Open Letter To Ben S. Bernanke

FOR IMMEDIATE RELEASE

OPEN LETTER TO BEN S. BERNANKE
CHAIRMAN OF THE FEDERAL RESERVE SYSTEM

September 22, 2009

Dr. Ben S. Bernanke
Chairman
Board of Governors of the Federal Reserve System
20th & Constitution Avenue, NW
Washington, DC  20551

Dr. Bernanke:

It appears that almost everyone is speculating on what the new rule on Executive Compensation in the banking and insurance industries will be.  As compensation consultants, we are obviously eager to learn what new thinking and constraints will be imposed, since these will obviously have a significant impact on the advice we will provide to our clients in the future. 

Executive Compensation is an extremely complicated subject, in which one well- intentioned action can have huge and often unintended consequences.  Therefore, we kindly request that you take the time to read the attached articles which discuss Executive Compensation issues, and at least consider some of the ideas that we put forward, while determining how to rein in excessive and often risky compensation practices. 

I would like to make a few additional points for your consideration:

1. Circuit Breakers vs. Clawbacks.  If the pay plans have qualitative tests that must be met before any payment are made (such as loan quality), it is much easier to stop any payments via “circuit breakers”, than trying to get the money back after it has been paid (“clawbacks”).  In reality, given the general distrust that many have for the banking industry's previous record of excessive compensation, having both circuit breakers and clawbacks provide extra levels of protection.  The circuit breaker stops payments if they are undeserved, and provides the mechanism to get an award back if it is paid in error, or if performance deteriorates.
   

2. Balance of Short-term and Long-term Incentives.  Organizational goals typically involve various timeframes, and the incentive plans should reflect the appropriate timing of those targets, such as when objectives overlap fiscal or calendar years.  This can often be handled by measuring “milestones”, which indicate that work is progressing against a longer-term performance target.  Short-term incentives reward annual and short-term achievements, while long-term incentives help to keep the focus on what is important over a longer range.  The size of the award should reflect the value and level of success achieved.
   

3. Judging Quality, not only Quantity.  Incentives should be based on how good performance is during a specific performance period, particularly when there is a requirement for qualitative measurement over an extended period.  A perfect example of this was the underlying problems with sub-prime mortgages.  Clearly, the quality of those risky loans was not known until defaults began to appear, which generally happened in the second and third years.  Therefore, incentive plan designs must withhold award payments until the effectiveness of a specific activity or level of achievement is known.   For loan origination, the payments should not be at the end of a short period (e.g., monthly or annually), but rather after a number of years (e.g., two to three years). 
   

4. Penalties, where Appropriate #1.  Within the regulations covering publicly-traded companies, there are very few built-in penalties that are prescribed for excessive compensation.  Under IRC Section 162m, if the compensation is in excess of $1 million, it must be performance based, or otherwise the company loses its tax deduction.  This impacts the shareholders, not the overpaid executives.  On the other hand, the regulations covering not-for-profits (IRC Section 4958/Intermediate Sanctions) contains penalties for both the executives and the board, and also requires that the excess must be repaid; those regulations have “teeth”.  The Sarbanes-Oxley Act does require the executive to “disgorge” the profits or awards they received, if the company’s financials have to be restated.  Other than giving back the award, there is no identified penalty, similar to that called for in the Intermediate Sanctions regulations.
   

5. Penalties, where Appropriate #2.  Even in the few situations in which penalties are imposed, they only address the recipient, not the maker.  In order to force the Boards and their Compensation Committees to focus in on the plans they approve, it would be appropriate to incorporate penalties, as well as Rebuttable Presumption requirements, similar to those already identified in the regulations for not-for-profit organizations (IRC Section 4958). 
   

6. Consistency is Critical.  All too often it seems that new rules coming from the government are at odds with existing regulations.  A perfect example is the approval of the compensation package for the new CEO of AIG by the Pay Czar.  The pay package is in conflict with existing IRC 162m regulations and in effect downplays performance while providing much higher salary and stock options with immediate vesting.  The concept of “pay for performance” is the basis of most pay programs within the US.  This emphasis should not be watered down, but enhanced in concept, while eliminating the risky nature of certain performance.  This also requires adding appropriate checks and balances, which would prohibit certain types of “unhealthy” transactions and activities. 
   

We hope these comments, as well as those in the attached articles, offer some insights which assist the government’s efforts to develop new pay rules.   We would welcome the opportunity to discuss these thoughts with you or members of your staff.  Please do not hesitate to let us know if we can provide any other insights garnered from over 40 years of designing effective incentive programs. 

Sincerely,
Paul R. Dorf, APD
Managing Director
Compensation Resources, Inc.

http://www.compensationresources.com/press-room/the-law-of-unintended-consequences.php

http://www.compensationresources.com/press-room/what-to-expect-from-the-new-pay-czar.php