Executive Compensation Is Changing — New Rules or No

WASHINGTON — President Obama put pressure on regulators this week to finish their long-delayed rule governing executive compensation, but by the time it gets implemented, much of the work may have already been done.

That rule — a provision of the Dodd-Frank Act designed to reduce the type of risk-taking that led to the financial crisis — would require compensation packages to avoid undue risk.

But even though regulators have not finalized a plan first released in 2011, compensation on Wall Street has evolved in key ways, partly in anticipation of regulatory requirements and partly because of investors themselves.

"The incentive compensation systems at our large institutions are like night and day compared to what they were pre-crisis," Federal Reserve Board Gov. Daniel Tarullo told Bloomberg TV in November. "So I think when those regulations become final they are… not going to require dramatic shifts in what banks are doing because the banks have already adjusted."

Recent data from the New York Comptroller's Office suggests that securities industry bonuses — including the banking sector — have declined over the last few years, falling 9% in 2015 from 2014. That trend is occurring even as employment in the financial sector has increased in the state by 2.7%.

Henrik Patel, a partner with White & Case, said a variety of factors have changed compensation practices in banking since the crisis to put more emphasis on ensuring executives are given incentives to value the long-term health of the company rather than short-term gains.

"It used to be that all that people cared about was tying performance to compensation. That is no longer the only thing," Patel said. "Now what's happening is people are saying … I want you to continue to ride with me."

Not everyone is convinced. Marcus Stanley, policy director of the public advocacy group Americans for Financial Reform, said that the shift toward taking a long view with executive compensation is anecdotal at best. He said current practices do not go as far as they should — making finalizing a rule so critical.

"From our perspective there hasn't really been a fundamental change," Stanley said. "What we would want to see is something that moves closer to the old partnership model, where you stay genuinely at risk for a long period of time and where you're just as sensitive to the downside … as the short-term upside incentives."

Compensation reform is a complex topic that has been evolving since well before Dodd-Frank. After the Enron Scandal in 2001, Congress passed a number of restrictions on executive pay in the Sarbanes-Oxley bill, forbidding personal loans to executives, restrictions on stock sales and enhanced auditing standards.

But there have been a handful of regulatory drivers of change in executive compensation since the crisis. Among them are the more dominant role of proxy investment advisory firms, the advent of enhanced disclosure of compensation packages since Dodd-Frank and the Troubled Asset Relief Program, which itself set certain restrictions on executive pay.

One of the biggest and most ubiquitous changes is the prevalence of "clawbacks" in bonus pay. A clawback essentially makes bonus pay provisional, enabling a company to reclaim the payment if a later scandal or impropriety emerges.

Patel said clawbacks were required under Tarp, and because so many firms took money from the program, they were required to put those provisions in place. After those institutions paid back the government, most firms viewed clawbacks as a best practice and kept them in place. Since then, they've expanded beyond the financial industry to executives in other sectors.

"What you ended up seeing is … a lot of companies did adopt some of those practices from Tarp going forward," Patel said. "There were clawbacks under Tarp, and you had to have them. And most banks that had them just kept them, even when they got out of Tarp. I think almost all financial services industries have a clawback now."

Because it is legally complicated, if not impossible, to retrieve cash bonuses after they've been paid — especially if it has been months or years since the payment — clawback provisions have had the secondary effect of making more bonuses come in the form of deferred or vested stock. That gives firms a simpler method of clawing back bonuses and also makes accounting for executive pay simpler and less onerous.

"Clawbacks are going to be very difficult to actually implement," said Susan O'Donnell, a partner at Meridian Compensation Partners, which consults banks and other financial firms on compensation packages. "If you have a program where you have long-term or deferred compensation, then you have the means, if you need to claw back, [to draw from] that pool of long-term compensation or equity."

That drive toward new and more restrictive best practices — of which clawbacks are a prime example — has also been boosted by other trends. For one, the Securities and Exchange Commission, as well as the Fed and other bank regulators, have issued rules and guidance since the crisis that has spurred greater emphasis on best practices and publicized compensation even more.

The bank regulators issued a guidance in 2010 that called for compensation packages to be risk-sensitive and "appropriately balance risk and reward." That effectively required banks to rationalize compensation practices in the context of the long-term risks to investors and the firm. That requirement, however vague, has made banks more cautious of skirting the line on compensation packages.

The SEC in 2011 also finalized a rule that would give shareholders a nonbinding vote on executive compensation, a practice known as "say on pay." Institutional investors represent a substantial and unified voice among shareholders, and many of those investors follow the recommendations of specialized firms to decide how to vote on a particular shareholder issue. Two firms in particular — Glass-Lewis and Institutional Shareholder Services, or ISS — have used that leverage to make important changes in corporate governance by favoring some kinds of compensation packages over others because they are considered wasteful or insufficiently tied to performance.

Those include targeting so-called "gross-ups" — where a company will pay an executive more so as to offset their tax burden — and stock options, which allow an executive to purchase or receive stock if the company performs well but not if it performs poorly.

"It's not truly activist — they're not complaining for board seats and that type of stuff," Patel said. "The ability to say, 'Yeah, we'll issue a withhold the vote for your compensation committee members because they voted for gross-ups' — that's what ISS and Glass-Lewis have done."

O'Donnell said the rise in the influence of those advisory firms has led firms away from some practices and toward others. For example, because stock options are not always considered a performance-based incentive, firms are moving toward something called performance-vested stock, where an executive can receive a stock bonus after a certain period of time, but the size of the bonus is variable depending on the performance of the company.

"There has been what I call a homogenization of compensation," O'Donnell said. "With the decline of options, that leaves you with restricted stock. Now, restricted stock on a purely time-based vesting basis … is not perceived by shareholders as performance-based. It can be a giveaway — it's a good retention tool but not a good performance tool."

Patel also said that advisory firms can have a say in determining an executive's peer group. A compensation committee will routinely reference where a proposed pay package lies in that spectrum — say it's 50-75% of the executive's peer group. But who the committee counts as peers — and therefore the potential range of compensation being considered — can be the subject of review by advisory firms as well.

Glass-Lewis and ISS declined to comment.

Bank regulators, along with the SEC and Federal Housing Finance Agency and National Credit Union Administration, released a joint proposal in 2011 that would bar banks, credit unions, broker-dealers, investment advisors and GSEs from adopting executive pay packages that "encourage inappropriate risks … that could lead to material financial loss." The plan would have codified many of the principles laid out in the 2010 guidance but would have required form of deferred compensation, as well as uniform compensation reporting requirements.

But the proposal has yet to be finalized, reportedly amid divisions among the agencies about how to proceed.

Comptroller of the Currency Thomas Curry said last summer that a new proposal would be issued, predicting it would be out by the end of 2015. Fed Chair Janet Yellen, meanwhile, told lawmakers last month that she couldn't give "a good answer" as to what is taking the agencies so long to repropose the rule.

But Stanley said that the final rule is still critical. Whatever gains that have evolved can erode over time, he said, and rules need to ensure that institutions — banks in particular — are incentivized toward long-term institutional health.

"Banking is special," Stanley said. "The losses are enormous and often imposed on other people. I think there's a lot of reason to question, especially incentive or bonus pay that's too large in an absolute sense."

Tim McTaggart, a partner with Pepper Hamilton and former Fed official, said his impression of the change in compensation — particularly on Wall Street — is that it increasingly emphasizes the few distinct individuals who are able to realize exceptional gains, either as traders or merger and acquisition specialists or elsewhere. Ordinary traders, meanwhile, are being overlooked.

"My sense is that it's even more of a star system on the street," McTaggart said. "I think individuals who are identified as the superstar traders, M&A deal makers, they are being compensated at even higher levels than before 2007, and their value-add is that much more important to the various firms."

But Stanley said, to the extent that a star-centered culture is emerging in the financial sector, regulators should be pushing back against that trend. Such a culture breeds resentment and encourages individuals to take excessive risk — precisely the kind of cultural values that the Fed and other regulators say they are trying to avoid.

"The star culture is problematic," Stanley said. "We're interested in healthy institutions, and healthy institutions aren't created by individual stars. If that star is out there, people are going to try to become that star individual as opposed to looking to the long-term health of their institution."

Regulators said that work on the remaining executive compensation rule is ongoing but declined to elaborate further. But regardless of when those final rules are proposed, O'Donnell said the changes already in place has brought the issue to the fore in a way that has had dramatic effects already.

"Say on pay single-handedly, I think, drove a lot of change," O'Donnell said. "Companies have to rationalize their pay, they have to explain it better, they have to do a better job of showing the connection between their performance and pay. When you get too rigid, that's where the challenge is."