The Advisors' Blog

– Frank Glassner, Veritas ECC

In the furious activity over the past few days, it’s easy to understand why many in Congress have demanded new measures for restraints on executive pay. The measures would give regulators the authority to prohibit “inappropriate” or “risky” compensation practices for banks or other regulated financial institutions. From a perception standpoint, this opens the door for overall government regulation of executive compensation.

Representative Spencer Bachus III (R – Alabama) stated that “doing something about executive compensation would be very popular with the American people”. No surprise here – in the eyes of the American public, many of the same executives whose compensation is to be “restrained”, are those currently leading the effort to get the diversified financial industry sector back on its feet, and, in their eyes, are the very same “masters of the universe” whose greed and myopia brought the sector, and, subsequently our country, to its knees in the first place.

Nonetheless, the decision of Congress last week to impose some form of still unspecified executive pay limits, is a mistake.

At this very moment, it’s a valiant struggle for many of you to keep a straight face when reading the words “talent”, “banking”, “auto industry”, and “Wall Street” in the same sentence. And yet, precisely because Wall Street, banking, automobile manufacturing, and many other industry sectors are currently a trainwreck, Corporate America will desperately need scores of simply brilliant, hard working executives and key employees, if it is to return to a state of financial health that benefits the rest of the economy.

The sort of sums that would satisfy Congress as “executive pay caps” may be far above the income levels of average Americans, but if artificial caps are put into place, there will be no surer way of driving American industry sectors offshore, or into other forms of private ownership where they will be beyond the gaze of regulators. Besides, if ever there was a time when executive pay in financial services, maufacturing, and in general industry overall is likely to be depressed by the market, it is now. The past financial bubble didn’t only inflate asset and stock prices, but, as a result of often flawed executive pay plan design that was largely equity-based, it also inflated pay. Now that bubble has burst in an unprecedented and ugly way, and millions of people want work.

As in the past, U.S. politicians have a lamentable record of intervening in setting executive pay. Too soon we forget that in the early years of the Clinton administration, Congress imposed IRS 162(m), a salary cap of $1 million, beyond which companies faced a tax penalty for any pay above the cap that wasn’t “performance-based”.

Executive pay rose as CEOs beneath the cap, realized that they might be “underpaid”, and another set of executives gained from an outpouring of creativity, as companies, with a great deal of help from (mea culpa) executive pay consultants invented myriad types of short- and long-term incentive plans get around the limit. This not only complicated an already confusing situation, it also made it harder for shareholders to know who was getting what, when, and most importantly, why.

If the “deja vu all over again” foolishness of Congress trying to set and regulate executive pay levels is an old lesson, the financial crisis is teaching some new lessons to shareholders. Forget the conventional wisdom that paying executives large grants of stock options or restricted stock in their own companies ensures “skin in the game”, thus driving sensible risk-taking and maximum shareholder value decision-making. In the collapses of Lehman Brothers and Bear Stearns, senior management didn’t just take reckless gambles with other people’s money. Dick Fuld and Jimmy Cayne took reckless gambles with their own, still failed to do the right things, consequently ended up losing everyone’s money, as well as most of their own fortunes. Public company shareholders, institutional investors, and watchdogs should remember that loading up top executives with shares can certainly be an aid to corporate governance, but not a substitute for it.

For executives and employees alike, the tales of Lehman Brothers, Washington Mutual, Merrill-Lynch, AIG, Countrywide, and other catastrophic corporate failures, especially after meltdowns of the past like Enron, Tyco, Global Crossing, the whole “.com bust”, etc., is a reminder of the danger of having too much capital tied up in the company where you work. Additionally, it clearly magnifies the need for a “balanced portfolio” of well designed executive pay vehicles that are both operationally and market driven. Many more truly talented executives and key employees will now demand their short- and long-term incentives in cash, and, perhaps ask for even more shares. That surely will have an effect on the way that companies recruit key employees and on equity-based executive pay in general. And, hopefully, the concept that forcing significant equity-based stakes on executives in their own companies as a means to stop bad decision making has finally been put to rest.

A strong message to Congress – the design and payout structure of executive pay programs is far more important than the amount — especially in troubled industry sectors. For Wall Street and banking, and financial services industry executives, foolish short-term risk-taking could be discouraged by matching the timing and payout of executive compensation to the achievement of performance metrics for the companies and portfolios they are responsible for. And, if we’re going to collect “bailout capital” from the taxpayers, we ought to insure that there is adequate return on invested capital to them, as well as any of our stakeholders, and link those successes directly to executive pay – without guarantees of wealth in spite of failure at the detriment of both employees and shareholders.

Congress can certainly ask that financial institutions, or any other business that has accepted bailout funding, to put up more capital if their executive pay structures appear to be dangerously risky. They have to be able to fund bonuses like any other business. That makes far more sense than “capping” executive pay.

In the end, companies, their Boards of Directors, and their shareholders are far better at setting executive pay than government bureaucrats will ever be. There will never be adequate fixes to executive pay in any industry sector – public or private – as long as there are guaranteed “Golden Parachutes”, or any other risk-free contractual provisions that allow executives to bail out of a failing company while both employees and shareholders go down with the ship.

Candidly, what has created the highest degree of recent outrage in executive pay has been the captains of those sinking ships paddling away in their own comfortable lifeboats and thumbing their noses as their employees and shareholders went under.