Eyes On Wall Street : Executive Compensation Lawyers & Attorneys : Labaton Sucharow Law Firm : Class Action Litigation, Shareholder Rights

Today the EU unveiled the most sweeping reforms to date of the troubled credit rating industry. The proposed rules, which will require the approval of the European Parliament and EU member states, represent some significant progress in ongoing efforts to improve ratings. 

The reform proposal includes “mandatory rotation provisions” which would force issuers of financial products in Europe to rotate the credit rating agencies they use at least every three years. In addition, the proposal also contains a “cooling off” provision which would compel issuers to wait four years before hiring the same agency. The purpose of these provisions is to increase competition and reduce conflicts of interest. 

While US regulators have been reluctant to intervene in rating methodologies, the reform proposals would give ESMA, the European market regulator, the power to develop technical standards and approve specific rating methods. New rating methodologies, or adjustments to existing models, would have to be open to consultation and submitted to ESMA for approval.

Crucially, the proposed rules include a method for private enforcement, in that they would allow investors to sue credit rating agencies for compensation if they break EU regulations "intentionally or with gross negligence.”

Regulators apparently have dropped one of the most controversial proposed rules, which would have permitted ESMA to ban agencies from rating sovereign debt issued by countries in the process of being bailed out—an edict that would have further undermined the confidence of investors in sovereign debt.

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On July 8, the European Parliament approved the world’s strictest rules on bankers’ bonuses. The rules apply to banks and investment firms, but not to hedge-fund managers.

The new rules ensure that bonuses provide less incentive for risky practices that increase executive compensation in the short term, at the expense of long term corporate financial stability.

Under the new regime, no more than 30% of bankers’ bonuses can consist of up-front cash, and, in the case of very large bonuses, no more than 20% can be cash. More importantly, about 70% of total bonus value would be deferred for up to three years and would paid in a new class of security called “contingent capital”.

Ordinarily, bonuses can be paid in the form of a note or “IOU” from the Company. Under the contingent capital scheme, however, in the event of financial difficulties, this debt is converted into equity, which, like stock, falls in value with declining company fortunes.

The new rules are likely to be formally adopted at a meeting of EU finance ministers this week, allowing them to come into effect at all banks operating in the European Union before this year’s bonus season. American policy-makers eager to prevent future financial crises would be wise to look closely at these overseas developments.

Contributed by Yoko Goto

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The G-20 has finally weighed in on the issue of executive compensation. Why should investors care what global financial policy leaders think about performance-related bonuses? Because reforms aimed at ending the financial incentive for executives to bet the house on risky securities will only work if they are adopted uniformly.

There is little mystery about the role that fat-cat compensation packages played in last year’s financial crisis. Top management of investment banks enjoyed bonus packages that rewarded short term bets that could be disastrous for investors, while eliminating any downside risk to executives themselves. It should surprise no one that the result was a vast appetite for dangerous investments that would prove to have tragic long term consequences for investors and taxpayers.

In the Leaders' Statement from the September 24 – 25, 2009 Summit in Pittsburgh, G-20 leaders urged that reforming compensation packages is essential to any effort to increase financial stability. The leaders stated that reforms should ensure that compensation is aligned with long-term value creation for investors, rather than excessive risk-taking. They suggested that this could be accomplished by requiring that a large proportion of performance-related compensation be deferred and be tied to long-term performance. Moreover, they argued that such provisions should have teeth, in the form of claw-back provisions permitting companies to reclaim compensation from executives whose decisions land investors in hot water.

Of course, general statements of policy will be useless unless member countries enact rules enforcing restrictions on pay. A September 5, 2009 address to world leaders by Treasury Secretary Tim Geithner outlines the steps that are being taken in the U.S. to change executive pay structures. Geithner noted that the House has already passed proposals designed to tie compensation to long term performance, and stated that the Federal Reserve would be charged with enforcing the proposed new standards.

It remains to be seen whether any legislative effort to reform compensation can survive powerful lobbying efforts by management interests, but international cooperation on the issue is an encouraging sign.

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