Seven Steps to Comp Control

Sound the boardroom siren: A five-alarm blaze is starting and it will burn some big names and change corporate executive compensation forever.

Andrew Cuomo tossed a match at bloodied and bailed-out insurance giant A.I.G. Wednesday and by Thursday, the company said it would be cooperating with the New York Attorney General "to recover any improper expenditures made by the company" as it fell to pieces in mid-2008, "including any inappropriate compensation paid to former executives," according to the Wall Street Journal.

One can understand Cuomo's motivation: It's generally considered poor form to charter a private jet, as A.I.G. execs did, and head off on a partridge-hunting trip in the English countryside immediately after agreeing to an $85 billion emergency loan.

But, exactly how can A.I.G. recover the tens of millions it paid to former C.E.O. Martin Sullivan and to Joseph Cassano, the guy who ran the derivatives unit that brought the company down?

By using a novel and very clever legal theory--one we're bound to hear a lot more about in the next few months. Cuomo's idea is that those payments constituted what lawyers call "fraudulent conveyances" or "preferential transfers."

Until now, these legal rules have been used to recapture things such as payments to suppliers for goods that were never received. Cuomo says that these executives were just like those suppliers: They didn't deliver.

In the meantime, Congress has already started legislating in the area, with the new, albeit weak, limitations on executive comp for companies taking advantage of the TARP legislation.

But all this is just the beginning, and for good reason. Much of the overleveraging of the financial institutions happened for a simple reason: Executives were heavily and personally incentivized to run them that way.

They made dizzying fortunes by taking percentages of the gargantuan profits generated by the leverage they placed on their companies; but they stood to lose essentially nothing if the whole thing fell apart. (Well, maybe a job, but who cares after you've raked in $30 million?)

This wasn't "pay for performance," as claimed. It was taking a cut from gambling other people's money. Fixing this fundamental disconnect is essential to rebuilding trust in the capital markets. And, given the simmering public fury (the full extent of which has not yet been seen) and the prospect of effective Democratic control of the government next year, it is certain to happen.

Therefore, the financial industry better get in front of this issue in a hurry if its members want to retain any semblance of the pay packages they've come to expect. It needs to suggest guidelines it can live with to head off far more punitive measures from Congress.

Here are a few ideas to play with:

1. Require all performance-based payments to senior executives above a threshold (over $500,000?) to be based on a rolling average of at least three years' performance.

2. Require that any performance-based severance payments take into account a substantial period of time after the executive departs. On this point, think about successful sports teams when the coach departs: They tend to keep winning for a couple of years because they have a successful system, good talent, and credible succession plans in place. Executives taking performance-based severance should be rewarded for doing the same (and not for having bet the farm, rolling a 7, and leaving the table).

3. Impose absolute caps on cash-bonus payments (Let's say maybe $10 million).

4. Require a major percentage of performance-based bonuses to be in restricted stock that must be held for a period of years, and on which at least some tax must be paid upon grant. This puts the executive in the position of having at least some skin in the game, with a stock value to protect.

5. Limit option grants. These are one-way, free bets that encourage taking undue risks.

6. Require minimum periods of service for any severance payments in excess of, say, $2 million. A.I.G.'s interim C.E.O. Bob Willumstad is to be commended for refusing to take the $22 million severance pay he "earned" for three months of service, but we can't rely on others to be so honorable.

7. Legislate the "Cuomo Rule": Treat any executive compensation in excess of certain amounts, and paid within a period of time prior to insolvency, subject to recapture.

Financial panics tend to have very ugly aftermaths. In this case, the witches better get ahead of the hunt if they wish to avoid the stake.

Bob Rice

Bob Rice is the author of Three Moves Ahead: What Chess Can Teach You About Business, and the former C.E.O. of a publicly-traded tech company. He now runs merchant bank Tangent Capital, which he founded in 2005.