Arnold Schwarzenegger said, when he was first elected as governor of California, that he wanted to "blow up the boxes" of the state bureaucracy.
The ongoing challenges presented by executive compensation, methods of paying executive compensation and inherent risks associated with certain forms of executive compensation have been a thorn in the side of state and federal regulators and shareholders for close to a decade now.
It is time for us to completely reconsider compensation for banking executives. Let's "blow up" the incentive model and replace it with a fair and equitable compensatory system rooted entirely in base pay.
In their guidance on sound incentive compensation policies, the primary federal bank regulatory agencies stated in June 2010 that "[f]lawed incentive compensation practices in the financial industry were one of many factors contributing to the financial crisis that began in 2007. Banking organizations too often rewarded employees for increasing the organization's revenue or short-term profit without adequate recognition of the risks the employees' activities posed to the organization."
The regulatory agencies then go on to highlight the multitude of ways in which incentive compensation arrangements should be structured so as to avoid imprudent risk-taking that is inconsistent with the safety and soundness of the organization.
Of course, the joint regulatory incentive compensation guidance wasn't the first effort, and won't be the last effort, to tackle perceived problems in the way executives have been paid. From the Sarbanes Oxley Act of 2002, which included selected compensation clawbacks, to the Troubled Asset Relief Program, which basically prohibited virtually all forms of bonuses and incentive compensation save restricted stock awards, to the Dodd-Frank Act and further clawbacks, and finally, in the horizon, the potential regulatory enforcement actions by the Consumer Financial Protection Bureau.
So why not derive a compensation system where executives receive solely an annual guaranteed salary set for each fiscal year? Let's do away with stock options, restricted stock awards, bonuses, stock appreciation rights, restricted stock units and the remaining alphabet of executive compensation incentive alternatives.
Certainly, to be effective and competitive with positions in other industries under this paradigm, the base salary would be set well above the high range of base salaries executives currently receive and it would be guaranteed for that year, regardless of how well the financial institution performed. That would provide both the executive and the institution with certainty.
But to be effective, and to truly judge an executive's performance, that salary would have to be fixed each year and the compensation committee would have to engage in a rigorous annual analysis when setting base salary for the following year.
The incentive for the executive to perform at the highest level would be the risk that the executive would lose his or her job, or suffer a significant drop in base salary from the previous year. Opponents of such an idea would argue that if base salary were the sole mechanism of compensating an executive, you would still have the potential for risky behavior as an executive would want to ensure that such an annual salary was as high as it could possibly be in subsequent years.
Understanding that risk, a key component of this proposal would be to include a clawback mechanism, which would provide for recovery of base salary in the event the executive was found to engage in activities which were inconsistent with running a financial institution in a prudent manner consistent with general standards on safety and soundness. The clawback would extend at least three years out to allow adequate time to discover risky behaviors or unlawful or imprudent actions.
Thus, there would be no stock performance based incentive. No incentive to inflate earnings or take on risky behaviors to realize rewards. There would also be the comfort associated with generous, guaranteed pay for the executive. No longer would an executive be concerned that if the company has a poor year that the amount of money the executive would make in that year would be drastically reduced in bonus or equity compensation.
Of course, the board of directors would always have the freedom to terminate an ineffective executive at any time. Tempered with that however, the executive should be entitled to receive for any termination without cause the total amount of base pay he or she otherwise would have received for that year. Because employment arrangements would be set on an annual basis, the risk to the financial institution of paying out for an ineffective executive would be balanced with the assurance the executive would have for his or her total compensation during that year (but only that year).
Incentive compensation, and the perceived abuses of incentive compensation, has been the poster child for regulatory, shareholder and public activism. Schwarzenegger may have effectively, in the end, failed to blow up those boxes in California, but banks directors can. If we rid ourselves of incentive compensation mechanisms, perhaps we will finally be able to get back to the real business of banking.
Craig D. Miller is a partner and co-chair of financial services and banking at Manatt, Phelps & Phillips. John J. Heber is a partner at the law firm.