The Pay Czar's New Rules
In the latest crackdown, Kenneth Feinberg announced a $500K salary cap on executives at bailed-out firms. Robert Pozen on how the banks can clean house—and get the feds off their backs.
On Friday, Ken Feinberg, the Treasury's pay czar, imposed a cap of $500,000 on the compensation of almost 500 executives at four large financial firms. But why are the pay packages of middle-level executives at these financial giants being set by government officials rather than the independent directors of these financial institutions? Because federal regulators have lost confidence in the effectiveness of independent directors despite the governance reforms adopted in the Sarbanes-Oxley Act of 2002.
Why are the pay packages of middle-level executives at these financial giants being set by government officials rather than the independent directors of these financial institutions?
After the spectacular failures of Enron and Worldcom, Congress required all boards of public companies to include a majority of independent directors, who had to follow elaborate procedures. Although the boards of Wall Street banks were comprised mainly of independent directors who followed these procedures, neither prevented the debacles at Bear Stearns, Lehman Brothers, or AIG.
The boards of large financial firms were ineffective for three main reasons:
1. Few of the independent directors had extensive experience in the financial-services industry. At Citigroup, for example, only one independent director had worked for a financial institution.
2. The boards generally met six times each year, for roughly one day each time. In six days per year plus inter-meeting phone calls, independent directors cannot hope to understand the complexities of a global financial firm.
3. Many of these banks had large boards, with 12 to 18 directors. Research has shown that directors take less personal responsibility for a board's actions in large boards than smaller ones.
To make boards more effective monitors of large financial institutions, their regulators should insist that boards be reorganized in three ways:
1. Bank boards should be comprised primarily of financial-industry experts, plus others with relevant experience like auditing. Such directors are most capable of evaluating the decisions and recommendations of the executives at a financial firm.
2. The independent directors should spend two to three days per month on the business of the financial institution. That level of time commitment is needed to stay on top of the complexities of a global financial institution.
3. The boards should be small—for instance, six independent directors and the CEO. This would permit every independent director to serve on two board committees and would encourage each of them to take more personal responsibility.
With these three reforms, the independent directors of large financial institutions would view their board roles as their main jobs, not something they were doing on the side. Given the time demands of such boards, independent directors should not serve on more than two or three for-profit boards.
For these reasons, the independent directors of large financial institutions should be paid differently than other directors. They should receive a modest base salary, plus stock options or restricted shares that would vest slowly and be held for many years to promote a long-term perspective.
As a practical matter, these professional independent directors would usually be recruited from retired executives from the financial-services industry. That would allow these directors to make a substantial time commitment to a large financial institution without material conflicts of interest.
As the American population lives longer, more financial executives will be interested in a second career as a professional director of financial firms. This career path should be facilitated by dropping mandatory retirement of directors at age 70 or 72.
In short, if we want boards to effectively monitor management of large financial institutions, we cannot just add another set of procedures for boards to follow. We need directors with the financial-industry experience, time commitment, and financial incentive to hold management accountable for profitable operations without excessive risk.
Robert Pozen is the author of Too Big to Save? How to Fix the U.S. Financial System. He is chairman of MFS Investment Management, and was formerly president of Fidelity Management & Research Co. He is a senior lecturer at Harvard Business School.