Government Service, Ethics and Executive Compensation
January 10, 2017
The Cabinet nominees of President-Elect Trump include a number of corporate leaders or those who have served as Directors of large companies. The prospect of having knowledgeable and successful individuals experienced in running large organizations oversee federal agencies has tremendous potential benefit for the country. These leaders should be encouraged to serve rather than face a financial penalty but also should not receive an incremental benefit for doing so.
Yet, as the vetting process for the nominations begins in earnest, questions have been raised about whether the pay arrangements for those who have served as company executives or directors may create conflicts of interest that weigh against their government service. Such individuals are typically required to put their holdings in a blind trust, consistent with Federal ethics rules, but the unique longer-term nature of executive and director compensation means that there is often incentive compensation which is in the process of maturing as the individual takes office that is not yet owned.
When executives are called to government service, the company’s board of directors, working with government ethics officials, should facilitate the transition by developing an arrangement that addresses potential conflicts of interest while also addressing, in a fair and appropriate way, the longer-term nature of executive and director compensation. Such an arrangement should neutralize the potential for any incremental premium to the executive, as well as the loss of earned compensation. These arrangements will vary company to company, based on the time horizon of the industry, compensation plan design and tenure of the individual among other factors and thus should be fully disclosed consistent with ethics laws and SEC disclosure requirements. This approach will ensure that individuals serving do not have inappropriate conflicts while encouraging experienced executives and directors to give back to their country through government service.
Pay Arrangements for Executives Focus on the Long-Term. A substantial majority of compensation for senior executives of S&P 500 is companies is predominantly long term, in response to the need for companies to take a long-term view of creating shareholder value, and not profit in the short term from actions that aren’t in the best interests of a company and its multiple stakeholders. According to a 2016 Equilar report, 66% of median S&P 500 CEO pay is in long-term equity arrangements with annual cash incentives comprising 21% and salary just 12%. The long-term equity arrangements consist of equity that is awarded based on the performance of the company, time-vested restricted stock, or stock options, and most such awards vest (i.e., mature) over three years or more. In addition, at the majority of large companies, a new long-term incentive award is made each year. Thus, at any given point in time, for companies that have long-term incentive plans vest over three years, for example, there are three different sets of awards outstanding.
Pay Arrangements for Directors. Directors of S&P 500 companies are typically paid an annual retainer composed of cash (20% of the total) and equity (80% of the total). Although the vesting schedule for equity awards varies from company to company, a significant portion of the equity granted is often deferred until the director leaves the board or retires.
The long-term nature of executive and director compensation arrangements introduces an element of complexity when seeking to transition a senior executive who has been called to government service. In fairness, executives called to government service should not be forced to choose between serving their country and losing outstanding incentive compensation or declining the call to service. The calls by some to require nominees who are executives to forfeit amounts earned are neither a fair nor a realistic solution. Indeed, the result of such policies would be to discourage such individuals from serving in government.
Understandably, however, ethics rules prohibit executives from receiving compensation from a former company after they enter government service if the government role could impact the company and thus impact outstanding compensation. Thus, Boards must structure arrangements to facilitate the executive’s transition to government service in a way that is balances company compensation philosophy and compliance with government ethics laws, rules and procedures.
Specific solutions will vary in each case, because companies in different industries have different performance horizons and cultures which influence overall pay philosophies and compensation structures. Based on the principles of balancing the need to avoid conflicts of interest while promoting fairness and transparency, a reasonable set of principles for consideration would include:
- Divestment by the executive of all shares owned in the company and rights to receive shares in the company outstanding under current arrangements.
- Payment by the company of cash compensation owed and outstanding to the executive into an irrevocable trust under the direction of a trustee not affiliated with the company.
- For equity, placing cash into the irrevocable trust based on a current valuation of outstanding equity to be paid according to the company’s compensation philosophy and ethics laws, with such amounts payable to the executive over a time frame similar to that of the original equity grant.
- For public companies, an SEC disclosure explaining the transaction and the actual agreements establishing the trust and the payments and any additional disclosure required by ethics laws and regulations designed to limit conflicts of interest.
- For private companies, disclosure of the arrangement as required by ethics laws and disclosure requirements.
These principles supplement the rigorous vetting process designed to ensure that nominees are fit to serve, while encouraging experienced and talented executives to share their expertise in service to the federal government.