Federal Regulation of Incentives--Baaaaad Idea!

The administration proposes that "federal regulators should issue standards and guidelines to better align executive compensation practices of financial firms with long-term shareholder value and to prevent compensation practices from providing incentives that could threaten the safety and soundness of supervised institutions."

Oh, where to begin?

You'll think this is a good idea if you agree that government lawyers are the best judge of long-term performance of a business. Five years ago Congress added section 409A to the IRC. Its purpose was to eliminate rare abuses in deferred compensation plans. It only took government lawyers 3+ years to publish the final rules for 409A--all 397 pages. Of course, that was before another several hundred pages of clarifications. Now hundreds of thousands of businesses are impact by the micromanagment built into 409A rules.

The moral of the story is that when the government pokes its head into business the law of unintended consequences runs rampant. Now government lawyers will decide what it means to create long-term value for shareholders.

How exactly shall shareholder value be judged? By stock price growth? Against what benchmark: peers? industry average? market average? And why should it be stock price? What if earnings grow steadily but the market punishes the stock for unrelated reasons? Should the management team be penalized? Maybe the government should select growth in earnings as the benchmark for creating value. Hmm. Which earnings component? PTI? Net Income? EBITDA? But these numbers are available for manipulation by any bright management team--if they want to. If that happens, we'll need some more rules, no doubt.

Let's not forget that different institutions set different objectives. One might be growing assets. Another might be looking to improve return on equity. It would be interesting to know how the regulators will determine alignment with goals when they vary from firm to firm. Pay-for-performance begins with establishing clear objectives that are unique to each organization.

Here's an idea: let shareholders decide if the management team is doing a poor job and/or is overpaid. If they think so, they can sell their stock. Sounds too simple.

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