[Senate Hearing 112-477]
[From the U.S. Government Publishing Office]
S. Hrg. 112-477
PAY FOR PERFORMANCE: INCENTIVE COMPENSATION AT LARGE FINANCIAL
INSTITUTIONS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING INCENTIVE COMPENSATION AT LARGE FINANCIAL INSTITUTIONS
__________
FEBRUARY 15, 2012
__________
Printed for the use of the Committee on Banking, Housing, and Urban
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
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
JEFF MERKLEY, Oregon
KAY HAGAN, North Carolina
Graham Steele, Subcommittee Staff Director
Michael Bright, Republican Subcommittee Staff Director
Kara Stein, Legislative Counsel
(ii)
C O N T E N T S
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WEDNESDAY, FEBRUARY 15, 2012
Page
Opening statement of Chairman Brown.............................. 1
Opening statements, comments, or prepared statements of:
Senator Corker............................................... 2
WITNESSES
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
(iii)
PAY FOR PERFORMANCE: INCENTIVE COMPENSATION AT LARGE FINANCIAL
INSTITUTIONS
----------
WEDNESDAY, FEBRUARY 15, 2012
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Subcommittee on Financial Institutions and Consumer
Protection,
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.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
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
disgraced.
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
pay.
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.
STATEMENT OF SENATOR BOB CORKER
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
here.
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
also.
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
school.
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
Compensation.
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
today.
Thank you to all of you. And if you will begin Mr. Hyde,
thank you very much for joining us.
STATEMENT OF KURT HYDE, DEPUTY SPECIAL INSPECTOR GENERAL FOR
THE TROUBLED ASSET RELIEF PROGRAM
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
April.
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.
STATEMENT OF LUCIAN A. BEBCHUK, WILLIAM J. FRIEDMAN AND ALICIA
TOWNSEND FRIEDMAN PROFESSOR OF LAW, ECONOMICS, AND FINANCE,
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.
STATEMENT OF ROBERT J. JACKSON, JR., ASSOCIATE PROFESSOR OF
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
incentives.
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.
STATEMENT OF MICHAEL S. MELBINGER, PARTNER, WINSTON & STRAWN,
LLP
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
companies.
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
dramatically.
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
questions.
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
pay.
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
them.
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
too.
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
tame.
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
incentives.
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
questioning?
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
addressed?
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
think.
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
policies.
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
enough?
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
position?
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
consequence.
I just want to add a few things to this last discussion on
hedging.
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
hedging.
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.
Melbinger?
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
questions.
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
bill.
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
out.
The prospective Federal judge has now been introduced. I
know not a big thing but a big thing for our State. So, thank
you.
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
at.
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
shareholders.
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
stakeholders.
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
company.
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
shareholders.
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
executives.
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
this?
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
you.
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
ago.
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
know.
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
partnerships.
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
Bebchuk?
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
partners.
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
us.
The Subcommittee for Financial Institutions is adjourned.
Thanks.
[Whereupon, at 3:24 p.m., the hearing adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF KURT HYDE
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.
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\1\ SIGTARP, ``Exiting TARP: Repayments by the Largest Financial
Institutions'', issued September 29, 2011, http://www.sigtarp.gov/
reports/audit/2011/
Exiting_TARP_Repayments_by_the_Largest_Financial_Institutions.pdf.
---------------------------------------------------------------------------
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
companies.
---------------------------------------------------------------------------
\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_ExecComp_Audit.pdf.
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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
decisions.
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
regulators.
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\
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\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.
\10\
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\6\ Board of Governors of the Federal Reserve System, press
release (Oct. 22, 2009) (online at www.federalreserve.gov/newsevents/
press/bcreg/20091022a.htm).
\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://
cop.senate.gov/documents/transcript-121610-geithner.pdf).
\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
www.federalreserve.gov/publications/other-reports/files/incentive-
compensation-practices-report-201110.pdf).
\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
www.federalreserve.gov/publications/other-reports/files/incentive-
compensation-practices-report-201110.pdf).
\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
www.federalreserve.gov/publications/other-reports/files/incentive-
compensation-practices-report-201110.pdf).
---------------------------------------------------------------------------
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
www.federalreserve.gov/newsevents/speech/tarullo20091102a.htm.
---------------------------------------------------------------------------
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
guidance.
---------------------------------------------------------------------------
\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/
76fr21170.pdf.
\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/
fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf).
---------------------------------------------------------------------------
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.
______
PREPARED STATEMENT OF LUCIAN A. BEBCHUK
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
http://ssrn.com/abstract=1673250.
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
only.
---------------------------------------------------------------------------
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
http://ssrn.com/abstract=1781318.
\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/
abstract=1592163.
\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
prices.
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
shareholders.
---------------------------------------------------------------------------
\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/
abstract=1914542.
\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/
abstract=1570161.
\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
stakeholders.
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'
perspective.
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
requirements.
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
decisions.
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
incentives.
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
shareholders.
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.
Conclusion
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.
______
PREPARED STATEMENT OF ROBERT J. JACKSON, JR.
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\
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\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/
download?&exclusive=filemgr.download&file_id=6035.
---------------------------------------------------------------------------
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\
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\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.
\4\
---------------------------------------------------------------------------
\3\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 956(a-b), 124 Stat. 1376, 1905 (2010) (emphases
added).
\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/
spotlight/dodd-frank/dfactivity-upcoming.shtml#07-12-12.
---------------------------------------------------------------------------
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
crisis.
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
practices.
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
implications.
---------------------------------------------------------------------------
\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
stability.
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://
www.oag.state.ny.us/media_center/2009/july/pdfs/
Bonus%20Report%20Final%207.30.09.pdf.
---------------------------------------------------------------------------
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
shareholders.
---------------------------------------------------------------------------
\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'
Incentives
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://
www.federalreserve.gov/publications/other-reports/files/incentive-
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.
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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.
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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.
Conclusion
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
have.
______
PREPARED STATEMENT OF MICHAEL S. MELBINGER
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
consumers.
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
programs.
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
performance.
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.
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\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.''
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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
found:
Overall levels of compensation were down for the last few
years.
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\
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\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.
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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
deferred;
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
statements.
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
changes.
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.
TARP
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'').
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\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).
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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.
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\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).
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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:
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\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
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practices to encourage imprudent risk-taking;
the actions an institution has taken or proposes to take to
correct deficiencies in its incentive compensation practices;
and
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
considered.
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
compensation.
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
Guidance'').
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
standards.
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\10\ Pub. L. 111-203, H.R. 4173
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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
committee.
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.