TARP comp limits: The executive summary

Posted by Marc Hodak on February 18, 2009 under Executive compensation, Politics, Unintended consequences | 4 Comments to Read

This is my public service announcement.

Many firms and a few compensation consultants are still trying to figure out what the stimulus plan restriction on executive compensation really mean, and what they should be considering as a result of these rules.  Here are the answers.

What are the limits on TARP firms?

– The limits apply to every employee of a TARP recipient.  I know the papers say it will only apply to the top 1, 5, 10, or 20 employees (on top of the five “senior officers” defined in the law), depending on how much government money the firm takes, and that may have been what was intended, but that is not what the laws says.  The law says that if your firm took over $500 million in funds–as have 30 of our largest financial institutions–then the highest amount that any employee can be paid is no more than 150 percent of the salary of the 25th highest paid employee.

-By the way, that means that for the vast majority of banks that took under $25 million from TARP, the compensation limit is simply 150 percent of the single highest salaried person, which would usually be the CEO.  So, for instance, little Ameriserv Financial in Pennsylvania pays their CEO a salary of $300,000.  So the pay limit for everyone in that firm, salary plus bonus (or any kind of retention or incentive award), is $450,000.  In contrast, Morgan Stanley’s third highest paid employee makes $300,000.  I don’t know the salary of MS’s 25th highest paid person, but it’s almost certainly much less than that of the CEO of Ameriserv.  So, yes, the effective pay cap for giant Morgan Stanley’s employees is much lower than it is for little Ameriserv’s.

– The main distinction between the top 25 of a large firm and the rest is that the only bonus allowed for sure for the top folks is time-vested restricted stock, with the timing being exit from TARP (the same time we will be seeing many golden parachutes popping open).

– Under a reasonable interpretation of the law, no one in the firm may get a performance-based bonus if the performance basis is in any way manipulable.  That immediately rules out earnings-based bonuses or most forms of profit sharing.  It very likely rules out bonuses based on any financial metric, since all of them affect earnings and are, in practice, manipulable.  That basically leaves non-financial metrics, which are notoriously manipulable, but only if they don’t influence earnings.  The safest bet is to award bonuses purely on subjective assessments.

– Subjective bonuses are also the best cover for satisfying the prohibition on incentives to take “unnecessary and excessive risks.”  Arguably any bonus based on objective criteria within a limited time horizon, such as an annual bonus plan based on revenue, profit, cost-cutting, etc., encourages the kind of short-term behavior that might pose such risks.

– Of course, there is also the requirement to establish an “Optics Committee” of the Board.  These directors will be reviewing expenditures that are far more material to the press and public than they are to the shareholders, things like office decorations and corporate jets.

– Say on Pay.  If you’ve got TARP funds, you have to submit your compensation plans to the shareholders for a non-binding vote.  Many critics considered this a toothless reform when a company could actually pay their people whatever they wanted.  Now, the shareholders might be clamoring for pay-for-performance and competitive levels of compensation to prevent a brain-drain, etc.  The board will have to say, “Sorry, but at least we didn’t approve fancy Kohl fixtures in the top floor bathroom.  We’re making do with Standard!”

– Of course, the most appalling limits will be the ones you didn’t know existed because you negotiated them before the Treasury Secretary was required to retroactively review and renegotiate any awards received that were not “in the public interest,” whatever that means.  You can suppose it will ultimately mean whatever Congressman Frank or Senator Dodd says it means.

So, what can TARP firms do about these restrictions?

– Of course, they may strictly abide by them…and kiss their top talent good-bye.  I know Senator Dodd thinks, “Some very high earners will have to adjust compensation expectations, and maintain a different sense of proportion than in the past.”  But I think the good Senator must be running afoul of certain drug laws if he really believes that some of our highest skilled financial players are going to forego multi-million pay opportunities in non-TARP firms to satisfy the Dear Senator’s sense of proportion.

– More likely, the banks that can will quickly get out from under TARP, some of them at considerable risk to the shareholders.  If their banks subsequently fail, they will be at risk of shareholder lawsuits, but at least they will then be able to afford to defend themselves.

– For banks that can’t easily get out from under the TARP, we will see an immediate replacement of target bonuses with salary, then an escalation in the salaries of the top X people (x being somewhere between 1 and 20).  The bonuses that they continue to offer will be based exclusively on subjective criteria, to avoid any of the several types of restrictions under the law.

– Finally, we will see the rapid growth of outside advisory and management firms.  These will be firms whose employees are, strictly speaking, not employees of the TARPed banks, but serve them exclusively with management and advisory talent.  These firms will be paid on a combination of retainers and commissions.  Banks will, in short, begin to outsource just about every high-return operation.  This may increase their costs and reduce their flexibility in how they manage their operations, but it will enable them to retain high-priced talent.

So, the net effect of this law will be to (a) encourage banks to rapidly de-leverage to the point where they can get out from under TARP, (b) rapidly escalate the salaries of their remaining top executives, (c) eliminate bonuses based on any objective performance criteria, and (d) increase the costs and reduce the flexibility of taxpayer-owned banks relative to their competition, domestic and foreign.

Oh, and it will also “help ensure that taxpayer dollars no longer effectively subsidize lavish Wall Street bonuses.”