Executive Compensation in an Obama Administration

Now that both the country and the world are in dire economic straits, attention has recently been drawn to the — in some cases — outsized amount of CEO compensation, especially in the cases of companies that have benefited from a U.S. government bailout.

The current economic morass notwithstanding, stockholders and special interest groups have roundly criticized executive compensation during the last 10 years or so. One, then, is forced to wonder where all of this is heading under a Barack Obama administration.

Setting Executive Salaries

Before prognosticating the landscape for executive compensation during an Obama administration, let’s take a look at how such compensation should be determined.

A well-run public company invariably has a compensation committee of its board of directors. That committee usually meets at least annually and in some cases more frequently. The task of that committee is to set executive compensation based upon achieved positive results and goals.

By actually specifying what goals must be met, an element of objectivity and fairness is injected into the process. Needless to say, when such compensation procedures have been established and imposed, the board of directors is at less risk of a shareholders’ suit.

The following are some key elements in setting executive compensation:

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  1. Base salary: A prudent board of directors will set a comparatively low base salary for its CEO. It wants the chief executive to be “hungry” to earn additional wages. The logic is that if the base salary is set too high, the executive might feel too comfortable in his job and might not be as focused on profits as he might otherwise be.

    Setting the base salary, then, is a rather tricky gambit for the board. The challenge is to set a base salary high enough to attract a competent executive. On the other hand, some executives have the confidence that they can deliver outsized profits and, therefore, don’t mind having a comparatively low salary.

  2. Short-Term Incentives: Short-term incentives are usually tied to performance and are sometimes formula-driven. In this case, the executive is given a benchmark to achieve, be it a certain level of sales, a quantifiable reduction in expenses, or a target figure for the bottom line — net profits.

    This type of incentive is often effective because it focuses the executive on a specific short-term task that, if achieved, will bring substantial rewards. Some boards utilize short-term incentives on an ad-hoc basis. If they see an urgent short-term need, they will come up with an incentive package that would reward the executive if the need is filled.

  3. Long-Term Incentives: This type of incentive usually applies for periods ranging from one to three years, or sometimes even longer. The incentive pay is commonly a combination of cash and shares of the company’s stock. The goal that the executive must achieve to earn the incentive is often based upon incremental sales or incremental profits.

    The shares that are given as part of this incentive normally have a vesting term attached to them. In other words, the shares have to be held for a specific period of time before the executive can sell them.

    A long-term incentive does two things: It keeps the executive’s eye on the goal to be achieved in order to earn the incentive, and it increases the chance that the executive will stay around at least long enough for the incentive shares to become fully vested.

  4. Employee Benefits: Items under this category include various non-wage compensations such as health, dental and life insurance as well as sick leave and vacation. A good executive and a good board of directors usually realize that this category should never become the tail wagging the dog. That is, it shouldn’t be outsized, and it shouldn’t include so-called hidden benefits that unreasonably and unjustly expand the executive’s compensation package.

    Normally, when an executive compensation scandal erupts on Wall Street, it doesn’t involve employee benefits.

  5. Perquisites (Perks): This is where some companies get into trouble. There have been cases where the perks to executives far exceed reasonable boundaries. Examples of perks are chauffeured limousines, executive jets and housing.

    There have been cases where these perks have amounted to a substantial portion of the executive’s salary, especially if expensive housing is thrown into the mix.

    Many of these perks go unnoticed or unreported until a company gets into trouble. Then, the press is all over the story, citing how much a company paid for an employee’s birthday party or, for that matter, an expensive umbrella rack. This can only let the board of directors look bad and expose them to stockholder suits.

Back to Prognostication

Given the fact that the buck stops with the directors insofar as setting executive compensation is concerned, my feeling is that the Obama administration would be foolish to usurp the directors’ fiduciary responsibility in setting compensation. The only exception to this that I can imagine will occur when a company has had to be bailed out by the government is under tight controls and supervision until the taxpayers’ money is returned to the government.

Absent that, I don’t see any governmental intervention under President Obama. The bottom-line in avoiding any kind of scrutiny — governmental or stockholder — is for the board to establish a compensation committee that sets strict guidelines on maximum compensation.

When that happens, board members can breathe a little easier.

Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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