Federal Regulators Must Tread Softly on Executive Pay

There are two basic, but different approaches to corporate governance.

Here in the U.S., corporate law has always been under the control of individual states as the law requires a company to register its situs in one of the 50 states. State laws follow the fiduciary agent definition of the responsibility of individual members of the elected board of directors. Under this system the shareholders designate the board as their agent and cede control of most issues, including selection and pay of managers, to its elected directors. The U.K., Canada, Australia and New Zealand follow similar approaches.

The rest of the world's industrial countries have since the late 1880s adopted a different approach to corporate regulation known as stakeholder governance. Swiss, German and Scandinavian law clearly defines the rights and responsibilities of not only equity shareholders, but also directors, managers, employee worker representation councils and trade unions. It also outlines what the corporation's relationship with customers, suppliers and the general community should look like. Many of these countries require employee and union membership on the board of directors of large companies.

However, until the recent financial crisis brought about broad-scale citizen resentment of the financial sector's role in bringing about the worldwide recession, the prerogatives of the board of directors has been maintained in both governance systems. Nothing seems to rile the individual citizen as much as their perception of the exorbitant pay and bonuses financial institutions pay to their executives.

In Europe, the moves on limiting executive pay have been direct. Earlier this month, a majority of the Swiss citizens voted in a national referendum in favor of the legislation that gave shareholders binding rights to vote on management pay and bonuses. The earlier action by the board at Novartis to grant a $78 million farewell bonus to their chairman played a key role in convincing the public to support the proposal. The grant has since been rescinded.

Just prior to the Swiss vote, the European Union moved to cap bankers' bonuses at twice their salary. Eurozone country finance ministers met in London early in March to discuss the proposed limits on executive pay in their countries.  Executives in London fear such limiting measures will greatly diminish the city's attractiveness and competitiveness as a world capital center. The British government also realizes the huge role financial institutions play in its economy. George Osborne, the U.K's Chancellor of the Exchequer, flew to Brussels for the meeting of the eurozone finance ministers, to challenge the EU move and plead the special interests of London in the global capital markets.

In the U.S., the Dodd-Frank Act includes a provision requiring financial institutions to hold an advisory, nonbinding shareholder vote on their executive pay practices at least every three years. Prior to the passage of Dodd-Frank, the SEC was already working to enhance the role of boards and the voting rights of shareholders. But these efforts were challenged and ultimately thwarted when the SEC's proxy access rule was struck down by the U.S. Court of Appeals for the District of Columbia in July 2011.

Many feel the SEC's attempt at diminishing the power of corporate boards as well and other new regulations emanating from Dodd-Frank interfere with established state corporate laws without appropriate legislation. Banks and other financial institutions are lobbying hard to modify these moves by challenges in court, pressure on Congressional committees and individual members of the Congress. The outcome is far from clear.

Executive compensation is an important issue. However, changing the longstanding structures of corporate law and the roles and responsibilities of bank boards would alter the long recognized role of elected board members to have sole responsibility for policy creation and implementation, including the compensation of corporate executives. Federal attempts to change this longstanding state law structure would alter basic corporate law (until now the dominion of the individual states) and create chaos in the global financial structure.

Federal legislators and regulatory agencies would be wise to act slowly and prudently in considering major changes to our capitalistic structures without well-accepted legislation changing the basis of the longstanding capitalistic system that gives states dominion over corporation law.

John Alan James is executive director of the Center for Global Governance, Reporting and Regulation at Pace University in New York. He is also program director of Pace University's Certified Compliance and Regulatory Professional certificate program.