Executive Compensation: What Obama's Plan Means

The Administration's attempt to deal with excessive pay is more about procedure than substance and will allow most companies to self-govern

By Ben W. Heineman Jr.

Despite headlines along the lines of "Obama Caps Exec Pay," the Administration's executive compensation initiative sets relatively few fixed, substantive requirements for most companies receiving funds under the Troubled Asset Relief Program (TARP).

Primarily, it imposes procedural requirements. To wit: that boards of directors and senior executives develop positions on pay levels, on whether compensation creates undue risk, on "clawbacks" of pay for financial misstatements, and come up with policies on luxury items—and then disclose the results and the reasoning; seek shareholder approval in some instances; and have CEOs certify company compliance with the new approach.

TARP Forces Company Hands

The new compensation rules appropriately force TARP companies to focus on some of the issues that caused the financial meltdown and to make their answers transparent in the belief that in this climate, excess pay will invite public or shareholder denunciation.

These proposals should be seen as just the opening regulatory shot in what will be a months-long or even multiyear debate on a variety of regulatory mechanisms—such as capital requirements, a product approvals process, an enhanced Fed role in evaluating risk to the financial system—that would limit or constrain business decision-making. These various regulatory responses would seek to address the immediate causes of the financial-sector meltdown that has thrown the global economy into crisis: e.g., the failure of risk functions; internal conflicts of interest rather than checks and balances; leadership failures; and a lax culture. Business must ultimately address the root causes: a failure to balance risk-taking with risk management, and to fuse high performance with high integrity.

In addition to opening the "deal with the causes" debate, the executive comp reforms are a necessary political precondition for using the second tranche of TARP money to deal with the direct effects of the meltdown—lack of credit and liquidity—and to gain support for the stimulus package.

Given the public's white-hot anger over the financial sector's unwillingness or inability to ease credit since TARP I and seemingly tone-deaf acts by corporations receiving taxpayer dollars (indiscriminate use of corporate jets, for example), the forthcoming proposals on TARP II will likely be dead on arrival if they don't appear to be tough on executive compensation.

Senator McCaskill's Hard Cap

The reforms also provide a more moderate alternative to any number of draconian and ill-conceived provisions that could be attached to the stimulus package in the Senate, such as Senator Claire McCaskill's proposal to set a hard cap of $400,000 (the same as the President's salary) on total compensation for all employees of every institution receiving funds under TARP.

With its emphasis on procedural requirements, the Administration is being political in another sense. By leaving it to boards, senior officers, and shareholders to address issues, design programs, and make disclosures, the Administration for now avoids imposing a set of detailed, substantive rules whose effects will be uncertain, and allows the private sector to develop a variety of responses appropriate to each corporation. These responses will then be considered as part of a longer-term regulatory reform process (also announced this week) for the alignment of compensation with proper risk management and long-term value and growth.

The main provision from the Administration illustrates the problems of applying fixed, substantive rules in complex circumstances. For companies receiving future "exceptional financial assistance" from TARP, pay for senior executives is capped at $500,000 and additional compensation may be provided through restricted stock that vests only after the government is repaid (or other negotiated conditions, as yet undefined, are satisfied).