions is adjourned. 
    [Whereupon, at 3:24 p.m., the hearing adjourned.]
    [Prepared statements supplied for the record follow:]
 Deputy Special Inspector General for the Troubled Asset Relief Program
                           February 15, 2012
    Chairman Brown, Ranking Member Corker, and Members of the 
Committee, I am honored to appear before you today to discuss 
compensation practices at the largest financial institutions.
    The Office of the Special Inspector General for the Troubled Asset 
Relief Program (SIGTARP) is charged with conducting, supervising, and 
coordinating audits and investigations of the purchase, management, and 
sale of assets under the Troubled Asset Relief Program (TARP). 
SIGTARP's mission is to promote economic stability through 
transparency, robust enforcement, and coordinated oversight. In 
fulfilling its mission, SIGTARP protects the interests of those who 
funded TARP programs--American taxpayers.
    This Committee is committed to examining an important and timely 
issue, the historical structure of financial sector pay practices, the 
role that these practices played in the financial crisis, and ongoing 
efforts to reform financial sector pay packages. As part of its mission 
of transparency, SIGTARP has shed light on the details of some of the 
largest institutions' pay practices and the Government's decision 
making in this area, including determinations made by the Office of the 
Special Master for Executive Compensation (OSM) on pay for companies 
that had received funds under TARP programs designated as ``exceptional 
assistance.'' For example, we released an audit report detailing the 
efforts by Federal banking regulators and Treasury to get the largest 
banks out of TARP. In that audit we highlighted that Bank of America 
Corporation (Bank of America) and Citigroup, Inc. (Citigroup) exited 
TARP's exceptional assistance program known as the Targeted Investment 
Program, citing a desire to be outside of the jurisdiction of OSM. \1\ 
In that audit, SIGTARP reported that Citigroup's CEO told SIGTARP that 
the desire to escape management compensation restrictions was a factor 
in motivating Citigroup's desire to exit TARP. The report also states 
that Sheila Bair, then-Chairman of the Federal Deposit Insurance 
Corporation (FDIC), worried that Citigroup's request to terminate its 
asset guarantee, another form of exceptional assistance it received 
under TARP, was ``all about compensation.'' As noted in the audit, two 
of Bank of America's former executives told SIGTARP that executive 
compensation was an important factor in the firm's decision to repay 
TARP. One of the executives told SIGTARP that executive compensation 
was a major factor behind the firm's repayment decision and that the 
company did everything possible to get out from under the executive 
compensation rules. Former Special Master Kenneth R. Feinberg testified 
before the Congressional Oversight Panel (COP) that one of the things 
he learned as Special Master was the desire of these companies to get 
out from under Government regulation. Specifically he was referring to 
Citigroup and Bank of America wanting to get out from under TARP and 
OSM's restrictions.
     \1\ SIGTARP, ``Exiting TARP: Repayments by the Largest Financial 
Institutions'', issued September 29, 2011, http://www.sigtarp.gov/
    Last month, SIGTARP published a report, ``The Special Master's 
Determinations for Executive Compensation of Companies Receiving 
Exceptional Assistance Under TARP,'' which examined executive 
compensation determinations made by OSM for the Top 25 employees at 
seven companies receiving exceptional assistance under TARP. \2\ 
SIGTARP reviewed the process designed by OSM to set pay packages and 
OSM's decisions on compensation for the Top 25 employees at the seven 
companies. Under this evaluation, SIGTARP assessed the criteria used by 
OSM to evaluate and make determinations on each company's executive 
compensation and whether OSM consistently applied criteria to all seven 
     \2\ SIGTARP, ``The Special Master's Determinations for Executive 
Compensation of Companies Receiving Exceptional Assistance Under 
TARP,'' issued January 23, 2012, www.sigtarp.gov/reports/audit/2012/
SIGTARP's Review of Executive Compensation Determinations Made By the 
        Office of the Special Master for TARP Compensation
    When Congress created TARP in 2008, it included some limits on 
compensation for employees at companies that received TARP assistance. 
After several major TARP recipients paid employees billions of dollars 
in bonuses for 2008, the President, the U.S. Department of the Treasury 
(Treasury), and Congress expressed frustration. The President announced 
the capping at $500,000 of annual salaries at companies that had 
received ``exceptional assistance'' under TARP, with any further 
compensation to be paid in stock that could not be cashed in until the 
company paid back TARP. After the President's announcement, Congress 
passed legislation under which Treasury created OSM. Kenneth R. 
Feinberg served as the Special Master and was succeeded by Patricia 
Geoghegan, who is the Acting Special Master.
    The seven companies that received assistance that was 
``exceptional''--because of the amount and the nature of their 
bailouts--stood out from the more than 700 financial institutions in 
the Capital Purchase Program. Those seven companies were American 
International Group, Inc. (AIG), Bank of America, Citigroup, Chrysler 
Financial Services Americas LLC (Chrysler Financial), Chrysler Holding 
LLC (Chrysler), General Motors Corporation (GM), and Ally Financial 
Inc. (Ally), formerly GMAC, Inc. The Special Master's authority was 
narrowly limited to setting pay for the Top 25 most highly paid 
employees at these companies, and approving compensation structures, 
rather than individual pay, for the next 75 most highly compensated 
employees. The Special Master was required to determine whether 
compensation structures and payments were inconsistent with the TARP 
legislation or were otherwise contrary to the public interest by using 
his discretion to apply six principles developed by Treasury: (1) 
avoiding incentives to take risks; (2) keeping the company competitive 
and retaining and recruiting employees who would contribute to the 
company's success and its ability to repay TARP; (3) allocating 
compensation between salary and incentives; (4) basing pay on 
performance metrics; (5) setting compensation consistent with similar 
peers at similarly situated companies; and (6) setting compensation 
that reflects an employee's contribution to the company's value. 
Special Master Feinberg told SIGTARP that these criteria are inherently 
inconsistent because of conflicting goals and company-specific 
circumstances. He explained that the criteria are intended for 
institutions to remain competitive and to promote employee retention 
but do not allow for compensation structures similar to those of some 
market participants because they are deemed to be excessive and not 
performance based over the long term. On October 21, 2010, Feinberg 
testified before COP that the clear direction given to him was that the 
most important goal was to get these seven companies to repay TARP.
    SIGTARP found that the Special Master could not effectively rein in 
excessive compensation at the seven companies because he was under the 
constraint that his most important goal was to get the companies to 
repay TARP. Although generally he limited cash compensation and made 
some reductions in pay, the Special Master still approved total 
compensation packages in the millions. Given OSM's overriding goal, the 
seven companies had significant leverage over OSM by proposing and 
negotiating for excessive pay packages based on historical pay, warning 
Special Master Feinberg that if he did not provide competitive pay 
packages, top officials would leave and go elsewhere.
    Special Master Feinberg said that the companies pressured him to 
let the companies pay executives enough to keep them from quitting, and 
that Treasury officials pressured him to let the companies pay 
executives enough to keep the companies competitive and on track to 
repay TARP funds. Feinberg testified to the House Committee on 
Financial Services, ``The tension between reining in excessive 
compensation and allowing necessary compensation is, of course, a very 
real difficulty that I have faced and continue to face in making 
individual compensation determinations.'' Feinberg told SIGTARP that 
every day he was pressured to soften his stance and that Government 
officials reminded him that the companies had large obligations to 
repay the taxpayers.
    In proposing high pay packages based on historical pay prior to 
their bailout, the TARP companies failed to take into account the 
exceptional situation they had gotten themselves into that necessitated 
taxpayer bailout. On October 28, 2010, Feinberg testified to the U.S. 
House of Representatives Committee on Oversight and Government Reform 
that for 2009 pay, six of the seven companies' compensation proposal 
submissions would result in payments contrary to the public interest, 
and should, therefore, be rejected. \3\ Special Master Feinberg 
testified that the companies requested excessive cash salaries and 
bonuses; stock compensation that could be immediately or quickly 
redeemed; ``perks'' such as private airplane transportation, country 
club dues, and golf outings; excessive levels of severance and 
retirement benefits; and compensation that did not take into account 
future cash awards already scheduled to be paid based on contracts that 
existed prior to current compensation regulations.
     \3\ The seventh company was Chrysler Financial.
    Rather than view their compensation through the lens of partial 
Government ownership, the companies argued that their proposed pay 
packages were necessary to retain or attract employees who were crucial 
to the company. For example, in 2009, AIG proposed cash raises for 
several of its Top 25 employees and the ability to sell stock salary 
immediately. Ally officials pushed for high pay, despite knowing that 
Feinberg was concerned that a majority of the company's Top 25 
employees were part of the problem that resulted in the need for a 
bailout. Ally CEO Michael Carpenter told SIGTARP, ``We had an 
individual who was making $1.5 million total compensation with $1 
million in cash. Cutting this person's salary to $500,000 cash resulted 
in the person being cash poor. . . . This individual is in their early 
40s, with two kids in private school, who is now considered cash poor. 
We were concerned that these people would not meet their monthly 
expenses due to the reduction in cash.'' In a few rare instances, the 
companies took it upon themselves to limit pay. In 2010, Ally's board 
told the new CEO that he would be paid stock but no cash. Citigroup's 
CEO told Congress that he would take only $1 in cash salary.
    Special Master Feinberg testified to Congress that he determined a 
new compensation regime be implemented for the seven companies that 
received exceptional assistance under TARP. The regime he envisioned 
was a replacement of guaranteed compensation with performance-based 
compensation designed to tie the individual executive's financial 
opportunities to the long-term overall financial success of each 
company. He told Congress that he hoped that his individual 
compensation determinations would be used, in whole or in part, by 
other companies in modifying their own compensation practices. He 
testified that he believed that his determinations were a useful model 
to guide others.
    Under conflicting principles and pressures, despite reducing some 
pay, the Special Master approved multimillion-dollar compensation 
packages for many of the Top 25 employees, but tried to shift them away 
from large cash salaries and toward stock. OSM approved pay packages 
worth $5 million or more over the 2009 to 2011 period for 49 
individuals. OSM set pay using what Feinberg called ``prescriptions'' 
that he developed, including that total compensation would be set at 
the 50th percentile for similarly situated employees, and that cash 
salaries should not exceed $500,000, except for good cause, with any 
additional compensation in the form of stock salary or long-term 
restricted stock. \4\ In testimony to the House Committee on Oversight 
and Government Reform, the Special Master said that he used stock 
salary to encourage senior executives to remain at the companies to 
maximize their benefit from the profitability of the company. To tie 
individual compensation to long-term company success, OSM used long-
term restricted stock contingent on the employee achieving specific 
performance criteria. The Special Master said that each company's 
independent compensation committee had to have an active role in both 
the design of incentives and the review and measurement of performance 
metrics. Although OSM developed general prescriptions, OSM did not have 
any established criteria at the beginning of the process for applying 
those prescriptions.
     \4\ The economic stimulus legislation did not contain a $500,000 
cash salary limitation, nor did the Treasury rules.
    Some companies pushed back on OSM by claiming that their 
compensation should be higher than the 50th percentile. The companies' 
beliefs may relate to what has been called the ``Lake Wobegon Effect,'' 
named after radio host Garrison Keillor's fictional hometown where 
``all the children are above average.'' Companies also proposed that 
their employees be paid cash salaries higher than $500,000, claiming 
that the employees were crucial. For 10 employees in 2009, and 22 
employees in 2010 and 2011, GM, Chrysler Financial, Ally, and AIG 
convinced OSM to approve cash salaries greater than $500,000. With the 
exception of Bank of America's retiring CEO, the Special Master 
approved cash salaries in excess of $500,000 for the CEO of each 
company who asked for a higher salary, and approved millions of dollars 
in CEO stock compensation.
    AIG's proposed compensation for its Top 25 employees did not 
reflect the unprecedented nature of AIG's taxpayer-funded bailout and 
the fact that taxpayers owned a majority of AIG. The proposed AIG 
compensation was excessive. In 2009, AIG wanted cash salary raises 
ranging from 20 percent to 129 percent for one group of employees and 
from 84 percent to 550 percent for another group. AIG proposed high 
cash salaries, even though some of these employees would also be paid 
significant retention payments. Feinberg told SIGTARP that AIG was 
against stock salary and wanted to pay employees in cash. Feinberg told 
SIGTARP that in his 2009 discussions with AIG, AIG believed that its 
common stock was essentially worthless. Feinberg testified before COP 
that AIG common stock ``wasn't worth enough to appropriately compensate 
top officials.'' Feinberg told SIGTARP that he was pressured by other 
senior Treasury officials and was told to be careful, that AIG owed a 
fortune, and that Treasury did not want it to go belly up. Treasury 
told him that paying salaries and grandfathered awards in stock rather 
than cash would jeopardize AIG. Feinberg said that Treasury officials 
felt those amounts were relatively small compared to the Government's 
exposure in AIG. However, Feinberg said that no one trumped his 
    In 2009, OSM approved total compensation of cash and stock of more 
than $1 million each for five AIG employees, including a $10.5 million 
pay package for AIG's new CEO that included a $3 million cash salary. 
OSM approved compensation ranging from $4.3 million to $7.1 million 
each for four AIG employees who that year were also scheduled to 
receive cash retention awards of up to $2.4 million. OSM was tough on 
employees of AIG Financial Products (AIGFP), the unit whose losses 
contributed to the need for Government intervention. For five AIGFP 
employees who were scheduled to receive retention awards of up to 
approximately $4.7 million, OSM froze their salaries at 2007 levels and 
gave them no stock. In 2010, OSM also cut AIG's proposed salaries, but 
compared to 2009, approved much larger compensation packages for AIG's 
Top 25 employees, despite the fact that 18 of these employees were 
scheduled to receive significant retention awards and other payments. 
In 2010, OSM approved 21 of AIG's 22 employees to receive between $1 
million and $7.6 million, with 17 of those pay packages exceeding $3 
million. OSM approved cash salaries of more than $500,000 for five 
employees, and cash salaries ranging from $442,874 to $500,000 for 12 
employees. OSM approved all but three of AIG's Top 25 employees to 
receive stock salary ranging from $1.3 million to $5.1 million each. 
OSM generally approved these same pay packages for 2011 for AIG, which 
included the CEO's same compensation as in earlier years, compensation 
packages of $8 million each for two employees, compensation packages of 
$7 million each for two employees, and compensation packages of $5 
million to $6.3 million each for seven employees.
    OSM's pay determinations are not likely to have a long lasting 
impact at the seven TARP exceptional assistance companies or other 
companies. Chrysler, Citigroup, and Ally executives said they would not 
fully follow the Special Master's determination framework after they 
exited TARP. OSM's decisions had little effect on Citigroup and Bank of 
America, which exited TARP, in part to escape OSM compensation 
restrictions. Once out of TARP, salaries and bonuses climbed. Today, 
only AIG, GM, and Ally remain subject to OSM's review. CEOs at AIG and 
GM told SIGTARP that they would not maintain OSM's practices once their 
company exits TARP. OSM has had little ability to influence 
compensation practices at other companies outside of the seven. 
Feinberg told SIGTARP that the long-term impact will likely come from 
The Role of Executive Compensation in the Financial Crisis
    In the years preceding the financial crisis, employee compensation 
at large financial institutions increased significantly. The Financial 
Crisis Inquiry Commission (FCIC) reports that pretax profit for the 
five largest investment banks doubled between 2003 and 2006 (from $20 
billion to $43 billion), and total employee compensation at these 
investment banks increased from $34 billion to $61 billion. According 
to the FCIC, in 2007 Wall Street paid workers in New York approximately 
$33 billion in year-end bonuses alone, and total compensation for the 
major U.S. banks and securities firms was estimated at approximately 
$137 billion. \5\
     \5\ Financial Crisis Inquiry Commission, The Financial Crisis 
Inquiry Report, Jan. 2011 (online at fcic.law.stanford.edu).
    Federal regulators have stated that compensation structures and 
practices at the largest financial institutions contributed to the 
financial crisis. Chairman of the Board of Governors of the Federal 
Reserve System (Federal Reserve) Ben S. Bernanke stated that 
compensation structures ``led to misaligned incentives and excessive 
risk taking, contributing to bank losses and financial instability.'' 
\6\ Treasury Secretary Timothy F. Geithner testified before COP that 
executive compensation played a ``material role'' in causing the 
financial crisis because it encouraged excessive risk taking. \7\ At 
the January 2010 FDIC Board meeting, then-FDIC Chairman Sheila Bair 
stated that ``there is such an overwhelming amount of evidence'' that 
compensation practices at the largest financial institutions were 
``clearly a contributor to the crisis and to the losses that we are 
suffering.'' \8\ In addition, in its October 2011 report on incentive 
compensation practices, the Federal Reserve stated that ``risk-taking 
incentives provided by incentive compensation arrangements in the 
financial services industry were a contributing factor to the financial 
crisis that began in 2007.'' \9\ Financial institutions have also 
identified compensation practices as a contributing cause of the 
financial crisis. In a 2009 survey conducted on behalf of the Institute 
of International Finance, of the 37 large banking organizations engaged 
in wholesale banking activities that responded, 36 agreed that 
compensation practices were a factor underlying the financial crisis. 
     \6\ Board of Governors of the Federal Reserve System, press 
release (Oct. 22, 2009) (online at www.federalreserve.gov/newsevents/
     \7\ Congressional Oversight Panel, Testimony of Timothy F. 
Geithner, Secretary, U.S. Department of the Treasury, Transcript: COP 
Hearing with Treasury Secretary Timothy Geithner (Dec. 16, 2010) 
(online at cybercemetery.unt.edu/archive/cop/20110402013346/http://
     \8\ Meeting of the Board of the Federal Deposit Insurance 
Corporation (Jan. 12, 2010).
     \9\ Board of Governors of the Federal Reserve System, Incentive 
Compensation Practices: A Report on the Horizontal Review of Practices 
at Large Banking Organizations (Oct. 5, 2011) (online at 
     \10\ The Institute of International Finance, Inc. (2009), 
Compensation in Financial Services: Industry Progress and the Agenda 
for Change.
    One area of particular concern are incentive compensation 
structures for nonsenior employees who can expose the firm to 
substantial risk that do not align the employees' interests with those 
of the institution. According to the Federal Reserve's October 2011 
report, incentive compensation practices may pose safety and soundness 
risks if not properly structured. The Federal Reserve report stated 
that before the crisis, most large firms whose compensation practices 
were reviewed by the Federal Reserve focused only on risk-based 
incentives for a small number of senior highly paid employees, and no 
firm systemically identified the relevant employees who could influence 
risk. \11\ The Federal Reserve reported in October 2011 that many of 
the large financial institutions have since determined that they have 
``thousands or tens of thousands'' of employees, who individually or as 
a group, are able to take or influence material risks, including 
mortgage originators, commercial lending officers, or traders. \12\
     \11\ Board of Governors of the Federal Reserve System, Incentive 
Compensation Practices: A Report on the Horizontal Review of Practices 
at Large Banking Organizations (Oct. 5, 2011) (online at 
     \12\ Board of Governors of the Federal Reserve System, Incentive 
Compensation Practices: A Report on the Horizontal Review of Practices 
at Large Banking Organizations (Oct. 5, 2011) (online at 
Efforts To Reform Executive Compensation
    The onus is on the financial institutions to take efforts to reform 
their own executive compensation practices in a manner that restrains 
excessive risk taking that could threaten the safety and soundness of 
the institution. This is particularly true for companies designated as 
systemically important financial institutions (SIFIs). These companies 
have a responsibility to reduce risk taking that could trigger systemic 
consequences. As Federal Reserve Board Governor Daniel K. Tarullo has 
noted, incentive compensation arrangements should not provide employees 
with incentives to engage in risk taking that are beyond the 
institution's capacity to effectively identify and manage. ``The 
amounts of incentive pay flowing to employees should reflect the risks 
and potential losses--as well as gains--associated with their 
activities. Employees are less likely to take imprudent risks if their 
incentive payments are reduced or eliminated for activities that end up 
imposing significant losses on the firm.'' \13\
     \13\ Governor Daniel K. Tarullo, ``Incentive Compensation, Risk 
Management, and Safety and Soundness'', at the University of Maryland's 
Robert H. Smith School of Business Roundtable: Executive Compensation: 
Practices and Reforms, Washington, DC, Nov. 2, 2009, online at 
    In its report of decision making by OSM, SIGTARP concluded that one 
lesson of this financial crisis is that regulators should take an 
active role in monitoring and regulating factors that could contribute 
to another financial crisis. In June 2010, one month prior to the 
enactment of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (Dodd-Frank Act), Federal banking regulators issued interagency 
guidance ``to ensure that incentive compensation arrangements at 
financial organizations take into account risk and are consistent with 
safe and sound practices.'' \14\ This guidance followed the regulators' 
in-depth analysis of incentive compensation practices at 25 large 
banking organizations, in which the Federal Reserve found deficiencies.
     \14\ Guidance on Sound Incentive Compensation, Final Guidance, 
Federal Register 75:122 (25 June 2010): p. 6395 (online at 
www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm) (accessed 
Feb. 10, 2012).
    The June 2010 interagency guidance does not mandate or prohibit any 
specific form of compensation, but is instead principle-based to allow 
for differences in the size and complexity of banking organizations. 
\15\ The interagency guidance recognizes that while incentive 
compensation serves important goals, including attracting and retaining 
skilled staff, ``these goals do not override the requirement for 
banking organizations to have incentive compensation systems that are 
consistent with safe and sound operations and that do not encourage 
imprudent risk-taking.'' \16\ The first principle in the guidance is 
that incentive compensation arrangements should balance risks and 
rewards so that pay takes into account risks and losses of employees' 
activities, including credit, market, liquidity, operational, legal, 
compliance, and reputational risks. In the guidance, the Federal 
banking regulators outlined four nonexclusive methods to make 
compensation more sensitive to risk:
     \15\ The principles include that incentive compensation 
arrangements should: (1) provide employees incentives that 
appropriately balance risk and reward; (2) be compatible with effective 
controls and risk management; and (3) be supported by strong corporate 
governance, including active and effective oversight by the 
organization's board of directors. Guidance on Sound Incentive 
Compensation, Final Guidance, Federal Register 75:122 (25 June 2010): 
p. 6395 (online at www.federalreserve.gov/newsevents/press/bcreg/
20100621a.htm) (accessed Feb. 10, 2012).
     \16\ Guidance on Sound Incentive Compensation, Final Guidance, 
Federal Register 75:122 (25 June 2010): p. 6395 (online at 
www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm) (accessed 
Feb. 10, 2012).

    adjusting performance awards to reflect the risks of 
        employee activities;

    deferring payments of awards and adjusting actual payments 
        to reflect risk outcomes using risk information that becomes 
        available at different points in time;

    using longer periods for measuring the performance on which 
        awards are based; and

    reducing the sensitivity of performance measures to short-
        term revenues or profits.

    Each method has advantages and disadvantages. For example, 
according to the guidance, compensation packages for senior executives 
at large institutions ``are likely to be better balanced if they 
involve deferral of a substantial portion of the executive's incentive 
compensation over a multiyear period with payment made in the form of 
stock'' with the amount ultimately received dependent on the 
performance of the organization. ``Deferral, however, may not be 
effective in constraining the incentives of employees who may have the 
ability to expose the organization to long-term risks, as these risks 
may not be realized during a reasonable deferral period.'' \17\ Another 
principle contained in the guidance is that compensation structures 
should be supported by strong corporate governance, including active 
and effective oversight by the organization's board of directors. In 
October 2011, the Federal Reserve reported that the 25 large banking 
organizations have made significant progress toward enhancing their 
incentive compensation arrangements, however, ``every firm needs to do 
more.'' The Federal Reserve stated that most firms still have 
significant work to do to achieve full conformance with the interagency 
     \17\ Guidance on Sound Incentive Compensation, Final Guidance, 
Federal Register 75:122 (25 June 2010): p. 6395 (online at 
www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm) (accessed 
Feb. 10, 2012).
    In addition to this guidance, the Dodd-Frank Act enacted July 21, 
2010, requires regulations on executive compensation at financial 
institutions that may force companies to change their compensation 
practices. The Dodd-Frank Act enhances disclosure and reporting 
requirements and prohibits certain incentive-based payment arrangements 
that regulators determine encourage inappropriate risks by covered 
financial institutions. \18\ The Dodd-Frank Act's provisions on 
executive compensation are to be implemented in new regulations by 
several Federal regulators, and some of those regulators have already 
implemented or proposed rules. \19\ The Dodd-Frank Act requires that 
the new Federal regulations require certain financial institutions to 
disclose the structures of all incentive-based compensation sufficient 
to determine whether the compensation structure provides an executive 
officer, employee, director, or principle shareholder with excessive 
compensation, fees, or benefits, or could lead to material financial 
loss. \20\ Federal regulators are also required to develop regulations 
that prohibit any type of incentive-based payment arrangement that the 
regulators determine encourages inappropriate risk. On April 14, 2011, 
Federal regulators published their joint proposal to ban ``excessive'' 
incentive-based compensation that may promote risky behavior or lead to 
material financial loss at financial institutions, but the rule is not 
final. \21\ In addition, the SEC adopted regulations that give 
shareholders a say-on-pay advisory vote on executive compensation and 
``golden parachute'' compensation arrangements. The Dodd-Frank Act also 
requires regulations for institutions designated as SIFIs. For example, 
the Federal Reserve recently proposed restricting executive pay and 
bonuses if a SIFI fails certain capital, liquidity, or stress test 
thresholds. \22\ It is too early to tell whether the Dodd-Frank Act 
will ultimately be successful in reforming financial sector pay 
packages because all of the regulations required under the Dodd-Frank 
Act are not final and their effectiveness remains to be seen. The 
regulators' strength and leadership in the area of executive 
compensation are critical.
     \18\ As to CEO pay, the Dodd-Frank Act requires public companies 
to disclose in public filings: (1) the median total annual compensation 
of all employees other than the CEO; (2) the annual total compensation 
of the CEO or equivalent position; and (3) the ratio between the median 
compensation of all employees and the CEO's total compensation.
     \19\ The regulators required to promulgate regulations under the 
Dodd-Frank Act include: the Federal Reserve, the Office of the 
Comptroller of the Currency (OCC), the FDIC, the National Credit Union 
Administration (NCUA), the Securities and Exchange Commission (SEC), 
and the Federal Housing Finance Agency (FHFA).
     \20\ Covered financial institutions include: Depository 
institutions or depository institution holding companies, broker-
dealers, credit unions, investment advisors, the Federal National 
Mortgage Association, the Federal Home Loan Mortgage Corporation, and 
other financial institutions that the appropriate Federal regulators, 
jointly, by rule, determine should be treated as covered. However, the 
requirements do not apply to covered financial institutions with assets 
of less than $1 billion.
     \21\ The regulators include OCC, Federal Reserve, FDIC, NCUA, SEC, 
and FHFA. Available at www.occ.gov/news-issuances/federal-register/
     \22\ Board of Governors of the Federal Reserve System, Enhanced 
Prudential Standards and Early Remediation Requirements for Covered 
Companies, 12 C.F.R. Part 252 (Dec. 20, 2011) (online at www.gpo.gov/
    Finally, the public continues to have a paramount interest in 
appropriate compensation structures and pay at companies in which 
Treasury has a significant ownership interest from a TARP investment. 
Only AIG, GM, and Ally remain as TARP exceptional assistance companies 
under OSM's oversight, and OSM will release its 2012 compensation 
package determinations for the Top 25 executives at these three 
companies in April. Taxpayers are looking to OSM and the regulators to 
protect them and to help reinforce the stability of the largest firms 
and the financial system.
    Chairman Brown, Ranking Member Corker, and Members of the 
Committee, thank you again for this opportunity to appear before you, 
and I would be pleased to respond to any questions that you may have.
  William J. Friedman and Alicia Townsend Friedman Professor of Law, 
               Economics, and Finance, Harvard Law School
                           February 15, 2012
    Chairman Brown, Ranking Member Corker, and distinguished Members of 
the Subcommittee, I would like to thank you very much for inviting me 
to testify today. Adequate design of compensation practices at large 
financial institutions is important for financial stability, and I am 
honored to have been invited to testify on this subject.
    Below I discuss the role that compensation practices played in the 
financial crisis and how they should generally be designed going 
forward. I describe two distinct sources of risk-taking incentives: 
first, executives' excessive focus on short-term results; and, second, 
their excessive focus on results for shareholders, which corresponds to 
a lack of incentives for executives to consider outcomes for other 
contributors of capital. I discuss how pay arrangements should be 
designed to address each of these problems. The issues I discuss are 
ones on which I have done a significant amount of academic writing, and 
my testimony draws on my writing. \1\
     \1\ My testimony draws on Lucian Bebchuk, Alma Cohen and Holger 
Spamann, ``The Wages of Failure: Executive Compensation at Bear Stearns 
and Lehman 2000-2008'', Yale Journal on Regulation 27 (2010): 257	282, 
available at http://ssrn.com/abstract=1513522; Lucian Bebchuk and Jesse 
Fried, ``Paying for Long-Term Performance'', University of Pennsylvania 
Law Review 58 (2010): 1915-1960, available at http://ssrn.com/
abstract=1535355; Lucian Bebchuk and Holger Spamann, ``Regulating 
Bankers' Pay'', Georgetown Law Journal 98 (2) (2010): 247-287, 
available at http://ssrn.com/abstract=1410072; and Lucian Bebchuk, 
``How to Fix Bankers' Pay'', Daedalus 139 (2010): 52-60, available at 
    Also, the views expressed herein are solely my own and should not 
be attributed to Harvard Law School or any other institution with which 
I am affiliated. My affiliation is noted for identification purposes 
    My focus throughout is on how senior executives of financial firms 
should be compensated. Regulators now rightly devote attention to the 
compensation of all employees of financial institutions who take or 
influence risk and not just senior executives. However, the pay 
arrangements of senior executives deserve special attention because 
such executives have substantial influence both on key risk choices of 
their firm and on the setting of compensation arrangements for other 
employees in their firm.
Problem I: Short-Term Focus
    Standard pay arrangements have incentivized and rewarded short-term 
results. Jesse Fried and I warned about this problem and its 
consequences in our book Pay Without Performance: The Unfulfilled 
Promise of Executive Compensation, published 7 years ago. \2\ Under the 
standard design of pay arrangements, executives have been able to cash 
out large amounts of compensation based on short-term results. This 
feature of pay arrangements has provided executives with incentives to 
seek short-term gains even when doing so creates excessive risk of a 
later implosion.
     \2\ Lucian Bebchuk and Jesse Fried, Pay Without Performance: The 
Unfulfilled Promise of Executive Compensation (Cambridge, MA: Harvard 
University Press, 2004).
    In our study ``The Wages of Failure: Executive Compensation at Bear 
Stearns and Lehman Brothers 2000-2008'', \3\ Alma Cohen, Holger 
Spamann, and I illustrate the problem through a case study of 
compensation at Bear Stearns and Lehman Brothers. We document that, 
notwithstanding the 2008 meltdown of the firms, the bottom lines for 
the period 2000-2008 were positive and substantial for the firms' top 
five executives. These top executives regularly unloaded shares and 
options, and thus were able to cash out a lot of their equity before 
the stock price of their firm plummeted.
     \3\ Bebchuk, Cohen, and Spamann, ``The Wages of Failure: Executive 
Compensation at Bear Stearns and Lehman 2000-2008'', supra n. 1.
    The top executives' payoffs were further increased by large bonus 
compensation during 2000-2007; while the earnings providing the basis 
for these bonuses evaporated in 2008, the firms' pay arrangements did 
not contain any ``claw back'' provisions that would have enabled 
recouping the bonuses that had already been paid. Altogether, while the 
long-term shareholders in these firms were largely decimated, the 
executives' performance-based compensation kept them in decidedly 
positive territory. Indeed, combining the figures from equity sales and 
bonuses, we find that, during 2000 to 2008, the top five executives at 
Bear Stearns and Lehman pocketed about $1.4 billion and $1 billion, 
respectively, or roughly $250 million per executive.
    The divergence between how the top executives and their companies' 
shareholders fared raises a serious concern that the aggressive risk-
taking at Bear Stearns and Lehman (and other financial firms with 
similar pay arrangements) could have been the product of flawed 
incentives. The concern is not that the top executives expected their 
aggressive risk-taking to lead to certain failure for their firms, but 
that the executives' pay arrangements--in particular, their ability to 
claim large amounts of compensation based on short-term results--
induced them to accept excessive levels of risk.
    Such incentives were not unique to these two firms: a subsequent 
study by Sanjai Bhagat and Brian Bolton finds a similar pattern--
precrisis cashing out of large amounts of compensation by the CEO that 
exceeded losses suffered by the CEO from stock price declines during 
the crisis--for other large financial firms that had to be bailed out 
during the financial crisis. \4\ There is also empirical evidence 
indicating that risk-taking was associated with the extent to which the 
CEO's compensation was sensitive to the volatility of the company's 
stock returns, \5\ as well as with the sensitivity of the CEO's 
compensation to short-term earnings per share. \6\
     \4\ Sanjai Bhagat and Brian Bolton, ``Bank Executive Compensation 
and Capital Requirements Reform'', Working paper (2011), available at 
     \5\ See, Marc Chesney, Jacob Stromberg, and Alexander Wagner, 
``Risk-Taking Incentives and Losses in the Financial Crisis'', Swiss 
Finance Institute Research Paper No. 10-18 (2010), available at http://
ssrn.com/abstract=1595343; Robert DeYoung, Emma Peng, and Meng Yan, 
``Executive Compensation and Business Policy Choices at U.S. Commercial 
Banks'', Journal of Financial and Quantitative Analysis, forthcoming, 
available at http://ssrn.com/abstract=1544490; Amar Gande and 
Swaminathan Kalpathy, ``CEO Compensation at Financial Firms'', SMU 
Working Paper (2011), available at http://ssrn.com/abstract=1865870; 
and Felix Suntheim, ``Managerial Compensation in the Financial Service 
Industry'', Working paper (2011), available at http://ssrn.com/
     \6\ Sugato Bhattacharyya and Amiyatosh Purnanandam, ``Risk-Taking 
By Banks: What Did We Know and When Did We Know It?'', Working paper 
(2011), available at http://ssrn.com/abstract=1619472.
Solving Problem I: Paying for Long-Term Performance
    To address the problem of short-term focus, financial firms should 
reform compensation structures to ensure tighter alignment between 
executive payoffs and long-term results. Senior executives should not 
be able to collect and retain large amounts of bonus compensation when 
the performance on which the bonuses are based is subsequently sharply 
reversed. Similarly, equity incentives should be subject to substantial 
limitations aimed at preventing executives from placing excessive 
weight on their firm's short-term stock price. Had such compensation 
structures been in place at Bear Stearns and Lehman, their top 
executives would not have been able to derive such large amounts of 
performance-based compensation for managing these firms in the years 
leading up to their collapse.
    Equity-based compensation is the primary component of modern pay 
packages. In a recent article, Jesse Fried and I, building on the 
approach we put forward in Pay Without Performance, proposed a detailed 
blueprint for preventing equity-based compensation from producing an 
excessive focus on short-term results. \7\
     \7\ Bebchuk and Fried, ``Paying for Long-Term Performance'', supra 
note 1.
    First, the time that options and restricted shares can be cashed 
should be separated from the time in which they vest. As soon as an 
executive has completed an additional year at the firm, the options or 
shares promised as compensation for that year's work should vest; it 
should belong to the executive even if he or she immediately leaves the 
firm. The executive, however, should not be free to cash out these 
vested equity incentives; rather, he or she should be permitted to do 
so only after a substantial passage of time.
    Second, unwinding should be subject to a combination of grant-based 
and aggregate restrictions. Grant-based limitations would require 
executives to hold equity incentives awarded as part of a given grant 
for a fixed number of years after vesting. For example, an executive 
receiving an equity award could be prevented from unwinding any awarded 
equity incentives for 2 years after vesting, with each subsequent year 
freeing another 20 percent of the awarded incentives to be unloaded.
    These grant-based limitations, however, are not sufficient to 
ensure adequate long-term focus. With only grant-based restrictions in 
place, longtime executives might amass large amounts of equity 
incentives that they could immediately unload, which could induce them 
to pay excessive attention to short-term prices. Therefore, grant-based 
limitations should be supplemented with aggregate limitations 
restricting the fraction of an executive's otherwise unloadable equity 
incentives that could be sold in any given year. To illustrate, 
executives could be precluded from unloading, in any given year, more 
than 10 percent of their total portfolio of otherwise unloadable 
incentives. By construction, such limitations would ensure that 
executives would not place substantial weight on short-term stock 
    Firms should not make limitations on unwinding a function of events 
under the control of executives. Some reformers have urged using, and 
some firms have been using, ``hold-till-retirement'' requirements that 
allow executives to cash out shares and options only upon retirement 
from the firm. Such requirements, however, provide executives with a 
counterproductive incentive to leave the firm in order to cash out 
their portfolio of options and shares and diversify their risks. 
Perversely, the incentive to leave will be strongest for executives who 
have served successfully for a long time and whose accumulated options 
and shares are especially valuable. Similar distortions arise under any 
arrangement tying the freedom to cash out to an event that is at least 
partly under an executive's control.
    Third, firms should generally adopt robust limitations on 
executives' use of hedging and derivative transactions, a practice that 
can weaken the connection between executive payoffs and long-term 
results. An executive who buys a ``put'' option to sell his or her 
shares at the current price is ``insured'' against declines in the 
stock price below current levels, which undermines incentives and the 
effectiveness of limitations on unwinding. Therefore, whether or not 
they are motivated by the use of inside information, executives should 
be precluded from engaging in any hedging or derivative transactions 
that would reduce or limit the extent to which declines in the 
company's stock price would lower executive payoffs. In 2009, following 
the antihedging approach that Jesse Fried and I advocated in our book, 
the Special Master for TARP Executive Compensation Kenneth Feinberg 
(whom I served as an adviser) required companies subject to his 
jurisdiction to adopt such an antihedging requirement. \8\ This 
approach should be followed by financial firms in general. Whatever 
equity-plan design is chosen by a given bank's board, executives should 
not be allowed to unilaterally use hedging and derivative transactions 
that undo the incentive consequences of this design.
     \8\ See, testimony of Kenneth R. Feinberg, the Special Master for 
TARP Executive Compensation, before the House Financial Services 
Committee, February 25, 2010, http://www.treasury.gov/press-center/
press-releases/Pages/tg565.aspx. Feinberg reports that one of the 
principles used in evaluating pay at subject firms was that ``employees 
should be prohibited from engaging in any hedging, derivative or other 
transactions that undermine the long-term performance incentives 
created by a company's compensation structures.''
    In addition to equity compensation, bonus plans should also be 
designed to encourage long-term focus. Bonuses should commonly be based 
not on 1-year results but on results over a longer period. Furthermore, 
bonuses should not be cashed right away; instead, the funds should be 
placed in a company account for several years and adjusted downward if 
the company subsequently learns that the bonus is no longer justified. 
The need for such a downward adjustment is not limited to firms in 
which financial results are restated. Even if results for a given year 
were booked consistent with accounting conventions, executives should 
not be rewarded for profits that are quickly reversed. Rewarding 
executives for short-term results distorts their incentives and should 
be avoided by well-designed compensation arrangements.
Problem II: Excessive Focus on Shareholder Interests
    Thus far, I have focused on the insulation of executives from long-
term losses to shareholders--the problem that has received the most 
attention following the recent crisis. However, as Holger Spamann and 
have highlighted in our research, \9\ there is another type of 
distortion that should be recognized: payoffs to financial executives 
have been shielded from the consequences that losses could impose on 
parties other than shareholders. This source of distortion is distinct 
from the ``short-termism'' problem discussed above and would remain 
even if executives' payoffs were fully aligned with those of long-term 
     \9\ Bebchuk and Spamann, ``Regulating Bankers' Pay'', supra n. 1.
    Equity-based awards, coupled with the capital structure of banks, 
tie executives' compensation to a highly levered bet on the value of 
banks' assets. While bank executives expect to share in any gains that 
might flow to common shareholders, they do not expect to bear (in the 
event losses exceed the common shareholders' capital) any part of 
losses borne by preferred shareholders, bondholders, depositors, or the 
Government as a guarantor of deposits. This state of affairs leads 
executives to pay insufficient attention to the possibility of large 
losses sustained beyond the shareholders' equity; it thus incentivizes 
excessive risk-taking.
    Insulation of executives from losses to parties other than 
shareholders can be expected to produce at least two types of risk-
taking distortions. First, it encourages executives to make investments 
and take on obligations that can contribute to ``tail'' scenarios, in 
which the bank suffers losses exceeding the shareholders' capital. 
Second, it creates reluctance to raise capital and fosters excessive 
willingness to run the bank with a capital level that provides 
inadequate cushion for bondholders and depositors.
    The above analysis is consistent with empirical evidence indicating 
that risk-taking was positively correlated with CEOs' equity-based 
compensation; \10\ that risk-taking was negatively correlated with 
inside debt holdings by bank CEOs; \11\ and that banks whose CEOs had 
larger equity holdings performed worse during the crisis. \12\
     \10\ Sudhakar Balachandran, Bruce Kogut, and Hitesh Harnal, ``The 
Probability of Default, Excessive Risk, and Executive Compensation: A 
Study of Financial Services Firms from 1995 to 2008'', Columbia 
Business School Research Paper (2010), available at http://ssrn.com/
     \11\ Frederick Tung and Xue Wang, ``Bank CEOs, Inside Debt 
Compensation, and the Global Financial Crisis'', Boston Univ. School of 
Law Working Paper No. 11-49 (2011), available at http://ssrn.com/
     \12\ Rudiger Fahlenbrach and Rene Stulz, ``Bank CEO Incentives and 
the Credit Crisis'', Journal of Financial Economics 99 (2011): 11-26, 
available at http://ssrn.com/abstract=1439859.
Solving Problem II: Linking Executive Pay to the Payoffs of 
        Nonshareholder Stakeholders
    How should pay arrangements be designed to address the above 
problem? To the extent that executive pay is tied to the value of 
specified securities, such pay could be tied to a broader basket of 
securities, not merely common shares. Thus, rather than tying executive 
pay to a specified percentage of the value of the common shares of the 
bank holding company, compensation could be tied to a specified 
percentage of the aggregate value of the common shares, the preferred 
shares, and all the outstanding bonds issued by either the bank holding 
company or the bank. Because such a compensation structure would expose 
executives to a broader fraction of the negative consequences of risks 
taken, it would encourage greater prudence in evaluating risky choices.
    One could broaden further the set of positions to which executive 
payoffs are tied by using the value of credit default swaps. Because 
the value of credit default swaps is associated with increases in the 
risk posed by the bank's operations, adjusting executives' long-term 
payoffs by an amount dependent on changes in the value of credit 
default swaps would provide executives an incentive to take into 
account the effects of their risk choices on nonshareholder 
    Similarly, in firms in which executives receive bonus compensation 
tied to specified accounting measures, bonuses could be linked instead 
to broader metrics. For example, the bonus compensation of some bank 
executives has been dependent on accounting measures that are of 
interest primarily to common shareholders, such as return on equity or 
earning per common share. Such plans could be redesigned to be based on 
more expansive measures, such as earnings before any payments made to 
bondholders. Alternatively or in addition, bonuses could be paid not in 
cash but rather in the form of a subordinated debt obligation of the 
bank payable in several years.
    Ensuring that executives perfectly internalize the expected losses 
their choices would impose on contributors of capital other than 
shareholders is far from straightforward. But doing so imperfectly 
would likely be better than not doing so at all. Requiring financial 
executives to expand their focus beyond consequences for shareholders 
would significantly improve their risk-taking incentives.
The Role of Regulations
    Outside the financial sector, the Government should not intervene 
in the substantive terms of pay arrangements. In the case of banks, 
however, financial regulators should monitor and impose meaningful 
regulations on financial firms' compensation structures. Such pay 
regulation is justified by the same moral hazard reasons that underlie 
the long-standing system of prudential regulation of banks.
    When a bank takes risks, shareholders can expect to capture the 
full upside, but part of the downside may be borne by the Government as 
guarantor of deposits. Because bank failure imposes costs on the 
Government and the economy that shareholders do not internalize, 
shareholders' interests may be served by greater risk-taking than is in 
the interest of the Government and the economy. This moral hazard 
problem provides a basis for the extensive body of regulations that 
restrict the choices of financial firms with respect to investments, 
lending, and capital reserves.
    Aligning the interests of executives with those of shareholders, 
which some governance reforms seek to do, could eliminate risk-taking 
that is excessive even from the shareholders' perspective. But it 
cannot be expected to get rid of incentives for risk-taking that are 
excessive from a social standpoint but not from the shareholders' 
    Shareholders' interest in greater risk-taking implies that they 
stand to benefit when bank executives take excessive risks. Given the 
complexities of modern finance and the limited information and 
resources of regulators, the traditional regulation of banks' actions 
and activities is necessarily imperfect. Regulators are often one step 
behind banks' executives. Thus, executives with incentives to focus on 
shareholder interests can use their informational advantages and 
whatever discretion traditional regulations leave them to take 
excessive risks.
    Because shareholders' interests favor incentives for risk-taking 
that are socially excessive, substantive regulation of the terms of pay 
arrangements--that is, limiting the use of structures that reward risky 
behavior--can advance the goals of banking regulation. Regulators 
should focus on the structure of compensation--not the amount--with the 
aim of discouraging excessive risk-taking. By doing so, regulators 
would induce bank executives to work for, not against, the goals of 
banking regulation.
    The regulation of bankers' pay could well supplement and reinforce 
the traditional direct regulation of banks' activities. Indeed, if pay 
arrangements are designed to discourage excessive risk-taking, direct 
regulation need not be as stringent as would otherwise be necessary. 
Conversely, as long as banks' executive pay arrangements are 
unconstrained, regulators should be stricter in their monitoring and 
direct regulation of banks' activities. At a minimum, when assessing 
the risks posed by any given bank, regulators should take into account 
the incentives generated by the bank's pay arrangements. When the 
design of compensation encourages risk-taking, regulators should 
monitor the bank more closely and should consider raising its capital 
    Before concluding, it is worthwhile to respond to objections that 
have been raised against a meaningful governmental role in this area. 
First, regulation of pay structures may be opposed on grounds that it 
is the shareholders' money and the Government does not have a 
legitimate interest in telling bank shareholders how to spend their 
money. The Government, however, does have a legitimate interest in the 
compensation structures of private financial firms. Given the 
Government's interest in the safety and soundness of the banking 
system, intervention here is no less legitimate than the Government's 
established involvement in limiting banks' investment and lending 
    Second, opponents of meaningful regulation have argued that one 
size does not fit all and that regulators are at an informational 
disadvantage vis-a-vis decision makers within each firm. But the 
knowledge required of regulators to effectively limit compensation 
structures that incentivize risk-taking would be no more demanding than 
that which is requisite to regulators' direct intervention in 
investment, lending, and capital decisions. Furthermore, setting pay 
arrangements should not be left to the unconstrained choices of 
informed players inside banks; while such players might be best 
informed, they do not have incentives to take into account the 
interests of bondholders, depositors, and the Government.
Proposed Regulations
    The case for meaningful regulation of pay structures in large 
financial firms is strong. Although regulators issued proposed rules 
for incentive-based compensation arrangements in April 2011, they have 
not thus far adopted final rules. Furthermore, and importantly, the 
proposed regulations should be tightened to ensure that firms take the 
steps discussed above as necessary to eliminate excessive risk-taking 
    The proposed regulations should be revised to include robust and 
meaningful rules requiring large financial firms to subject all equity 
compensation of senior executives not only to vesting schedules but 
also to grant-based limitations on unwinding for a substantial period 
after equity incentives are vested, as well as to aggregate limitations 
on unwinding. The proposed regulations should also be revised to 
require large financial firms to prohibit their senior executives from 
engaging in any hedging or derivative transactions that would reduce or 
limit the extent to which declines in the company's stock price would 
lower executive payoffs. Adopting the rules discussed in this paragraph 
would serve both financial stability and the long-term interests of 
    In addition, the proposed regulations should be revised to include 
rules that would induce firms to make the variable compensation of 
senior executives significantly depend on long-term payoffs to the 
bank's nonshareholder stakeholders and not only on the payoffs of 
shareholders. In designing such rules, regulators should recognize that 
securing risk-taking incentives that are optimal from shareholders' 
perspective would be insufficient to eliminate risk-taking incentives 
that are excessive from a social perspective.
    To reduce the likelihood of future financial crises, it is 
important to pay close attention to the incentives provided to 
financial firms' senior executives. The structure of pay should induce 
executives to focus on long-term rather than short-term results, as 
well as to take into account the consequences of their decisions for 
all those contributing to the bank's capital (rather than only for 
shareholders). Because of the importance of providing such incentives 
for financial stability, ensuring that financial firms design pay 
arrangements to provide such incentives should be regarded as a 
regulatory priority.
            Associate Professor of Law, Columbia Law School
                           February 15, 2012
    Thank you, Chairman Brown and Ranking Member Corker, for the 
opportunity to testify before you about incentive compensation at 
America's largest financial institutions. Hard experience has taught us 
that bankers' pay can be a source of concern for all Americans, so I 
welcome your invitation and look forward to participating in this 
hearing. As a researcher at Columbia Law School who writes on, among 
other matters, bankers' incentives, I am pleased to have the 
opportunity to testify on this important issue. \1\
     \1\ My institutional affiliation is given for identification 
purposes only. Further, from 2009 to 2010 I served at the Department of 
the Treasury as an advisor to senior officials on executive 
compensation and in the Office of the Special Master for TARP Executive 
Compensation. The views set forth here are solely my own and should not 
be attributed to the Treasury. This testimony expands upon comments I 
submitted to Federal regulators in May 2011, see Robert J. Jackson, 
Jr., Ltr. to the Board of Governors of the Federal Reserve System, 
available at http://www.law.columbia.edu/null/
    The financial crisis of 2008 brought the potential dangers 
associated with bankers' incentives into sharp relief. In 2010, 
Congress responded with the Dodd-Frank Wall Street Reform and Consumer 
Protection Act, which included several important new rules that now 
govern executive pay at large public companies. For example, one 
provision proposed by the Administration and included in Dodd-Frank now 
requires large public companies to give shareholders a vote on 
executive pay. Boards of directors initially resisted federally 
mandated ``say-on-pay'' votes, arguing that they might compromise the 
board's long-standing freedom to use its business judgment in setting 
executive pay. While it is too soon to know how say-on-pay will affect 
executive compensation in the long run, preliminary study of results 
from the first year of votes suggests that say-on-pay has facilitated 
important dialogue between directors and shareholders on pay while 
leaving the ultimate decision to the sound judgment of the board. \2\
     \2\ See, e.g., ``Council of Institutional Investors, Say on Pay: 
Identifying Investor Concerns'', (Sept. 2011), at 20 (concluding, 
following empirical study of the shareholder votes cast during the 2011 
proxy season, that ``[i]nvestors by and large agree that they do not 
want to dictate executive pay arrangements'').
    Say-on-pay has been the subject of considerable political debate 
and media scrutiny. But Dodd-Frank's broadest compensated-related 
provision has received much less attention. That provision, Section 
956, gives nine Federal agencies, including the Federal Reserve, the 
Federal Deposit Insurance Corporation and the Securities and Exchange 
Commission, extraordinarily expansive authority to ensure that bonus 
practices at our largest banks never again endanger financial 
stability. Section 956 gives the agencies two key powers in regulating 
banker bonuses. First, the agencies must ``prohibit any'' bonus 
arrangement that gives bankers excessive pay or could lead to material 
financial loss. Second, the agencies must require banks to disclose 
``the structures of all'' bonus arrangements to regulators so that 
those who oversee our financial institutions can identify incentive 
structures that could lead bankers to take excessive risks. \3\ In 
Section 956, Congress and the Administration gave Federal regulators 
the expansive powers they will need to ensure that bonus practices do 
not threaten the safety and soundness of America's financial system. 
The agencies jointly issued proposed rules under Section 956 last 
April, and these rules are scheduled to be finalized later this year. 
     \3\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Pub. L. No. 111-203, 956(a-b), 124 Stat. 1376, 1905 (2010) (emphases 
     \4\ Office of the Comptroller of the Currency et al., Incentive-
Based Compensation Arrangements, 76 Fed. Reg. 21,170 (April 14, 2011). 
Although the agencies initially expressed hope that the rules would be 
finalized in the first 6 months of 2012, they recently signaled that 
final rules will not be issued until the second half of this year, see, 
``SEC, Implementing Dodd-Frank Wall Street Reform and Consumer 
Protection Act--Upcoming Activity'', available at http://www.sec.gov/
    Unfortunately, the agencies' proposals fall far short of the 
rigorous oversight of banker pay that Congress authorized in Section 
956. In this testimony, I will provide three reasons why Congress 
should not expect these rules to change bonus practices at America's 
largest banks, and describe three principles for reform that would help 
ensure that incentive structures give bankers reason to pursue long-
term value rather than the illusory, short-term profits that led to the 
    First, the rules focus their attention on the few top executives 
who lead America's banks. But bank executives' incentives have for many 
years been the subject of extensive disclosure rules and media 
scrutiny. That is not to say that top executives' incentives are 
unimportant. But for two reasons the rules governing bankers' 
incentives should apply beyond this limited group. First, one of the 
clearest lessons of the crisis was that bankers outside the executive 
suite can cause a great deal of systemic damage. None of the employees 
at American International Group's Financial Products division, the unit 
that contributed to the system's collapse in September 2008, was an 
executive. If that division were still operating today, the agencies' 
most stringent rules under Section 956 would not apply to bonuses paid 
to its employees. Second, because executives' incentives have long been 
scrutinized by investors and the public, rules governing their bonuses 
may be redundant to existing practices. Indeed, as I explain below, the 
agencies' most rigorous rule under Section 956 is redundant to pay 
practices that were in place at many large banks years before the 
crisis. Accordingly, I argue that rules governing bankers' bonuses 
should not be limited to the group of executives, and regulation of 
executives' incentives should go beyond long-standing industry pay 
    Second, the rules provide little hope that regulators will actually 
oversee or address the incentives of employees, like those who worked 
at AIG Financial Products, who make decisions with critical 
consequences for the safety and soundness of our financial system. The 
rules require only that banks identify these employees using a vague 
standard--and then have the bank's own board of directors approve the 
employees' pay. For two reasons, we should not expect these rules to 
address bonus structures that encourage bankers to take excessive risk. 
First, because there is no clear standard for identifying these 
employees, there is little hope that the rule will apply to all of the 
risk takers whose decisions might threaten systemic stability. In 2008 
alone, just six of our largest banks collectively had more than 1.3 
million employees, more than 4,500 of whom received bonuses of more 
than $1 million each. A vague standard applied by the banks themselves 
is hardly likely to lead to the identification of the few employees in 
that large group whose incentives warrant special attention. Second, 
even if banks do identify the appropriate group of employees, the rule 
is unlikely to eliminate bonuses for those employees that encourage 
them to pursue short-term profits at the expense of systemic stability. 
Because directors, as a matter of law, owe their allegiance to 
shareholders rather than to financial stability, there is no reason to 
think that requiring the board to approve bonuses will eliminate 
incentives for excessive risk taking. Thus, regulators should provide 
clear rules for identifying significant risk takers at large banks and 
require bonus structures for these risk takers to be reviewed by 
regulators rather than the boards of directors of the banks themselves.
    Third, while there can and should be debate about how regulation 
should influence bonus practices, there is no question that regulators 
need detailed information about those practices to do their work under 
Section 956. Congress and the Administration understood as much; that 
is why the broadest language in Section 956 is reserved for the 
requirement that banks disclose detailed information about incentives 
to regulators. But the agencies' proposal requires only that banks 
provide qualitative, general descriptions of their policies on pay. 
These reports will be redundant to disclosure long required by 
securities rules. And, more importantly, because they will consist of 
qualitative reports rather than clear, quantitative data, they have 
very little chance of giving regulators the information they need to 
identify bonus practices that could lead bankers to take the kinds of 
excessive risks that contributed to the financial crisis. Instead, I 
argue, the agencies should require banks to provide meaningful 
quantitative disclosure of bankers' incentives rather than the 
duplicative qualitative reporting that the agencies have proposed.
    Despite the sweeping authority Congress granted Federal regulators 
in Section 956, the agencies' proposal likely leaves bonuses completely 
unregulated for many significant risk takers at our largest banks. 
Below I explain why--and what might be done about it.
I. Regulation of Executives' Incentives
    Consistent with Section 956's command that regulators prohibit 
incentive-pay arrangements that encourage bankers to take inappropriate 
risks, the agencies' proposal requires that, at large financial 
institutions, at least 50 percent of each executive's incentive pay be 
deferred for at least 3 years. Many have debated whether a 50 percent 
deferral requirement is likely to give bankers optimal risk-taking 
incentives. I agree with the agencies that deferrals can be useful in 
structuring incentives--because, as the agencies have explained, 
deferral ``allows a period of time for risks not previously discerned'' 
``to ultimately materialize,'' and for bankers' pay to be adjusted for 
those risks. But for two reasons, the agencies' decision to apply this 
rule only to executives means that the deferral requirement will have 
little effect on bankers' incentives.
    First, one of the few clear lessons from the financial crisis is 
that employees outside the group of executives frequently make 
decisions that affect systemic stability. None of the employees at 
American International Group's Financial Products division was an 
executive; nor was the Citigroup banker who earned more than $100 
million in annual bonuses trading energy futures in the years leading 
up to the crisis. \5\ Congress and the Administration understood well 
that, even though they are not executives, these employees' incentives 
demand scrutiny. That is why both Congress's rules and the Treasury 
Department's oversight for bonuses at recipients of financial 
assistance under the Troubled Asset Relief Program apply beyond the 
group of executives, \6\ and that is why the language of Section 956 
itself specifies that it applies not only to payments to any 
``executive'' but also to any other ``employee.'' That is also why 
international standards on banker pay require that mandatory-deferral 
rules apply to employees outside the executive suite. \7\ But the 
agencies' deferral rules under Section 956 apply only to executives, 
excluding many employees whose decisions can have important systemic 
     \5\ See, American International Group, Inc., Form 10-K (filed Feb. 
2, 2008), at 15 (listing AIG's executives, including its general 
counsel and chief human resources officer--but excluding employees at 
Financial Products). Compare, Michael Sinconolfi and Ann Davis, ``Citi 
in $100 Million Pay Clash'', Wall St. J. (July 25, 2009), at A1 
(describing the trader, who was an employee of Citigroup's energy-
trading unit, Phibro) with Citigroup, Inc., Form 10-K (filed Feb. 22, 
2008), at 129, 201 (listing Citigroup's executives, including its 
general counsel and vice chairmen but excluding this trader--even 
though Phibro earned $843 million in trading revenues in 2007 alone).
     \6\ Congress placed limits on bonuses for employees of TARP 
recipients that applied, for most large banks, to the senior executive 
officers and 25 most highly paid employees of each firm, see, American 
Recovery and Reinvestment Act, Pub. L. No, 111-5 7001, 123 Stat. 115 
(2009). For seven significant recipients of TARP assistance, the 
Treasury Department went even further, requiring review by the Special 
Master for TARP Executive Compensation of compensation structures for 
both executives and the 100 most highly paid employees, Department of 
the Treasury, TARP Standards for Compensation and Corporate Governance, 
74 Fed. Reg. 28,394 (2009).
     \7\ For example, standards on banker pay adopted by the Financial 
Stability Board state clearly that incentive pay should be deferred for 
``senior executives as well as other employees whose actions have a 
material impact on the risk exposure of the firm.'' Financial Stability 
Board, Principles for Sound Compensation Practices: Implementation 
Standards 3, Basel, Switzerland (Sept. 2009) (emphasis added). 
Similarly, deferral rules recently adopted by the European Parliament 
expressly apply ``at least'' to ``senior management, risk takers, . . . 
and any employee whose [pay] takes them into the same [pay] bracket as 
senior managers and risk takers.'' European Parliament, Directive 2010/
76/EU (Dec. 14, 2010) at Par. 3.
    Second, because bank executives' pay has long been subject to 
disclosure and public scrutiny, the proposed deferral rule is redundant 
to long-standing pay practices at America's largest banks. Figure 1 
below describes the percentage of executives' incentive pay that was 
deferred at six of America's largest banks in the years leading up to 
the financial crisis:
     \8\ The data reflected in Figure 1 include incentive payments 
disclosed for the top five executives at Bank of America, Citigroup, 
Goldman Sachs, J.P. Morgan Chase, Morgan Stanley, and Wells Fargo, in 
each case drawn from the ExecuComp dataset. See, ``Compustat Executive 
Compensation Dataset, Wharton Research Data Services'', available at 
http://wrds-web.wharton.upenn.edu/wrds/index.cfm (last accessed 
February 11, 2012). Figure 1 assumes that payments under long-term 
incentive programs and in the form of options or stock are ``deferred'' 
for purposes of the agencies' proposal, because a standard term of 
those programs is that amounts paid vest over several years on a pro 
rata basis. Compare Morgan Stanley, Schedule 14A (filed February 24, 
2006), at 22 (noting that stock awards granted to executives vested 50 
percent on the third anniversary of the grant date and 50 percent on 
the fourth anniversary of the grant date) with Office of the 
Comptroller of the Currency et al., supra n. 4, at 21,194 (explaining 
that the agencies' proposal under Section 956 requires deferrals ``over 
a period of no less than 3 years, with the release of deferred amounts 
to occur no faster than on a pro rata basis'').

    As Figure 1 shows, the largest U.S. banks deferred more than 50 
percent of their executives' incentive pay for years prior to the 
financial crisis. Moreover, in the years immediately following the 
crisis, the banks voluntarily agreed to defer even larger proportions 
of executives' incentives even before Congress enacted Section 956. \9\ 
Because the proposed rules are redundant to long-standing industry 
practices on executive pay, we should not expect that the agencies' 
proposed rules will meaningfully change bankers' incentives. \10\
     \9\ See, e.g., ``Goldman Sachs Grp., Goldman Sachs Compensation 
Practices'', 12 (March 2010) (noting that all of Goldman's executives, 
as well as other officials who are members of the firm's Management 
Committee, received 100 percent of their incentive pay in stock that 
was not transferable for 5 years pursuant to policies voluntarily 
adopted months before the passage of Dodd-Frank).
     \10\ In addition to the deferral requirement, the agencies' 
proposal also requires that, during the deferral period, incentives 
paid to executives be subject to a claw back, or ``look-back'' 
provision, that would require incentives to be ``adjusted downward to 
reflect actual losses.'' Office of the Comptroller of the Currency et 
al., supra n. 4, at 21,198. This requirement, too, is redundant to 
existing executive pay practices at large U.S. banks. See, e.g., 
``Goldman Sachs Grp.'', supra n. 9, at 12 (describing the adoption of 
such a claw back); ``Morgan Stanley'', Schedule 14A (filed April 14, 
2010), at 18 (same).
    The agencies' most stringent rules on incentives do not apply to 
bankers who take significant risk--and are redundant with respect to 
the few executives to whom they do apply. To the extent that Congress 
and the agencies seek to ensure that bonus structures do not give 
bankers incentives to pursue excessive risk, rules governing bankers' 
bonuses should not be limited to the group of executives, and 
regulation of executives' bonuses should go beyond long-standing 
industry practices on executive pay. \11\
     \11\ Indeed, in many respects the agencies' proposal lags 
prevailing industry practices on executive pay. For example, the 
proposal would not prohibit executives from hedging--that is, from 
using derivatives and similar instruments to undermine the incentives 
created by stock compensation. ``Office of the Comptroller of the 
Currency et al.'', supra n. 4, at 21,183 (requesting comment on whether 
hedging should be prohibited). Many large U.S. banks have prohibited 
executives from hedging for years, see, e.g., ``Goldman Sachs Grp.'', 
Schedule 14A (filed March 7, 2008) at 21 (``Our [executives] are 
prohibited from hedging . . . their equity-based awards.''), and 
academics long ago provided evidence that hedging is used to undermine 
the incentives provided by stock-based pay, see, J. Carr Bettis et al., 
``Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost 
Collars and Equity Swaps by Corporate Insiders'', 36 J. Fin. and Quant. 
Analysis 345, 346 (2001) (finding that executives ``use [hedging 
transactions] to cover a significant proportion of their holdings of 
the firm's stock''). Hank Greenberg, the CEO of AIG, provided perhaps 
the most prominent example, hedging approximately $300 million worth of 
AIG stock in 2005 and avoiding $280 million in losses when the firm 
collapsed in 2008. Id. at 347. The Office of the Special Master for 
TARP Executive Compensation has prohibited hedging for all of the 
employees at all of the firms subject to its jurisdiction. Kenneth R. 
Feinberg, U.S. Dept. of the Treasury, Ltr. to Bob Benmoche (Oct. 22, 
2009), at 3.
II. Regulating the Incentives of Significant Risk Takers
    As I have noted, the agencies' proposed deferral requirement 
applies only to executives. With respect to all other employees, 
including significant risk takers, the proposal requires only that the 
board of directors of the bank identify employees who ``individually 
have the ability'' to cause losses ``that are substantial in relation 
to the institution's size''; for these employees, the board must 
approve their incentive pay as ``appropriately balanced.'' This 
approach is unlikely to allow regulators or banks to identify the 
employees whose incentives deserve special scrutiny. More importantly, 
even if those employees are identified, it is doubtful that the 
proposal will ensure that their incentives are consistent with systemic 
    At a large financial institution, thousands of risk takers are 
spread throughout the firm. Although it is difficult to know how many 
of these employees take systemically important risk, pay levels may 
serve as a helpful means of identifying those who bear substantial 
organizational responsibility. Table I below describes the number of 
employees at six large U.S. banks--and the number of bankers who 
received bonuses of more than $1 million--in 2008:

    At the height of the crisis these six firms alone had more than 1.1 
million employees, more than 4,500 of whom received bonuses of more 
than $1 million in 2008--a year in which performance suffered 
considerably. Identifying the key risk takers among a group of this 
size and scope requires a careful assessment of the relationship 
between employees' activities and the firm's exposures against a clear 
set of rules. One might expect, for example, that the agencies would 
require that the group of significant risk takers include the employees 
who, according to the regulators' risk models, are responsible for the 
firm's most significant exposures. Instead, however, the agencies' 
proposal provides only a vague standard under which the banks 
themselves are responsible for identifying these critical employees. 
This approach is likely to lead either to an overinclusive group, with 
too little attention given to each risk taker's incentives, or an 
underinclusive analysis that excludes significant risk takers from 
regulators' reach.
     \12\ See, Andrew M. Cuomo, ``No Rhyme or Reason: The `Heads I Win, 
Tails You Lose' Bank Bonus Culture'', available at http://
    More importantly, even if the group of significant risk takers is 
properly identified, incentives for these employees to take excessive 
risk will likely remain in place. That is because the agencies' 
proposal requires only that the board of directors of the bank itself 
approve the compensation of significant risk takers. The problem with 
this approach is that, as a matter of law, the board owes its duties 
strictly to the shareholders of the bank. And it is now well-accepted 
that shareholders in large banks prefer that the bank take excessive 
risk. That is because shareholders capture the full upside from such 
risk taking, while some of the downside of bank failures is borne by 
the Government, both as an insurer of deposits and as a provider of 
bailout financing. \13\ Thus, even if the board of directors identifies 
employees with incentives to take excessive risk, their legal 
obligations will not necessarily lead them to eliminate those 
incentives. Considerations regarding the socially appropriate level of 
risk taking are not within the purview, or expertise, of banks' boards 
of directors. Those considerations are more appropriately addressed by 
bank regulators, which is why Section 956 requires those regulators to 
``prohibit all'' bonus structures that could someday lead to material 
losses--even if those structures are in the short-term interests of 
     \13\ See, generally, Lucian A. Bebchuk and Holger Spamann, 
``Regulating Bankers' Pay'', 98 Geo. L.J. 247, 284-85 (2010).
    The proposed rules under Section 956 would permit large banks to 
identify their most significant risk takers under a vague standard. 
Once these risk takers are identified, the proposal requires only that 
the bankers' bonuses be approved by the bank's own board of directors--
whose duties are to shareholders, not systemic stability. This approach 
is unlikely to provide needed scrutiny for the incentives of all of the 
risk takers whose decisions have implications for the safety and 
soundness of our financial system--and, even if it does, that scrutiny 
will be applied by directors with no duty to pursue systemic stability 
rather than short-term profits. To the extent that Congress and banking 
regulators want to ensure that the incentive structures of significant 
risk takers are subject to meaningful oversight, clear, uniform rules 
for identifying significant risk takers are needed--and bonus 
structures for these risk takers should be reviewed by banking 
regulators rather than the banks' own boards of directors.
III. Providing Meaningful Quantitative Disclosure of Bankers' 
    Section 956 requires ``enhanced disclosure and reporting of 
compensation'' at financial institutions, including disclosure on the 
``structures of all incentive-based compensation arrangements.'' This 
broad language empowers, and indeed directs, regulators to obtain 
detailed information from large banks about their employees' 
incentives. The agencies' proposal would require that each financial 
institution provide a ``clear narrative description'' of its incentive-
pay arrangements; a ``succinct description of [the bank's] policies and 
procedures'' on incentive pay; and ``specific reasons why the [bank] 
believes the structure of its [incentive pay] does not encourage 
inappropriate risks.'' For two reasons, these disclosures are 
inadequate to carry out both the purpose of Section 956 and the 
agencies' policy mandate.
    First, most large banks are public companies subject to securities 
rules that have long required qualitative disclosure of exactly the 
kind required by the proposal. \14\ In Section 956, Congress gave the 
agencies sweeping authority to obtain ``enhanced disclosure and 
reporting'' on bankers' incentives. Congress's purpose is hardly met by 
requiring banks to provide duplicative reports identical to those that 
banks already must provide under securities law.
     \14\ See, e.g., 17 C.F.R. 229.402(b)(2)(i) (requiring a 
qualitative description of the company's ``policies for allocating 
between long-term and currently paid out compensation''); see also id., 
229.402(e)(1)(i-iv) (requiring a ``narrative description'' of 
incentive pay). The proposal's language on this reporting requirement 
is nearly identical to the language that has governed securities-law 
disclosure requirements since 2006. Financial institutions and their 
counsel have generally concluded that the agencies' proposal allows 
them to use identical reports to comply with identical language in the 
agencies' proposal under Section 956 and long-standing securities 
rules. This might explain why comments from the Financial Services 
Roundtable and Chamber of Commerce, among others, although critical of 
some aspects of the agencies' proposal, offered only ``applau[se]'' in 
response to the ``streamlined'' nature of the reporting rules. Letter 
from Center on Executive Compensation et al. to Elizabeth M. Murphy, 
Sec'y, SEC (May 25, 2011), at 10.
    Second, and more importantly, qualitative reports are unlikely to 
give regulators the information they need to supervise banker 
incentives. Importantly, the securities rules that require qualitative 
discussion of pay policies are accompanied by clear, quantitative 
tables describing the amount and structure of the compensation to be 
paid. \15\ Unlike those rules, the agencies' proposal requires only 
generalized essays that will be difficult to compare either to each 
other or to prevailing best practices. \16\ It is hard to see how 
regulators will be able to use these reports to identify bonus 
practices at large banks that could threaten financial stability.
     \15\ 17 C.F.R. 229.402(c).
     \16\ Recently the Federal Reserve, upon the conclusion of its 
``horizontal review'' of bonus practices at 25 large banks, indicated 
that its staff ``intends to implement'' disclosure requirements on 
banker pay recently promulgated by the Basel Committee. ``Board of 
Governors of the Federal Reserve System, Incentive Compensation 
Practices: A Report on the Horizontal Review of Practices at Large 
Banking Organizations'' (Oct. 2011), at 3, at http://
compensation-practices-report-201110.pdf (citing ``Bank of 
International Settlements, Pillar 3 Disclosure Requirements on 
Remuneration Issued by the Basel Committee'', at http://www.bis.org/
publ/bcbs197.pdf (July 2011)). The Basel standards appear to require 
disclosure of some quantitative information on bonus structures, see, 
``Bank of International Settlements'', supra, at 4. Those standards 
were promulgated in July 2011, however, and the agencies have not yet 
indicated that U.S. banks are required to provide that information to 
their regulators. Thus, it remains to be seen whether banks will be 
required to disclose meaningful quantitative information on their bonus 
practices under Section 956. Moreover, even the Basel standards would 
not provide regulators with all of the information they need to have a 
full picture of bankers' incentives. See, infra, n. 18.
    Indeed, qualitative descriptions, in the absence of quantitative 
data, may well give regulators misleading information about bankers' 
incentives. Suppose, for example, that a large bank qualitatively 
describes its pay practices as requiring that its employees' bonuses be 
paid in stock. Regulators might well conclude that these bankers have 
strong incentives to increase the value of the firm because the bankers 
will suffer personal losses if the bank's stock price falls. But this 
assumes that the bankers have not ``unloaded'' their shares--that is, 
sold a sufficient number of shares to eliminate the incentives created 
by the stock-based bonus. Empirical study has shown that unloading is 
common at the largest U.S. banks--both for executives and for other 
significant risk takers. \17\ Without quantitative detail on unloading, 
qualitative disclosures will give regulators no way to distinguish 
between a banker whose pay is actually tied to the long-term future of 
her firm--and the banker who has unloaded, taking advantage of short-
term increases in value before the systemic consequences of her risk 
taking can be known. \18\
     \17\ See, e.g., Lucian Bebchuk et al., ``The Wages of Failure: 
Executive Compensation at Bear Stearns and Lehman 2000--2008'', 27 Yale 
J. On Reg. 257 (2010) (documenting unloading prior to the collapse at 
Bear Stearns and Lehman Brothers); Robert J. Jackson, Jr., ``Stock 
Unloading and Banker Incentives'', 112 Colum. L. Rev. (forthcoming 
2012) (documenting unloading by the partners of Goldman Sachs).
     \18\ More generally, the financial-economics literature on 
managerial incentives has shown that equity ownership in the firm 
provides a far stronger pay-performance link than standard incentive 
payments like cash bonuses. See, e.g., Michael C. Jensen and Kevin J. 
Murphy, ``Performance Pay and Top-Management Incentives'', 98 J. Pol. 
Econ. 225, 226 (1990). More recent research has suggested that 
substantial equity stakes may lead bankers to pursue levels of risk 
taking that is socially excessive. See, e.g., Bebchuk and Spamann, 
supra n. 13, at 284. All agree, however, that bankers' equity ownership 
in their firms is a critical determinant of their incentives. Yet under 
the agencies' proposal and the Basel standards, Federal regulators 
would have no quantitative data from America's largest banks about the 
equity ownership of their employees--even those who take systemically 
significant risk.
    In sum, the reporting provisions of the agencies' proposal will 
give regulators no new information on bonus compensation at America's 
largest banks. As proposed, the rules will leave regulators unable to 
identify which bankers have incentives to take excessive risk. These 
rules are inconsistent with the sweeping authority that Congress 
provided in Section 956 and the agencies' objective of ensuring that 
incentive-pay practices do not threaten the safety and soundness of 
these institutions. Rather than the duplicative qualitative reports 
required by the agencies' proposal, the rules under Section 956 should 
require large banks to provide the agencies with clear quantitative 
data on the structure of incentive compensation for all employees who 
take significant risk.
    Bankers' incentives remain a significant concern for all Americans 
who rely upon the safety and soundness of our financial system. In 
Section 956, Congress and the Administration provided Federal 
regulators with the sweeping authority they will need to ensure that 
bankers do not have incentives to pursue short-term gains that could 
compromise systemic stability. The agencies' proposed rules on banker 
incentives are, however, inadequate to the regulators' critical task. 
Further diligence from Congress, from the Administration and from the 
regulators themselves is needed to make certain that the agencies use 
this new authority to ensure that banker incentives are aligned with 
all Americans' interest in a safe and secure financial system.
    Thank you once again for the opportunity to testify about this 
important issue. This statement concludes my formal testimony; I will 
of course be pleased to answer any questions you or your staff may 
                     Partner, Winston & Strawn, LLP
                           February 15, 2012
    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee: thank you for the opportunity to address the subject of 
``Pay for Performance: Incentive Compensation at Large Financial 
Institutions.'' My name is Mike Melbinger and I Chair the Employee 
Benefits and Executive Compensation practice group at the law firm of 
Winston & Strawn LLP. I am also an Adjunct Professor of Law at 
Northwestern University School of Law, and I write extensively on the 
topic of executive compensation. I have practiced exclusively in the 
area of executive compensation for 29 years.
    I appear today on behalf of The Financial Services Roundtable (the 
``Roundtable''). The Roundtable is a national trade association that 
represents 100 of the Nation's largest integrated financial services 
companies. Member companies of the Roundtable provide banking, 
insurance and investment products and services to millions of American 
    I will provide observations about the current state of management 
members' and boards of directors' approaches to compensation plans and 
the significant improvements made since 2008. I will then review the 
range of recent laws and regulations that impose new requirements in 
the areas of executive compensation and corporate governance, and how 
they have affected compensation policies for better. Finally, I will 
provide my thoughts on whether the enforcement and monitoring of the 
laws in place will be sufficient or whether additional laws and 
regulations are needed in this area.
Observations on the Evolution of Compensation Policies Since 2008
    First, I would like to offer my observations as to financial 
industry compensation trends and describe how financial institutions 
have transformed their compensation practices in response to the 
financial crisis, the Dodd-Frank Act, board oversight requirements, and 
other recent regulations.
    All of the members of the Roundtable and, indeed, other of my 
clients which are not in the financial services industry, have been 
working very hard to design and implement best practices and 
compensation programs that reflect appropriate incentives to motivate 
employees to achieve defined corporate objectives.
    Large financial institutions have embraced principles of safety and 
soundness and profoundly changed their executive compensation 
practices. Today, financial institutions have become the thought 
leaders in corporate America on issues such as pay for performance and 
mitigating the potential risks created by incentive compensation 
    Aligning executive pay with company performance has been an 
objective of the boards of directors and compensation committees of 
financial institutions and other public companies for decades. However, 
the economic crisis--beginning with 2008 and continuing to today--
surprised even the most experienced leaders of business with how close 
to the brink that our economy and businesses came. From that experience 
came difficult but not easily forgotten lessons--particularly for those 
who were convinced that ``that could never happen.'' Many companies 
have responded, even those that are not in the financial services 
industry, by adopting a more balanced and comprehensive view of 
compensation philosophies with a view to align employees compensation 
to a more conservative risk profile and to align corporate goals with 
investor priorities.
    In addition, since 2008 Board Compensation Committees have 
sharpened their focus on pay for performance as part of good corporate 
governance. While no silver bullet exists to align executive pay to 
company performance perfectly, significant efforts are being made. 
However, several challenges exist in aligning long-term compensation 
plan components to performance priorities. For example, during highly 
volatile economic times, multiyear priorities may change dramatically 
and indeed, external changes may heighten rather than mitigate risks in 
compensation plans. Management and Board Compensation Committees must 
be vigilant to recognize these changes and have plans that can be 
appropriately changed. One effective way to align pay for performance 
is to design plans to avoid paying for short-term gains at the expense 
of true long-term performance. In the financial institutions area, 
various forms of risk mitigation are applied to incentive compensation 
policies, and have become a significant component of pay for 
    For example, Section 165 of the Dodd-Frank Act, would require large 
financial institutions designated as systemically important to 
establish a separate Board-level ``Risk Committee'' consisting of 
independent directors, with at least one risk expert on it. \1\ Most 
large bank holding companies have established separate risk committees 
of the board. Risk management and oversight have become a major 
component of the work of financial institution Boards and Compensation 
Committees. In much the same way that Say on Pay proxy proposals moved 
from being a financial institution only issue to one that effects most 
public companies, nonfinancial companies have established separate 
board level risk committees.
     \1\ Dodd-Frank Act Section 165, ``Enhanced Supervision and 
Prudential Standards for Nonbank Financial Companies Supervised by the 
Board of Governors and Certain Bank Holding Companies.''
Roundtable Survey
    Financial institutions have led the way in designing plans with 
reduced risks attributable to incentive compensation, greater 
transparency, better correlation between pay and performance, and just 
plain lower compensation. One hundred percent (100 percent) of surveyed 
Roundtable companies reported that they had significantly reformed 
their executive compensation practices since 2008, according to a 2011 
Financial Services Roundtable membership survey. In part, the Survey 

    Overall levels of compensation were down for the last few 

    Annual bonuses have come down.

    The benefits, perquisites, and other contractual 
        protections contained in the employment agreements of the 
        senior executives--things like golden parachutes and 
        supplemental executive retirement plans--have been reduced 
        significantly since 2008.

    Roundtable member companies reported many other executive 
compensation reforms they had undertaken over the last 3 years, all 
without legislative or regulatory mandates, including:

  1.  Instituting maximum payout caps (87 percent of companies)

  2.  Having claw back provisions in place (83 percent of companies)

  3.  Improving risk management (77 percent of companies)

  4.  Introducing new performance metrics (69 percent of companies)

  5.  Restricting stock awards (52 percent of companies)

  6.  Instituting new performance reviews (45 percent of companies)

  7.  Creating stock holding requirements (41 percent of companies)

  8.  Developing new bonus formulas (38 percent of companies)

  9.  Increasing base salary and linked performance to stock (31 
        percent of companies)
Federal Reserve Board Report
    In October 2011, the Board of Governors of the Federal Reserve (the 
``Federal Reserve'') released its report ``Incentive Compensation 
Practices: A Report on the Horizontal Review of Practices at Large 
Banking Organizations,'' as mandated by the Dodd-Frank Act. The 
Horizontal Review was a supervisory initiative, under the Federal 
Reserve's Proposed Guidance on Sound Incentive Compensation Policies 
(the ``Proposed Guidance''), \2\ to perform a multidisciplinary, 
horizontal review of incentive compensation practices at 25 large, 
complex banking organizations (LCBOs). \3\
     \2\ Proposed Guidance on Sound Incentive Compensation Policies, 74 
Fed. Reg. 55227 (Oct. 27, 2009).
     \3\ The financial institutions in the Incentive Compensation 
Horizontal Review were Ally Financial Inc.; American Express Company; 
Bank of America Corporation; The Bank of New York Mellon Corporation; 
Capital One Financial Corporation; Citigroup Inc.; Discover Financial 
Services; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan 
Stanley; Northern Trust Corporation; The PNC Financial Services Group, 
Inc.; State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; and 
Wells Fargo & Company; and the U.S. operations of Barclays plc, BNP 
Paribas, Credit Suisse Group AG, Deutsche Bank AG, HSBC Holdings plc, 
Royal Bank of Canada, The Royal Bank of Scotland Group plc, Societe 
Generale, and UBS AG.
    The Federal Reserve observed that ``every firm in the review has 
made progress during the review in developing practices and procedures 
that will internalize the principles of the interagency guidance into 
management systems at each firm.''

        With the oversight of the Federal Reserve and other banking 
        agencies, the firms in the horizontal review have implemented 
        new practices to make employees' incentive compensation 
        sensitive to risk.

    In its 2011 Report, the Federal Reserve concluded that:

  1.  The largest banks are already at or above Dodd-Frank proposed 
        guidelines for executive compensation (to defer 50 percent for 
        3 years);

  2.  Senior executives have more than 60 percent of their incentive 
        compensation deferred on average;

  3.  Some of the most senior executives have more than 80 percent 

  4.  Deferral periods generally range from 3 to 5 years, with 3 years 
        the most common.

    Finally, for last year's proxy season, and again this year, most 
financial institutions, and other public companies generally, directly 
address pay for performance in their proxy statements. Institutions and 
other corporations generally took this step to address the need to seek 
shareholder approval of the executives' pay packages--shareholder say 
on pay. The financial industry directly took on this issue in both the 
Compensation Discussion and Analysis CD&A section of the proxy--usually 
with an executive summary--and in a supporting statement for the 
shareholder say on pay resolution. Last year financial institutions and 
other public companies provided investors with heightened transparency 
through detailed charts showing companies' performance compared to 
executive pay, and as well as better explanations in the text of proxy 
Recent Laws and Regulations Imposing New Requirements on Executive 
        Compensation and Corporate Governance
    Dramatic changes in financial institutions' compensation programs 
since 2008 have occurred. To begin with, financial institutions 
dramatically changed their executive compensation programs in reaction 
to lessons learned from the financial crisis. Other changes were 
prompted by the various laws passed by Congress and regulations 
promulgated by the financial regulatory agencies. However, financial 
institutions not only have complied with new regulatory strictures; 
institutions have actively embraced the role as thought leaders 
nationwide in how to balance risk with reward, implement appropriate 
compensation claw backs, compensation holdbacks, and other needed 
    These new attitudes can be seen in the way that the industry 
responded to significant changes required under the Troubled Asset 
Relief Program (TARP), the 2010 Interagency Guidance, the Horizontal 
Review process, and the Dodd-Frank Act.
    In October 2008, President Bush signed into law the Emergency 
Economic Stabilization Act (EESA), \4\ creating the Troubled Assets 
Relief Program (TARP). In February 2009, President Obama signed into 
law the American Recovery and Reinvestment Act (ARRA), \5\ which 
included amendments to the executive compensation provisions of EESA. 
Section 111 of EESA, as amended by ARRA, \6\ imposed a variety of new 
limitations and restrictions on the executive compensation plans and 
arrangements of any entity that received financial assistance under 
TARP. These restrictions and standards applied throughout the period 
during which any obligation arising from financial assistance provided 
under TARP remained outstanding (the ``TARP obligation period'').
     \4\ Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-
343, 122 Stat. 3765 (2008).
     \5\ American Recovery and Reinvestment Act of 2009, Pub. L. No. 
111-5, 123 Stat. 115 (2009).
     \6\ 12 U.S.C. 5221 (2010).
SEC Reporting Rules
    The influence of the executive compensation provisions affecting 
financial institutions receiving TARP funds were further extended on 
December 15, 2009, when the U.S. Securities and Exchange Commission 
(SEC) issued a new Final Rule on executive compensation disclosure and 
corporate governance that imposes risk assessment requirements similar 
to those under TARP to all publicly traded companies, beginning in 
2010. \7\ The SEC's Final Rule requires all public companies to assess 
their compensation policies and practices to determine if they are 
reasonably likely to have a material adverse effect on the institution.
     \7\ Proxy Disclosure Enhancements, 74 Fed. Reg. 68334 (Dec. 23, 
2009) (to be codified at 17 C.F.R. pts. 229, 239, 240, 249 and 274).
Horizontal Review
    In late 2009, the Federal Reserve initiated a multidisciplinary, 
horizontal review of incentive compensation practices at 25 LCBOs, to 
foster implementation of improved practices. \8\ The Horizontal Review 
was a supervisory initiative, under the Federal Reserve Board's 2009 
Proposed Guidance on Sound Incentive Compensation Policies, \9\ which 
preceded the Interagency Guidance described below. The Horizontal 
Review was designed to assess:
     \8\ The financial institutions in the Incentive Compensation 
Horizontal Review were Ally Financial Inc.; American Express Company; 
Bank of America Corporation; The Bank of New York Mellon Corporation; 
Capital One Financial Corporation; Citigroup Inc.; Discover Financial 
Services; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan 
Stanley; Northern Trust Corporation; The PNC Financial Services Group, 
Inc.; State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; and 
Wells Fargo & Company; and the U.S. operations of Barclays plc, BNP 
Paribas, Credit Suisse Group AG, Deutsche Bank AG, HSBC Holdings plc, 
Royal Bank of Canada, The Royal Bank of Scotland Group plc, Societe 
Generale, and UBS AG.
     \9\ ``Proposed Guidance on Sound Incentive Compensation 
Policies'', 74 Fed. Reg. 55227 (Oct. 27, 2009).

    the potential for incentive compensation arrangements or 
        practices to encourage imprudent risk-taking;

    the actions an institution has taken or proposes to take to 
        correct deficiencies in its incentive compensation practices; 

    the adequacy of the organization's compensation-related 
        risk-management, control, and corporate governance processes.

    One goal of the horizontal review was to assist the Federal 
Reserve's understanding of incentive compensation practices across 
financial institutions and categories of employees within institutions. 
The second, more important goal was to guide each financial institution 
in implementing the interagency guidance on sound incentive 
compensation policies.
    In four key areas of the Horizontal Review, the Federal Reserve 
concluded that:

    Effective Incentive Compensation Plan Design. All firms in 
        the horizontal review have implemented new practices to balance 
        risk and financial results in a manner that does not encourage 
        employees to expose their organizations to imprudent risks. The 
        most widely used methods for doing so are risk adjustment of 
        awards and deferral of payments.

    Progress in Identifying Key Employees. At most large 
        banking organizations, thousands or tens of thousands of 
        employees have a hand in risk taking. Yet, before the crisis, 
        the conventional wisdom at most firms was that risk-based 
        incentives were important only for a small number of senior or 
        highly paid employees and no firm systematically identified the 
        relevant employees who could, either individually or as a 
        group, influence risk. All firms in the horizontal review have 
        made progress in identifying the employees for whom incentive 
        compensation arrangements may, if not properly structured, pose 
        a threat to the organization's safety and soundness. All firms 
        in the horizontal review now recognize the importance of 
        establishing sound incentive compensation programs that do not 
        encourage imprudent risk taking for those who can individually 
        affect the risk profile of the firm.

    Changing Risk-Management Processes and Controls. Because 
        firms did not consider risk in the design of incentive 
        compensation arrangements before the crisis, firms rarely 
        involved risk management and control personnel when considering 
        and carrying out incentive compensation arrangements. All firms 
        in the horizontal review have changed risk-management processes 
        and internal controls to reinforce and support the development 
        and maintenance of balanced incentive compensation 
        arrangements. Risk-management and control personnel are engaged 
        in the design and operation of incentive compensation 
        arrangements of other employees to ensure that risk is properly 

    Progress in Altering Corporate Governance Frameworks. At 
        the outset of the horizontal review, the boards of directors of 
        most firms had begun to consider the relationship between 
        incentive compensation and risk, though many were focused 
        exclusively on the incentive compensation of their firm's most 
        senior executives. Since then, all firms in the horizontal 
        review have made progress in altering their corporate 
        governance frameworks to be attentive to risk-taking incentives 
        created by the incentive compensation process for employees 
        throughout the firm. The role of boards of directors in 
        incentive compensation has expanded, as has the amount of risk 
        information provided to boards related to incentive 
2010 Interagency Guidance
    In June 2010, the Office of the Comptroller of the Currency, 
Treasury (OCC); Board of Governors of the Federal Reserve System, 
(Federal Reserve); Federal Deposit Insurance Corporation (FDIC); and 
Office of Thrift Supervision, Treasury (OTS) issued Guidance on Sound 
Incentive Compensation Policies in final form (the ``2010 Interagency 
    The 2010 Interagency Guidance describes four methods that are 
``often used to make compensation more sensitive to risk'': (i) risk 
adjustment of awards; (ii) deferral of payment; (iii) longer 
performance periods; and (iv) reduced sensitivity to short-term 
performance. (In February 2011, new interagency rules were proposed, as 
described below. These new rules, when finalized, may make the 2010 
Interagency Guidance obsolete.)
The Dodd-Frank Act
    In July 2010, President Obama signed into law the Dodd-Frank Wall 
Street Reform and Consumer Protection Act \10\ (the ``Dodd-Frank 
Act''). The Dodd-Frank Act technically became effective on July 21, 
2010. However, many of the provisions relating to executive 
compensation are not self-executing, in that they require the SEC to 
modify its requirements for maintaining an effective registration under 
the Securities Exchange Act of 1934 (the ``Exchange Act'') and/or 
require the national securities exchanges to modify their listing 
     \10\ Pub. L. 111-203, H.R. 4173
    The Dodd-Frank Act included between 10 and 13 separate provisions 
directly or indirectly effecting executive compensation, depending on 
how you count, including two applicable to financial institutions only.

  1.  Dodd-Frank Act Section 951, added a new Section 14A to the 
        Exchange Act, entitled ``Shareholder Approval of Executive 
        Compensation'', which provides that, not less frequently than 
        once every 3 years, a company's annual proxy statement must 
        include a separate resolution, subject to nonbinding 
        shareholder vote, to approve the compensation of executives, as 
        disclosed in the company's Compensation Discussion and Analysis 
        (CD&A), the compensation tables, and any related material. 
        Dodd-Frank Act Section 951 also requires that, not less 
        frequently than once every 6 years, the proxy statement must 
        include a separate resolution subject to a nonbinding 
        shareholder vote to determine whether future votes on the 
        resolutions required under the preceding paragraph will occur 
        every 1, 2, or 3 years.

  2.  Dodd-Frank Act Section 951 added a new Section 14A to the 
        Exchange Act, ``Shareholder Approval of `Golden Parachute' 
        Compensation'', which requires in any proxy solicitation 
        material for a meeting of shareholders at which the 
        shareholders are asked to approve an acquisition or merger, the 
        party soliciting the proxy must disclose any agreements or 
        understandings that the party soliciting the proxy has with any 
        named executive officers of company concerning any type of 
        compensation that relates to the transaction and the aggregate 
        total of all such compensation that may be paid or become 
        payable to or on behalf of such executive officer.

  3.  Dodd-Frank Act Section 952 added a new Section 10C(a) to the 
        Exchange Act, ``Independence of Compensation Committees'', 
        which requires the SEC to promulgate rules that direct the 
        NYSE, NASDAQ, and other national securities exchanges and 
        associations to prohibit the listing of any equity security of 
        a company that does not have an independent compensation 

  4.  Dodd-Frank Act Section 952 added a new Section 10C(b) to the 
        Exchange Act, ``Independence of Compensation Consultants and 
        Other Compensation Committee Advisers'', which provides that 
        the compensation committee, in its sole discretion, may obtain 
        the advice of independent legal counsel, compensation 
        consultants, and other advisers. If it does, the committee may 
        only select a compensation consultant, legal counsel or other 
        adviser after taking into consideration factors identified by 
        the SEC.

  5.  Dodd-Frank Act Section 954, ``Recovery of Erroneously Awarded 
        Compensation Policy'', added new Section 10D to the Exchange 
        Act, which requires the SEC to direct the national securities 
        exchanges to prohibit the listing of any security of an issuer 
        that does not develop and implement a claw back policy.

  6.  Dodd-Frank Act Section 955, ``Disclosure of Hedging by Employees 
        and Directors'', added a new subsection 14(j) to the Exchange 
        Act, which requires the SEC to require companies to disclose in 
        their annual proxy statement whether the company permits any 
        employee or director to purchase financial instruments that are 
        designed to hedge or offset any decrease in the market value of 
        equity securities (1) granted to the employee or director by 
        the company as part of the compensation; or (2) held, directly 
        or indirectly, by the employee or director.

  7.  Dodd-Frank Act Section 953(a), ``Disclosure of Pay Versus 
        Performance'', added a new 14(i) to the Exchange Act, which 
        requires each public company to disclose in its annual proxy 
        statement ``information that shows the relationship between 
        executive compensation actually paid and the financial 
        performance of the issuer.''

  8.  Dodd-Frank Act Section 972, ``Corporate Governance'', added a new 
        Section 14B to the Exchange Act, which requires the SEC to 
        issue rules that requires the company to disclose in its annual 
        proxy statement the reasons why it has chosen the same or 
        different persons to serve as chairman of the board of 
        directors and chief executive officer (or in equivalent 
        positions) of the company.

  9.  Dodd-Frank Act Section 953(b), ``Executive Compensation 
        Disclosures'', requires the SEC to amend the proxy statement 
        disclosure rules to require each public company to disclose the 
        ratio of the median of the annual total compensation of all 
        employees of the company, except the CEO to the annual total 
        compensation of the CEO.

  10.  Dodd-Frank Act Section 957, ``Elimination of Discretionary 
        Voting by Brokers on Executive Compensation Proposals'', 
        amended Section 6(b) of the Exchange Act.

  11.  Dodd Frank-Act Section 956, ``Enhanced Compensation Structure 
        Reporting'', applies only to financial institutions with assets 
        of $1 billion or more.

  12.  Dodd-Frank Act Section 165, ``Enhanced Supervision and 
        Prudential Standards for Nonbank Financial Companies Supervised 
        by the Board of Governors and Certain Bank Holding Companies'', 
        requires the Federal Reserve to establish prudential standards 
        for nonbank financial companies supervised by it and bank 
        holding companies (BHCs) with total consolidated assets equal 
        to or greater than $50 million, which are more stringent than 
        the standards and requirements applicable to nonbank financial 
        companies and bank holding companies that do not present 
        similar risks to the Nation's financial stability.
Interagency Rules Under Dodd-Frank Act 956
    In February 2011, the Office of the Comptroller of the Currency, 
Treasury (OCC), Federal Reserve System, FDIC, Office of Thrift 
Supervision, Treasury (OTS), National Credit Union Administration 
(NCUA), SEC, and Federal Housing Finance Agency (FHFA), proposed rules 
to implement Dodd-Frank Act Section 956, ``Enhanced Compensation 
Structure Reporting.'' Section 956 requires the reporting of incentive-
based compensation arrangements by a covered financial institution, and 
prohibits incentive-based compensation arrangements that encourage 
inappropriate risks by covered financial institutions by providing a 
covered person with excessive compensation, or that could lead to 
material financial loss to the covered financial institution. These 
rules have not been finalized.
FDIC Final Rules
    In July 2011, the FDIC issued final rules to implement certain 
provisions of its authority to resolve covered financial companies 
under Section 210(s)(3) of the Dodd-Frank Act, which directed the FDIC 
to promulgate regulations with respect to recoupment of compensation 
from senior executives or directors materially responsible for the 
failed condition of a covered financial company. The final rules adopt 
a rebuttable presumption that certain senior executives or directors 
are ``substantially responsible'' for the failed condition of a 
financial entity company that is placed into receivership under the 
orderly liquidation authority of the Dodd-Frank Act.
Current Laws and Regulation Are Sufficient
    The Dodd-Frank Act and Interagency Guidance on executive 
compensation and corporate governance promulgated since 2009 give 
financial institutions and other nonfinancial public companies, the 
mandates and tools they need to design appropriate compensation plans 
and give regulators the tools they need to monitor them. The 
Interagency final rules under Dodd-Frank Act Section 956 will complete 
the picture.
    For financial institutions and their boards of directors, there is 
no turning back on the good governance reforms and best practices they 
have adopted since 2008. Boards of directors and compensation committee 
members are highly intelligent and experienced fiduciaries. They value 
their reputations. They want to do the right thing. They have learned 
important lessons from the financial crisis and they have been further 
empowered by the legislation and regulation promulgated in its wake.
    Boards of directors, compensation committee members, and management 
at financial institutions are taking much more care in the design and 
implementation of their incentive plans. They are involving more 
outside independent experts in the process. These independent advisors 
have provided not only industry specific expertise that the boards or 
committee members may not possess, but also access to good benchmarking 
data and independent thought.
Roundtable Study on Incentive-Based Compensation Practices
    Roundtable members are cognizant of the risk that faulty 
compensation practices may result in a material financial loss. In 
order to gauge what actions industry members are taking with respect to 
their incentive-based compensation practices, the Roundtable conducted 
a study of a portion of its membership. The Roundtable collected 
detailed information and commentary from numerous member companies 
regarding both their risk management strategies and their procedures 
for determining compensation.
    Roundtable Members are committed to robust planning and oversight 
of incentive-based compensation plans. Each of the companies who 
participated in the study maintains a compensation committee of the 
board of directors that must approve all salary packages for the Chief 
Executive Officer and other high-level employees. The committee also 
must approve any material change in the compensation plans of the 
employees they monitor. At several companies, the compensation 
committee retains the discretion to reduce any award due to the overall 
financial performance of the company.
    Roundtable members generally use detailed data to create their 
compensation plans for high-level executives. Nearly 90 percent of 
study respondents employ a board of director's compensation consultant 
that conducts a peer-review analysis of the compensation plans put 
before the board, and 87 percent establish maximum payout targets for 
high-level executives.
    Each of the companies surveyed also employ policies and procedures 
concerning the incentive-based compensation of mid-level and low-level 
employees, though these practices vary widely. Some companies report 
centralized oversight of all incentive-based compensation arrangements. 
Other respondents make use of external audits. Over 75 percent of 
companies employ claw back agreements or holdback procedures for the 
vesting of incentive-based compensation beyond a certain level.
    Industry members are actively monitoring and changing the content 
of their incentive-based compensation programs. All of the companies 
involved in the Roundtable study reported changes to their incentive-
based compensation practices since 2008. An overwhelming majority of 
these companies, 83 percent, reported that the risk of material 
financial loss was a leading factor in instituting changes to their 
past incentive-based compensation systems.
    The strategies used by Roundtable companies to address risk vary 
widely as each company attempts to devise and apply solutions that work 
for its circumstances. Study participants mentioned more than 15 
different approaches that are currently being analyzed and implemented 
by either the compensation committee or their human resources 
departments. In all cases, a variety of three or more approaches is 
being used.
    Finally, the statutory and regulatory changes provide great tools 
sufficient for regulators to examine for appropriate practices, to test 
for best practices implementation and review results through 
institution reports.
    We appreciate the opportunity to provide this statement to the 
Subcommittee for its consideration. We would be happy to respond to 
questions the Subcommittee Members may have.