Principles for Reforming Executive Pay

Reining in excessive management compensation will be high on the "to-do" list of the 111th Congress

By Ben W. Heineman Jr.

The rocket fuel that sent the financial sector soaring into the stratosphere (where it ultimately exploded) was excessive executive compensation, which rewarded the churning of paper and risk-taking rather than the creation of sustained economic value and risk management.

The day of regulatory reckoning on the causes of the financial meltdown will soon be upon us, even as governments struggle with the severe effects and the world waits for a "mega-stimulus" proposal from President-elect Barack Obama. Reforming executive pay will likely be high on the financial reregulation "to do" list for the 111th Congress as anger at executives remains white-hot.

To be sure, partial ad hoc measures are popping up, both in the U.S. and abroad, from a flat cap on executive pay at German companies receiving bailout funds to active oversight of payouts by the British government in its varying roles as shareholder, director, and regulator of troubled companies. Under the Troubled Assets Relief Program (TARP), Congress last fall hastily imposed executive compensation limits on senior leaders in financial sector entities, including limiting tax-deductibility on exec comp over $500,000; providing new clawback rules for material mistakes; capping or eliminating golden parachutes; and requiring board assessments of the relationship between compensation and risk-taking.

Striking a Balance

As more thoughtful, comprehensive approaches evolve, agreeing on principles will be key to effecting any real change. Here are three principles that I believe should be the foundation of any substantive change.

First, executive pay should promote a fundamental balance between taking risk and managing risk as the core of high performance. Executives must be rewarded both for stimulating value-creating innovation and for disciplines that assess, spread, and manage risk. There can be little doubt that compensation in the financial sector was not based on personal ownership and understanding by top leaders of risk assessment and management.

Second, compensation must clearly reward a foundational fusion of high economic performance with high integrity. That means a tenacious adherence to the spirit and letter of formal rules, legal and financial; voluntary adoption of uniform ethical standards that bind the company and its employees to act in its enlightened self-interest; and employee commitment to the core values of honesty, candor, fairness, reliability, and trustworthiness.

Promoting a Culture of Integrity

Third, to reward that balance—and that fusion—the annual compensation of top financial-sector executives and key "risk-takers" should be redirected away from short-term cash toward longer-term payouts. Affirmative performance goals, which measure the creation of real value and the implementation of a culture of integrity, should guide the amount. But a significant portion of a year's compensation should be withheld; to be paid out over time if value is sustained and cancelled if adverse events occur.

Such adverse events could include: financial results that exceed established risk parameters; outsize, unpredictable financial losses; significant financial restatements due to accounting failures; and major legal or ethical lapses for which the pay recipient is responsible in whole or in part. The withheld compensation may be either cash (held in escrow) or equity instruments (subject to cancellation).

Such reform would encourage a focus on creating real economic value and discourage baleful "short-termism." It would also retain control of payouts, rather than requiring boards to go through a cumbersome clawback process to recover monies already paid to culpable executives. And it would make it more difficult for employees to leave after bonus season.