Pay scale justice

With the largest U.S. investment and commercial banks set to receive massive cash infusions, lawmakers on Capitol Hill are happy to point out that the top five chief executives of participating financial institutions are facing unprecedented and "historic" federal limits on their pay packages.

"This is the first time in American history that the federal government has applied these kinds of restrictions on the compensation that goes to top executives," says House Financial Services Committee Chairman Barney Frank, D-Mass. "We will be watching how the Treasury implements these important provisions to ensure that the restrictions are binding and enforceable."

But as with previous attempts at limiting CEO pay packages, this endeavor may have wide-ranging, unintended consequences. And it's not even clear that it will have teeth.

Treasury Secretary Henry Paulson is allocating $125 billion of a $700 billion government stabilization plan to buy large minority stakes in nine large financial institutions, reserving another $125 billion for smaller thrifts and bank allocations. But to get Treasury money, participating banks must agree to restrictions on the pay packages of the top five executives. In addition to CEOs and CFOs, top paid officials at banks that may face these limitations for the first time could include the firm's general counsel.

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One restraint, a measure that prohibits participating banks from deducting from their taxable income more than $500,000 a year for base salary paid to each of their five most senior executives, is expected to drive corporate directors to find other means of compensating CEOs.

Columbia University Law School professor John Coffee says he believes this limitation could end up pushing more board compensation committees to allocating stock options as a way of offsetting reductions in salary stemming from the prohibition. The pay-package transfer could follow a similar shift toward stock options that took place after companies across the board were prohibited by a 1993 regulation from deducting, for the most part, more than $1 million in CEO pay. "By limiting tax deductibility for salaries and bonuses, you encourage firms to move out of salaries and bonuses for compensation packages," Coffee says.

Such a shift to stock option payments may be limited by recent regulatory prohibitions on stock option expensing. Some academics and other observers are raising questions about whether a vague provision in the Treasury rules barring pay packages that encourage "unnecessary and excessive risks that threaten the [firm's] value" could discourage stock option grants. The provision, which Treasury has no plans to clarify, requires bank board pay package committees to interpret this small but important section. Without further guidance, expect many compensation committees to take a hard look at stock option risks when drafting internal bylaws based on the rule. "Treasury doesn't want executive compensation packages to encourage excessive risk taking, and stock options are the part of the compensation package that is most likely to provide the executive with the incentive to take risks," says Temple University Business School professor Steven Balsam.

All this could lead to more restricted stock grants, where a CEO is provided stock that can't be sold for a certain period of time, say, four years. Balsam says restricted stock programs may gain acceptance by participating banks because they don't rely on performance and are presumably less risky.

The top five corporate executives at participating banks may be on the hook more than ever when it comes to their bonuses. If it turns out that the benchmarks executives reached entitling them to bonuses were based on "materially inaccurate financial statements" or other inaccurate performance metrics, this so-called clawback provision requires CEOs to return that payment to the business.

In those cases, boards are required to recover bonuses from any top five executives involved. This measure is intended to be significantly tougher than a similar rule adopted under the Sarbanes-Oxley Act by the Securities and Exchange Commission in 2002. For one thing, only the CEO and CFO can have their bonuses clawed back under SOX. More importantly, SOX requires CEO or CFO misconduct for it to be triggered, a much higher burden. "With SOX, boards would have to prove that the CEO intentionally made the mis-statement," Balsam says. "How do you prove intent? With the new law, when financial statements are wrong, there is no requirement for misconduct to trigger the clawback."

The question that remains is how the new Treasury rule will be enforced. Since the SEC adopted clawback rules, many corporate boards have been apprehensive about taking clawback actions against CEOs, especially if they liked the executive. In other cases, settlements between executives and companies have been reached behind the scenes. Coffee says he expects to see more settlements come out of the new Treasury law, especially if stringent enforcement protocols are in place. Lawmakers on Capitol Hill are watching to make sure Treasury makes these provisions fully enforceable.

Another major regulation is a measure that prohibits banks receiving Treasury infusions from providing golden parachute compensation packages to new top five employees as long as the institution is holding on to government capital. That restriction, says Balsam, will limit a bank's ability to attract top talent, at least until it buys out the Treasury stake. "People are going to opt for private equity jobs and stay away from highly regulated public banks," Balsam says. "It also provides an incentive for the banks to buy out the government stake as soon as they can -- maybe too soon."

The golden parachute provision may also have the unintended consequence of encouraging blockbuster and smaller bank deals. Balsam points out that when a participating bank is acquired, the purchaser in many cases will buy out the government share, leaving new compensation committees free to provide whatever golden parachutes they want. If the acquirer doesn't buy out the government stake or if the buyer is another participating bank, the severance prohibition remains.

Even with all these shifting regulatory considerations, the market will also have its say. Balsam says CEO pay packages may be cut back because it is harder for boards to justify to hypersensitive shareholders large compensation programs. Laraine Rothenberg, tax partner at Fried, Frank Harris, Shriver & Jacobson LLP in New York, says she doesn't think tougher new limits on corporate tax deductions for CEO pay will discourage most major financial companies from providing substantial compensation packages. "Losing a tax deduction may not be a major constraint on paying compensation."
Rothenberg says.

The Financial Services Committee's Frank contends that the compensation restrictions aren't too restrictive. "We're always told that if you do that [restrict CEO pay], it will have terribly negative effects -- nobody is going to want to be a banker if they can't make $27 million a year and get a big bonus and not have to pay it back if it turns out the bank didn't actually make the profit benchmarks," Frank says. "I think we're going to show what most of us believe, which is that the main incentive for taking these jobs is that people want to have a lot of money and that incentive remains."

Corporations watching these financial institutions from the outside may want to take a closer look at the restrictions. They are expected to be a model for new executive compensation prohibitions Congress will consider in January for all companies. Frank, for example, plans to introduce CEO pay legislation in 2009. Expect a stronger Democratic-controlled Congress to take major steps to clamp down on megacorporation CEO payments with the financial institution rules as guidelines. "I would have written tougher executive compensation limits for participating banks, but we will build on this next year," Frank says.

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