Human Capital & Careers

Vague Comp Limits Are Paralyzing Banks

Most of the stimulus plan's executive compensation provisions need Treasury Department guidance, and banks want it now so they can get on with busi...
David McCannFebruary 19, 2009

While the economic stimulus package was signed into law on Tuesday, it left unanswered many questions about how one of its most talked-about principles — limits on compensation for executives of firms that take federal bailout funds — will be applied in practice.

Financial institutions that participated in the first round of the government’s Troubled Assets Recovery Program, and those that hope to get in on round two, are not yet clear on how and when to proceed with changes to their compensation programs, if necessary. They are waiting for the Treasury Department to issue regulations and interpretations amplifying the broad principles set forth in the stimulus law.

But they are not waiting patiently. The American Bankers Association sent a letter to Treasury Secretary Timothy Geithner yesterday, complaining about hardships for its members while they await the department’s guidance.

“Because the Act ties compliance with the executive compensation provisions directly to standards that have not yet been established and issued by the [Treasury] Secretary, we believe it is clear that these provisions are not effective until these standards are established,” the bankers group wrote, adding, “Our industry is badly in need of immediate clarification.”

The ABA claimed that some banks are unable to close transactions, including at least one acquisition, because of uncertainty over the effective date of the law.

Another problem, according to the ABA, is that some institutions may not be able to file their 2009 proxy statements as scheduled because they do not know how the act may impact the required compensation disclosures. Others are questioning whether they may have to restate their 2008 financial results due to the potential retroactive impact the compensation restrictions could have on the income statement, the letter said.

Bashed for the Past?

There may be “retroactive impact” because Congress gave Treasury the right to look back at any compensation paid to senior executive officers, and the next 20 most highly paid employees, of entities that received TARP assistance before the stimulus bill became law. If the department determines that payouts were “contrary to the public interest,” it will initiate a negotiation for “appropriate reimbursements.”

In fact, the wording of the provision does not necessarily limit the review to 2008 bonuses. It ambiguously leaves open the door to reevaluating prior compensation as well. “Technically, they could be going back 20 years,” said Steve Barth, a partner with the law firm Foley & Lardner, “though how that would be enforceable, no one knows.”

Additional uncertainty for TARP beneficiaries lies in other still-to-be-clarified elements of the compensation limitations, which modify or replace some of those that were included in the original TARP legislation enacted last fall.

President Obama had ballyhooed a $500,000 limit on all compensation for executives of firms that took bailout money. But that provision was replaced at nearly the last minute, in an amendment pushed through by Sen. Christopher Dodd last weekend, with a new one that says incentive compensation can be no more than one-third of total pay (and must be in the form of restricted stock that does not fully vest until the firm repays its loan to the government).

Now there is no limit on base pay, and it remains to be seen if firms, out of determination to retain their top talent, will try to get around the spirit of the legislation by ratcheting that up. That’s what happened with equity-based pay in the mid-1990s when Congress established a $1 million tax deductibility limit for cash compensation.

Absent Treasury Department interpretations, firms would be “asking for trouble” if they try to do anything other than make market adjustments to executive compensation, according to Mark Poerio, a compensation and benefits partner with the law firm Paul Hastings. They could be held accountable for violating the principles of the law not only by public opinion, he said, but by the Treasury Department and states’ attorneys general.

I’ve Got It in Writing

A perhaps more troublesome loophole concerns the extent to which the limitation on incentive pay would apply to executives with pre-existing employment contracts calling for higher incentive compensation.

While the original TARP was silent on the employment-contract issue, the stimulus law explicitly says that “any bonus payment” payable under a written contract executed before February 11, 2009, is not subject to the requirement that incentive pay be limited to one-third of total compensation. However, that may not be as clear-cut as it sounds.

What if, for example, a contract stipulates a target bonus but says the actual payout depends on a subjective evaluation of the executive’s performance? “Will that be enough to bring it within the exception, or will the exception be only a contract right that’s objectively determinable, like 1 percent of profit?” Poerio said. “It all may depend on how a contract is written, but right now it’s not clear what’s going to fit within the statute.”

A Game of Leapfrog

Possibly the trickiest aspect of the law’s compensation provisions involves determining which executives are subject to them. The quick answer is that, for the largest firms, they apply to the five top officers and the next 20 most highly compensated employees, and to fewer and fewer people as firm size shrinks. There is not yet any guidance, though, as to how to specifically define “compensation” — for example, do currently value-less stock options count? — and thus how to specifically identify the most highly paid.

Even more perplexing is this: Once 25 executives’ pay has been restricted under the stimulus law, it is extremely likely that other employees, especially traders who earn most of their income from commissions and bonuses, will then be more highly compensated than the former top 25. Do they then become subject to the law? If so, when — immediately, or upon the next proxy filing? “These are questions that we don’t know the answers to yet,” said Poerio.

Barth said that while there has been some talk that Treasury will exclude largely commission-based pay arrangements from the applicability of the law, “no one really knows.”

In fact, though, the department may do more than that. It is well-known in Washington, according to Barth, that Treasury did not agree with all elements of Sen. Dodd’s late amendment to the compensation provisions. “We may see some relaxation on some of these standards from Treasury,” he suggested.

Headline Hell

Any such relaxation could, of course, carry potential political risks, given the public’s mood toward alleged excess on Wall Street. It might be especially unwise to dial back limitations on luxury expenditures that were included in the executive compensation section of the law, and which also need further guidance from Treasury in order to be practicable.

The luxury spending provision states that firms accepting TARP money must have a written policy regarding “excessive or luxury expenditures, as identified by the Secretary.” It specifically singles out spending on entertainment, events, office and facility renovations, and air travel or other transportation as areas that may receive the greatest scrutiny.

The common denominator of those activities is the black eyes bailed-out firms have suffered following media reports about the firms engaging in them. “There will be more definition around this by Treasury, but I expect most boards of directors will be very strict on those policies,” Barth said.

Poerio was incredulous. “The list they gave was straight from the front pages of the newspapers,” he said. “It’s incredible that now we’re taking the headlines of the moment and putting them right into law.”

This may signal a coming crossroads whereby certain provisions of the stimulus legislation will be applied beyond entities that accept bailout money, according to Poerio.  “One line of thinking is that this is all appropriate in the context of protecting taxpayer monies where they’re invested,” he said. “But it is such an extreme response to public outcry that it wouldn’t surprise me to see Congress be very active in taking what’s in this law and applying it more broadly.”

Also carrying implications for companies generally is a prohibition on compensation that provides executives with an incentive to take “unnecessary and excessive risks,” a remnant from the original TARP legislation. As before, no further explanation of that phrase is given.

The provision reflects an anti-risk climate that has settled in so thickly that Barth said he has been advising all his clients, not just financial services firms, to analyze in greater detail how their compensation programs match up with their risk assessments and risk-mitigation plans and their strategic goals and objectives. “You should be doing this regardless what industry you’re in, even if you’re a private company,” he said.

To TARP or Not to TARP

Meanwhile, one aspect of the stimulus law that is not open to much interpretation is a flat-out prohibition on golden parachutes for executives departing from bailed-out firms. While that term historically has been held to mean lucrative compensation awarded to an executive upon a change in control of the company, the new law defines it as “any payment to a senior executive officer for departure from a company for any reason, except for payments for services performed or benefits accrued.” Observed Poerio, “That provision is severe.”

Indeed, overall, the new compensation limitations are going to have “a dramatic effect,” he said.

That is, if they don’t scare away many firms that otherwise would gladly take the government’s money. That’s what Barth is predicting.

“Almost all of the institutions that are participating so far are financially healthy enough that they don’t need the money to survive,” Barth said. “And that’s one of the main things TARP is for — to make the healthy healthier, to allow them to have sounder balance sheets and more of a capital base that would encourage more lending and unfreeze the capital markets. But it will be very hard for firms to participate now. Most are not going to take any money.”