May 5, 2011
RE: Comment of Claire Hill and Richard Painter on Proposed Rules on Incentive Based Compensation Arrangements, SEC File No. S7-12-11
We write to comment on the SECs Proposed Rules on Disclosure of Incentive-Based Compensation Arrangements at Financial Institutions (the Proposed Rules). The Proposed Rules are designed to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which provides that the SEC and other agencies shall prescribe regulations or guidelines to require each covered financial institution to make certain disclosures about incentive-based compensation arrangements, and to prohibit any such institutions from having incentive-based payment arrangements that the regulators determine encourage inappropriate risks by covered financial institutions. The rationale for the Proposed Rules is that incentive-based compensation arrangements encouraged risk-taking that was a significant cause of the present financial crisis.
Adjusting-- and in some cases limiting-- incentive-based compensation is one way to discourage excessive risk taking by managers of financial institutions. But managers bearing true downside risk would also probably be inclined to make more prudent business decisions regardless of their upside compensation incentives. We therefore recommend that the Commission exempt from the proposed Rules the incentive-based compensation for managers who bear a substantial degree of personal liability for the debt of their firms (the extent of personal liability needed to qualify for the exemption should be determined by the Commission, but it should cover a substantial portion of the managers personal assets apart from the managers existing investments in the firm). The reward for bearing such risk should be the ability to capture whatever portion of upside gains is allocated by the firms internal governing bodies (directors and sometimes shareholders) free of regulation by the government. Government regulation, by contrast, should concern itself with situations where risk and reward are disconnected, as they are with our present combination of incentive-based compensation and limited personal liability in financial institutions. We recognize that few Wall Street firms will consider returning to the general partnership organizational form. But our recommendation can be adopted consistent with these firms continuing as corporations. Contractual arrangements between firms and their most highly paid officers could restore some of the personal liability – and personal responsibility – that characterized investment banking in an earlier era. Joint venture agreements between officers and their firms, personal guarantees of firm indebtedness and assessable stock are a few of the many options that boards of directors and officers could consider introducing into managers employment contracts. See Claire Hill and Richard Painter, Berle's Vision Beyond Shareholder Interests: Why Investment Bankers Should Have Some Personal Liability, 33 SEATTLE UNIV. L. REV. 1173 (2010).
Before the 1980s, most of Wall Streets largest investment banks were run as general partnerships. The partners determined their own compensation without interference from regulators, but were unlimitedly liable for their banks obligations. Since then, most large financial firms have become public companies, and managers compensation has been decoupled from personal responsibility for firm losses. The Proposed Rules seek to address the difficulties this decoupling has caused, but there are other perhaps more effective ways of proceeding. One is recoupling compensation and liability. Firms should be permitted to impose personal liability on their most highly paid managers as an alternative to complying with the substantive restrictions on compensation in the Proposed Rules. The choice of personal liability should not obviate the need to comply with disclosure requirements concerning executive compensation: without commenting on the specifics of the disclosure requirements in the Proposed Rules, we believe they should apply uniformly to all firms in the same industry that are public companies.
We agree with the Proposed Rules premise that the form of incentive compensation offered at many financial institutions encouraged inappropriate risk-taking. Several components of the compensation were problematic, including its size, that it was based on short-term results, and that it was not subject to clawback. Someone able to get and keep several million dollars at year-end for engaging in transactions that initially seem profitable but may perform poorly in the moderate or long term is clearly motivated to engage in such transactions. The Proposed Rules address some of these problems.
At the same time, we are concerned the merely controlling the form or amount of upside compensation may not be sufficient to discourage irresponsible risk taking. Stock and stock options, even with the longer time horizons contemplated by the Proposed Rules, may still be viewed as house money, money that managers are willing to bet with and potentially lose. Even bankers with considerable equity in their banks but no downside liability exposure may be willing to cause their banks to make risky bets because they know that they have other assets left over even if their banks fail. We do not at this point propose that any of these personal liability arrangements be imposed on financial services firms by the SEC or other regulators, although such a step may be required if the firms do not take such steps on their own and the Proposed Rules do not bring managers appetites for risk into line with the cost of risks to their firms, firm creditors and society as a whole.
In sum, we think that excessive risk-taking could more simply – and probably more effectively – be dealt with if bankers were to have some personal liability for the debts of their firms. Firms boards of directors should be encouraged to consider what portion of the downside risk should potentially fall upon the firm managers who share in so much of the upside. Some firms may choose this approach to deal with the problem of excessive risk taking, an approach that was validated by the generally successful history of Wall Street general partnerships in the period between the enactment of the federal securities laws and the 1980s. Firms that promote personal responsibility by imposing a substantial amount of personal liability upon their managers should be exempt from the Proposed Rules substantive restrictions on compensation. Rather, their boards of directors and shareholders should be free to determine levels of compensation as they see fit.