Compensation elements of the Bailout Bill

Posted by Marc Hodak on October 2, 2008 under Executive compensation | 3 Comments to Read

I was up way late last night trying to figure out what all this will mean for executive compensation, so here goes.

There are two sections dealing with compensation governance in this giant bailout bill.

Sec. 111 says that when the government makes a direct purchase of assets, then it must impose certain conditions on the compensation of “senior executive officers” (i.e., the top five NEOs).

The first condition is the elimination of incentives for “unnecessary and excessive risks.” Of course, any variable compensation encourages risk taking. That’s the point; shareholders want their CEOs to do more than clip coupons and resist takeovers. Clearly, some CEOs took too much risk, i.e., leveraging their firm’s huge bets on dodgy mortgage assets, but now the government will have to develop guidelines distinguishing “appropriate” risks from “unnecessary and excessive” risks. This is a very difficult thing for even the most conscientious and accomplished boards. One person’s “appropriate” is bound to be another person’s “excessive.”

What if the objections of a particular director regarding a risky compensation element are overrode by the rest of the board, and the company hits trouble because of decent bets that had poor results? It happens. What boards will take that chance? Few. Or none. I predict that the most timid or economically ignorant member of any board will become the bottleneck regarding various compensation elements designed to add some risk to pay. Even a former Goldman exec at Treasury, knowing what his incentives are, won’t risk overruling them.

Another provision requires that bonuses based on materially wrong information must be returned. This claw-back provision is reasonable. So, if it’s reasonable, why hasn’t it been implemented at companies already? Because it’s costly. It would be impossible to implement a claw-back mechanism without some banking of bonuses. All else being equal, bonus banking, which is basically deferring compensation at risk, requires extra compensation; more risk, higher expected reward. For those who simply don’t believe that most boards are actually interested in keeping a lid on compensation expenses, you may skip this part: their desire to keep expenses down means that compensation committees are eager to find ways to reduce compensation risk rather than increase it. That’s a major reason that real claw-back provisions haven’t taken hold. This clause is basically a way to force boards to take on that expense. This is not the end of the world–just another imposed constraint.

Another key provision is the elimination of golden parachute payments if the government makes any investment in the firm. This will require renegotiation of existing contracts, or the accelerated departure of the current CEO before the government invests, and a contract with the new CEO without a golden parachute. Of course, that new contract must still compensate the new CEO sufficient to attract him or her into a risky, politicized environment where the government is likely to be an important customer. Asking these CEOs to fly without a parachute will require some other form of compensation (see above re: risk/reward), most likely in the form of a higher salary.

These provisions also require that if, instead of investing in the firm, the government buys more than $300MM in assets via direct purchase or an auction, then they can also prohibit golden parachute clauses in new employment agreements for senior officers in the event they are fired or the firm goes under. This is basically an acknowledgment that the government can’t abrogate an existing contract. Beyond that, this clause is likely to have no practical effect. It might lead to overly conservative management, which certainly won’t bother politicians as much as it might shareholders of under-performing firms, but it seems unlikely that CEOs will be fired for under-performance in lieu of being allowed to depart “for personal reasons.”

Golden parachutes were, themselves, invented in the 1980s–a time of escalating management pay–in order to disguise those pay increases from critics devouring the then-newly required disclosures of CEO salaries and bonuses. The golden parachute ban in this law, however, will not be a permanent issue for boards; this rule is in effect only until the end of 2011, meaning that it is likely that any contract considered too onerous or expensive for lack of a golden parachute clause will get renegotiated after this section has been sunset.

Sec. 302 of this legislation will have even more impact. It begins by reducing the “162(m) cap” on the deductibility of income for top execs down to $500K from $1 million. The amazing thing about this provision is the apparent elimination of the “performance-based” exception. What will that mean? All those $10-15 million compensation plans where 90% of the target comp was variable or at-risk pay will quickly turn into $7-10 million comp plans paid mostly in salary. Managers will be relatively indifferent about lower guaranteed pay vs. higher at-risk pay, but shareholders would much rather pay taxes on the overall lower amounts rather than higher possible amounts.

Congressmen clearly expected this lower level of deductibility to penalize CEOs by encouraging lower pay in order to avoid a tax penalty. But this assumes, as do all laws passed by Congress on this matter, that boards can pay their CEOs whatever they wish. It ignores that most boards have to compete for CEO talent, that the market for that talent goes a long way toward dictating what companies must pay to attract people of a certain caliber. CEOs will, in fact, be getting lower pay, but it will be more guaranteed and less performance-based. At a time when financial firms need the best people they can get, Congress is basically penalizing financial corporations for acquiring or positively motivating that talent as those firms try to control their costs, now made significantly higher by the tax code.

In any case, the net effect of these provisions will be to “bureaucratize” top executive compensation at participating firms. Will this result in more bureaucratic behavior, swinging the pendulum back to where we were in the ’60s and ’70s? Yes–for the next couple of years, anyway. Such an outcome probably suits the Max Baucus’s of the world, with a nostalgiac view of CEO pay in a less entrepreneurial age, who thinks that every job looks like a government job, or perhaps should be a government job with no one making more than a GS-14. Shareholders, however, are in for the doldrums over the next couple of years.

Of course, what it really means is that larger companies with highly paid top executives will be avoiding this bailout like a plague in order to save their own pay, and their shareholders tens of millions of dollars in additional taxes. They have the resources to wait until the government (or, more likely, private equity) establishes a reasonable market for the assets they don’t want, which they can then sell at their leisure.