Truth and consequences of the bailout’s compensation provisions

Posted by Marc Hodak on October 5, 2008 under Executive compensation | Read the First Comment

This is a more up-to-date and (hopefully) better packaged version of my prior write up of the bailout…er, rescue package’s executive compensation provisions. It’s a story of consequences, some intended, some not.

Sec. 111(b)(2)(A): The Treasury Secretary is charged with eliminating “incentives for executive officers of a financial institution to take unnecessary and excessive risks” for firms in which the government has taken an investment position.

Intent: To discourage firms from overly high risk-taking on the part of senior management.

Likely effect: To discourage appropriate risk taking on the part of managers.

Analysis: The relevant consideration in this scenario is not management incentives, but board incentives. Boards are remarkably, perhaps inherently, poor at distinguishing strategic or governance risk. No government-appointed director, even a Goldman refugee who might know better, will risk a major problem arising from a strategy with significant uncertainty. The most risk averse (or economically ignorant) director will drive the board’s appetite for risk. There will be no force to stop the pendulum in the middle. The board will be happy to pay its managers like bureaucrats for bureaucratic results.

Sec. 111(b)(2)(B): Participating firms must claw back any bonuses paid on the basis of accounting-based results that turn out to have been false.

Intent: To prevent bosses from benefiting from accounting errors or manipulations that overstate results.

Likely effect: To increase the total compensation paid to top managers.

Analysis: The only way to effectively implement a viable claw back mechanism is to bank bonuses before they are paid out. This basically makes this element of compensation deferred and at risk. Managers value deferred compensation or at risk compensation much less than current or guaranteed compensation. Therefore, the board will have to offer a higher level of target compensation to remain competitive with the portion of the market that doesn’t hold as many bonus dollars deferred and at risk.

Now, such a claw back provision may be a good idea at many firms. In fact, a good number of firms employ bonus banks for various purposes; I have implemented such mechanisms myself at a number of clients. But that doesn’t mean that a one-size-fits all scheme is a good idea. Such mechanisms are not costless for the shareholders, so most of them would likely prefer to have the right to continue to make those cost/benefit trade-offs for their own companies. Participation in the bailout means forfeiting that right.

Sec. 111(b)(2)(C): Prohibits any golden parachute payment to the CEO while the government has an investment in the firm.
Sec. 111(c): If the government purchases significant assets, they can prohibit golden parachutes in new employment agreements.

Intent: To reduce the financial benefit to CEOs at firms participating in the bailout, especially if the CEOs are forced to leave for poor performance.

Likely effect: To accelerate the departure of CEOs at firms just as they are approaching the government for their emergency help, or force firms to renegotiate higher salaries or other benefits for the CEOs they really need to keep in lieu of golden parachutes they are asked to forfeit.

Analysis: While the government can’t compel a firm to abrogate contracts with existing managers, it can require a golden parachute prohibition as a condition to participate in the program. Such a requirement simply throws the firm and its CEO into a renegotiation, with one benefit off the table. To remain competitive, many boards will have to come up with some other way of keeping their executives “whole,” or risk watching them walk. Forced re-negotiations almost always work in favor of the managers.

Most boards will also likely maintain informal agreements to reinstate the golden parachutes after this law is sunset in one to three years.

Sec. 302(a)(5)(A)(i): $500K limit on deductibility of executive compensation (top three paid officers, including CEO and CFO).
Sec. 302(a)(5)(A)(ii): deferred portions of compensation will be subject to this tax limitation even after the firm has ceased to participate in the bailout.

Intent: Encourage lower pay for the top officers via a tax penalty.

Likely effect: Dramatic increase in salaries for these officers in a wholesale shift from variable to fixed pay. Total target compensation will, in fact, come down, but 99 percent of the tax penalty will hit the shareholders (and eventually workers and customers), not the executives.

Analysis: Unlike the current $1 million limit on tax-deductible pay, the $500K limit has no performance-based exceptions. So, as far as the board is concerned, it no longer matters what the pay mix is between fixed vs. variable, or guaranteed vs. contingent, or current vs. deferred. And since anything that makes pay more variable, contingent, or deferred also makes the pay package more expensive, they will have no reason to maintain those aspects of compensation–especially the variable and contingent aspects–for the duration of their participation in the program. Managers will be somewhat indifferent to lower total expected compensation if it is less variable or contingent, but shareholders will definitely prefer anything that lowers the expected cost (they may not have any choice on the deferred aspect because of the claw-back requirement). So, expect to see more $5-8 million salaries with much smaller bonuses or equity grants.

Net primary effect of executive compensation provisions: All kinds of games will develop to funnel bad assets through a small number of firms willing to take on these temporary compensation constraints.

– Firms with very highly paid officers will likely avoid direct involvement with the government on the bailout like the plague. If they can, they will instead wait for a secondary market for their toxic assets to develop.
– Top officers of firms that can’t afford to wait will have a clear incentive to find buyers for the whole company, or to accept a marginally higher risk of their company failing, in order to avoid these compensation limitations.
– Firms with smaller amounts of troubled assets (<$300 million) may be able to sell to the government while avoiding these compensation constraints. - Firms forced to accept these constraints will end up paying their top managers in a more bureaucratic manner, i.e., much high salaries, little in the way of bonuses or new equity. But these firms may be able to take advantage of their participation in the program by becoming a funnel of these toxic assets into Uncle Sam's coffers. These managers will not have to wait for heaven for their reward--only one-to-three years, when these provisions are scheduled to sunset. Secondary effect: If Congress sees that the participating firms in fact lowered total compensation while they were in the program, our politicians may be encouraged to extend several of these provisions to other levels of management, or to other sectors, or the whole public company market. This may lead to a permanent tax on managerial talent born by all public company investors. Congress kills two birds with one stone–pretending to penalize fat cat CEOs (even though that penalty will, in fact, be spread among the shareholders and other stakeholders of the firm), and collecting more tax revenue–Congress’s incentives don’t change a bit.

Tertiary effect: Complex, tax efficient compensation structures will evolve to get around this tax penalty for public companies. (Yes, you’re welcome.) Congress and the IRS will join this new ‘arms race.’ To the extent they fall behind, the tax effect will be neutralized. To the extent they get ahead, public companies will bleed talent to the private equity market, which will prosper and grow at the continued expense of public firms.