Like a house of cards, all it took was one faulty piece to bring the whole company down. When insurance giant AIG collapsed in September 2008, experts knew exactly where to place the blame. Not on the entity that insured vacationers’ lost baggage or the one backing purveyors of renewable energy. It all boiled down to the risks taken by one division insuring mortgage-backed securities.
And senior management took that risk for good reason: Deals that resulted in billions of dollars in AIG losses netted $165 million in bonuses for executives in that troubled division–after the company had received roughly $180 billion in government bailout funds.
The catastrophic losses at AIG, as well as at other companies aided by the federal Troubled Asset Relief Program (TARP), compelled the Securities and Exchange Commission (SEC) to propose a new rule in July that aims to shed light on how a company’s compensation practices relate to its risk profile. If passed, the rule will require public companies to disclose these relationships in their annual proxy statements to shareholders.
“The turmoil in the markets during the past 18 months has demonstrated the importance of ensuring that activities that materially contribute to a company’s risk profile are fully disclosed to investors,” SEC Chairman Mary Schapiro said in the announcement. “The amendments … are the result of a re-examination during which we repeatedly asked ourselves: Are investors being provided with the right information?”
From an investor’s perspective, the proposed rules probably seem like an appropriate reaction to the economic crisis, says Marc Gerber, a partner at Skadden, Arps, Slate, Meagher & Flom. But he believes the broad reach of the rules to all public companies may be a bit of an overreaction from the SEC.
“[Investors] saw the problems financial institutions receiving TARP funds had with risk management,” he says. “But the perception of problems at those companies is being exported to other companies that may have had no role in the financial meltdown.”
The proposed rule also appears to be an effort at public goodwill as the SEC re-establishes transparency as a crucial element of a company’s everyday behavior, says Julie Jones, head of Ropes & Gray’s Federal Securities and Public Companies Practice.
“[The SEC] is reacting to the fact that a lot of top officers got really rich and walked away, leaving the public with depleted 401(k)s and retirement and college savings because they got stuck with all the risk,” she says.
Schapiro has emphasized that the SEC is seeking not just increased disclosure from companies, but better disclosure, which Jones says is exactly where the agency should focus. In order to manage the length of already unwieldy proxy statements, the SEC specified companies need only release more information if it’s relevant to their risk profile.
“If you take an average company, its general counsel is saying, ‘Well, I don’t think we’re doing anything to incent inappropriate risk-taking,’” Jones says. “That said, as they plan their compensation practices for upcoming years, it’s totally appropriate for all companies to be stepping back and looking at things.”
For many companies, additional disclosure won’t be necessary, says David Lynn, a partner at Morrison & Foerster and former chief counsel in the SEC’s Division of Corporation Finance. There’s no need for companies that don’t have a risk-based element to their compensation structure to alter their disclosure policies, he says.
Specifically targeted will be policies that reward short-term success but may come at the expense of a company’s long-term financial stability, Lynn says. At some high-risk companies, temporary achievement reaps large payday rewards for executives. But when things go south, he says the compensation structure features no equivalent penalty.
“When times are good, people make a lot more money,” he says. “And when things are bad, people make about the same amount of money, or their salaries just are not increasing.”
Companies where specific divisions bear the brunt of the risk, such as AIG, also will be liable for producing more detailed explanations of their compensation structure, Jones says. “They had so many well-established and profitable units, but they had this one unit that was trading these incredibly complex instruments,” she says. “[That unit] got paid a lot of money and ended up bringing the whole entity down.”
One aspect of the proposed rule addresses whether compensation consultants act independently from management when recommending executive pay scales. Often these advisors earn additional fees by providing other services, such as human resources or benefits consulting, which the SEC says could create a conflict of interest.
Disclosing the role of compensation consultants would allow shareholders to decide for themselves if they think the incentive of more work with the company leads to tainted advice on executive compensation, Jones says.
“The thought is if there is any possibility that the advice of the consultant shows some level of loyalty to management, [investors] will be able to see that based on how much money the entity was making from working with other areas of the company’s business,” she says.
It will be pretty easy, however, to determine whether this facet of the rule applies to any particular company, says Howell Reeves, of counsel at Duane Morris.
“If the only role the consultant plays is with respect to advising on the executive compensation, this new requirement won’t have any impact,” he says. “It’s only applicable if that consultant provides other services in addition to that role.”
Because companies’ entire compensation policies are up for examination, Lynn says it’s critical to start preparing for the changes now. “It may not be on the same scale as Sarbanes-Oxley was,” he says, “but it will be an enormous amount of change concentrated in a very short amount of time.”
A 60-day public comment period concludes Sept. 15, meaning the SEC will likely release a final rule by mid-November. That doesn’t leave a lot of time to analyze and potentially overhaul company disclosure policies, Gerber says.
“You want to give the board and board committees sufficient time to consider changes in policy or practice,” he says. “Start that process now rather than running up against the clock as you try to get your proxy statement out the door.”
But while directors will certainly start taking a closer look at compensation practices, Jones doesn’t necessarily see a revolution coming to the boardroom.
“I wouldn’t be surprised if in a year, as we pick up proxy statements, that six out of 10 will look pretty similar [to each other],” she says. So the new disclosure policies might not enlighten investors as much as the SEC intends them to. “That doesn’t mean the compensation committees aren’t thinking about it,” Jones says. “But it’s likely that as disclosure evolves, it may not be that helpful to the investor community.”