Compensation for Business Leaders

Risk and Compensation Practices

Incentive compensation can promote excessive risk-taking behavior, which was a dominant force of the 2008 financial crisis. Companies are being more diligent in identifying individuals in a position to expose the company to significant risk and are aligning pay programs for those individuals to discourage unnecessary or excessive risk-taking.

Looking at compensation through a lens that focuses on risk-taking raises important issues about compensation plans. Shareholders are concerned with pay-for-performance, balanced between reasonable performance goals and risk-taking.

Companies are putting greater emphasis on long-term sustainable value rather than short-term goal achievement. Long-term incentive plans that pay with equity are more effective when the plan requires top management to hold the equity through to retirement. Annual cash incentives will continue to play a role in executive compensation but may constitute a smaller component of pay depending on the business requirements.

Dodd-Frank Clawback Extension

The Dodd-Frank Act has several executive compensation rules related to clawbacks, CEO Employee pay ratio and other disclosures.

Clawbacks. Pay recovery policies, or “clawbacks”, came to the forefront with the Sarbanes-Oxley Act in 2002, requiring that in the event of any accounting restatement based on misconduct, incentives paid to the CEO and CFO within 12 months preceding the restatement must be recovered.

Dodd-Frank proposed expanding the use of clawbacks to require all listed companies on stock exchanges to have a policy for clawbacks of incentive-based compensation, including stock options, for all current or former executive officers who perform policymaking decisions (not only the CEO and CFO) when financial statements are restated for any reason, not just misconduct. The Securities and Exchange Commission voted on October 26, 2022, to approve this rule, which applies to compensation paid in the three years leading up to the restatement.

Pay Ratio Disclosure. The Dodd-Frank rule requiring public companies to report a ratio of CEO pay to employee pay requires public companies to disclose their CEO pay ratio based on compensation paid for a company's full fiscal year.

The CEO pay ratio rules require U.S. public companies to disclose the following: annual total compensation (median) of all employees excluding the CEO; annual total compensation of the CEO; and the ratio of these two numbers.

It is important to refer to the SEC.gov website for details on compliance with this important ruling. Exemptions are those covered by the JOBS Act, such as for emerging growth, foreign private issuer, and small reporting companies.

Why is Executive Pay So High?

Key executives are so well compensated for a variety of reasons:

• Labor Market: The labor market recognizes the market value of the top executives. As equity compensation grows, the market value influences the total direct compensation of these jobs among competitor companies as well.
• Skill: The people in these jobs are highly skilled, must have vision, leadership, and creativity, and their replacement can be difficult.
• Training: Ordinarily, managers have worked for the organization a number of years, and the organization may have spent a considerable amount of money in training them as they move up the managerial ranks. These individuals' knowledge bases are assets to the enterprise.
• Commitment: Managers spend a great deal of time at their work, usually 60 hours a week or more. Even if they are not formally working, they often take their jobs home with them. Because of this heavy responsibility, they must find the rewards worth their efforts.
• High Turnover: Any group that is as important and visible as top management will have to be paid competitively in order to minimize unwanted turnover.
• Economic Growth: In good times, the economy and companies expand, increasing the need for executives.