Paying the Piper

The American Recovery and Reinvestment Act, signed by President Obama on February 17, 2009 mandates strict new rules on executive compensation for recipients of the federal Troubled Asset Relief Program.

June 21 2009 by Russ Banham


In what used to be called polite society, what other people earned and your own salary were nobody’s business. Those days are over for CEOs and other highly paid corporate executives at public companies. The populace not only knows, it doesn’t like what it sees, and the federal government doesn’t either. Goodbye, politesse; hello, new regulations.

While outrage over executive pay had been boiling for some time, it spilled over when American International Group’s credit default swap unit in London collectively received $165 million in government-paid performance bonuses after taxpayers had spent $185 billion bailing out the sinking insurer. Since incentive-based compensation is geared to a company’s financial performance, this did not make sense “if results go down, so should compensation. Infuriated shareholders vented their rage through organized bus tours of AIG executives’ homes in Connecticut, while others took to stalking the London-based traders. Needless to say, executive compensation is the cri decoeur of the moment.

The question is, Should it be? Several recent surveys indicate that executive compensation has fallen on a relative par with the descent in company financial performance and share values. Barring the few examples of egregious bonuses at AIG and Merrill Lynch, the system seems to be working. Nevertheless, all this may be moot. “The government has found the scapegoat for the economic crisis and it is executive pay,” says William E.Mayer, chairman of the compensation committees of newspaper group Lee Enterprises and two other companies, and chairman emeritus and former CEO of the Aspen Institute, an international nonprofit organization dedicated to fostering enlightened leadership and open-minded dialogue on contemporary issues.

The American Recovery and Reinvestment Act, signed by President Obama on February 17, mandates strict new rules on executive compensation for recipients of the federal Troubled Asset Relief Program. As the largest shareholder of TARP companies in many cases, calling the shots on executive compensation seems appropriate, but is it equally fair to apply these rules to all companies? “I don’t know who has the answers,” Mayer says. “The world has been turned upside down. I’ve never seen compensation under such an intense spotlight.”

Mayer fully understands the harsh public and government rhetoric over executive pay, and cites disapprovingly automakers flying in company owned jets to Washington to beg for federal largesse. Other pricey (and publicized) perquisites, from country club memberships to remodeled executive suites, make him cringe, yet he does not believe government regulations are the solution. “Congress often passes a compensation law that leads to unintended consequences,” he says. “It’s happened before and will happen again.”

A case in point is Section 162(m) of the Internal Revenue Code of 1986. The Clinton-era rule was crafted to limit excessive salaries by disallowing tax deductions above $1 million in executive pay, with an exception made for performance based compensation like stock options and annual bonuses. The unintended consequence of the regulation was a shift from high salaries to high stock options and bonuses. In theory this seemed prudent since performance based incentive compensation presents a greater upside potential for earnings. The problem was the lack of a risk management methodology to separate real performance from illusory performance, as the AIG bonuses underscored.

Another unintended consequence was that many companies lifted CEO salary to $1 million to keep par with their peers. In the years since, overall executive pay levels increased “the opposite of the rule’s intent. “It didn’t take long for comp committees to set up a formula for CEO pay reaching the GNP of Africa,” says Bruce R. Ellig, an advisor to corporate boards and author of The Complete Guide to Executive Compensation.

The Obama Administration is not about to gut §162(m). In fact, it is considering the Treasury Department’s idea of owering the threshold to $500,000 for all public companies. Several other compensation rules mandated for TARP recipients also

are being seriously considered. If House Financial Services Committee Chair Barney Frank; Senate Banking, Housing and Urban Affairs Committee Chair Christopher Dodd; and U.S. Treasury Secretary Timothy Geithner have their way, each will become law in the months ahead. “The regulations are coming fast and furious, setting one’s head spinning to figure out where a company stands and what it needs to do,” says Alexander Cwirko-Godycki, research manager at executive compensation research firm Equilar.

Getting Under the TARP

The American Recovery and Reinvestment Act is the government’s populist response to the public uproar over the economic crisis and its impact on their jobs and wallets. In handing out hundreds of billions of dollars to troubled firms, President Obama attached a few strings. The legislation prohibits cash bonuses and incentive compensation other than restricted stock (shares that are not registered for trading in a public market) for the five most senior officers and 20 highest-paid executives of companies. Until federal TARP dollars are repaid, recipients cannot award bonuses to the 25 executives that exceed one-third of their annual compensation. The rules also require TARP recipients to recover the performance-based compensation awarded the 25 executives if the bonuses were based on “statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate.” Such claw back provisions are not new-they were part of the Sarbanes-Oxley Act of 2002, albeit only affecting CEO and CFO pay.

The Obama legislation also mandates a “say on pay” provision, permitting shareholders to vote “for” or “against” a public company’s executive compensation program. And it mandates an end to “golden parachutes,” in addition to banning severance payments for senior executive officers and the next five most highly compensated employees. While the legislation fails to cap salaries at $500,000 as originally proposed by the Treasury Department, the President seems committed to the idea as the new threshold for IRS §162(m).

Depending on whom you ask, all these measures are likely legislative remedies to rein in excessive and unnecessarily risky compensation practices at public companies. As it recently proved with the 90 percent excise tax imposed on the maligned AIG bonuses, the government is very serious about “cleaning up” executive compensation practices. Preparing for this new era requires sifting through the TARP compensation rules to get a jump on what may be in store. Since executive salaries and bonuses are strategically designed to lure top talent by rewarding a measure of risk-taking to do competitive battle, these are neither easy nor clear-cut tasks.

“It’s very hard to predict exactly what restrictions we’ll see in general, but I would definitely begin to examine whether or not there is a direct link between pay and performance, and make sure it does not encourage executives to take unnecessary risks that lead only to failure,” says David Swinford, CEO and president of Pearl Meyers & Partners, a New York-based compensation consultancy.

Several compensation consultants and law firms specializing in crafting compensation contracts expect the TARP “say on pay” provision to become law for all public companies, deservedly or otherwise. At present, the rules apply to any TARP recipient that filed its proxy statement after February 17, thus affecting about 300 to 400 companies. “It’s just a matter of time before ‘say on pay’ will apply across the board,” says Paul Ritter, head of the executive compensation practice at Kramer Levin Naftalis and Frankel LLP, a New York-based law firm. “Comp committees are well-advised to scan their [compensation] policies this year to reevaluate how they may come out in a vote next year.”

“It’s definitely going forward,” says Patrick Mc Gurn, special counsel to the institutional shareholder governance services unit of Risk Metrics, a provider of risk management and corporate governance research and services. “I’m 100 percent sure it will be part of ‘Frado’” the anticipated Frank-Dodd legislation [on compensation]. This makes it incumbent for board comp committees to consider doing it voluntarily before it becomes law, getting it under the belt now.”

A perceived problem with “say on pay” is its imprecision. Shareholders will be asked to vote yes or no on a company’s entire compensation program and not the discrete elements within. “While the spirit of the rule is good in that it lets shareholders have a say on the pay of executives in whose companies they own stock, it’s a very blunt instrument,” charges Russell Miller, managing director of Executive Compensation Advisors, a division of executive search firm Korn/Ferry International. “Many compensation programs have multiple elements, each with a specific purpose. While the shareholders may agree with this element and not that one, they have no way of expressing it, no opportunity to do any type of ‘line-item veto.’ It’s just not fine-tuned for specifics. What we need instead is meaningful conversation and dialogue between boards and shareholders on compensation issues.”

Next up is claw backs, another TARP provision expected to hit the big time. Unlike “say on pay,” this one has near- Universal support, given its premise of taking back dollars from executives who, retrospectively, didn’t deserve the money “the “If you didn’t earn it you must return it” argument. Since the underlying premise of incentive compensation is pay for performance, clawing back compensation that did not heighten performance makes straightforward good sense. There are drawbacks, however. One is determining when financial results are based on materially inaccurate statements of earnings, revenues and other stated metrics. “It’s a simple solution on paper and very reasonable policy; implementation is another matter altogether,” Miller says. “If an executive making a decision did all the right things, and then FASB [Financial Accounting Standards Board] changes a standard that results in a restatement of financial results, should the executive be penalized? There haven’t been many examples post-Sarbanes-Oxley of how this would proceed. We need more clarity to ensure claw backs achieve their intended purpose.”

Since the passage of Sarbanes Oxley, only one successful claw back has been made public. In December 2007, the Securities and Exchange Commission announced a settlement with former CEO William W. Mc Guire at United Healthcare to repay $468 million as a partial settlement in his prosecution for allegedly backdating stock options.

Ritter brings up another downside. “Who gets whacked with a claw back-the guy reporting the numbers or everyone who reported up to him?” Michael A. Braun, CEO of Intact, a vendor of financial management and accounting applications, echoes the uncertainty: “There are plenty of individuals making obscene amounts of money who would escape the claw back provision even though they may have been the root cause of the misrepresentation.”

Others argue there are alternative compensation strategies that accomplish the intent of claw backs. “I love claw backs conceptually, but legally they’re hard to prove, as they require ‘bad faith’ on the part of the executives receiving the compensation,” says Prof. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. “Besides, the money often is gone-spent. There are better ways to achieve the same thing, like using restricted stock and preventing executives from selling the stock for a period after they leave the organization. If the stock goes down, it essentially has the same effect as a claw back.”

More problematic are the TARP rules limiting incentive compensation to restricted stock for the five most senior officers and 20 highest paid executives, while also reducing the bonuses of these executives to no more than one-third of their annual compensation. Like IRS Code §162(m), there may be unintended consequences. By limiting restricted stock to one-third of annual compensation, companies might be compelled to increase base salaries that are not directly related to performance. Elson calls this a “dangerous” possibility. “The whole point of compensation is aligning share holder value and executive incentive. This turns shareholder theory inside out.”

If the bonus limitations and proposals to lower the threshold of §162(m) to $500,000 both become law, it may encourage prospective and incumbent executives to seek employment at foreign firms and private companies immune to the mandates. “If you’re at JP Morgan and are capped out at half a million, and Credit Suisse or Deutsche Bank called and said ‘Come on Over- we don’t have a cap,’ where do you think you’ll be working?” says Mayer. “The unintended consequence is a weakening of U.S. companies at a time when they can least afford it.”

A so-called hard cap on pay-one that is not tied to tax deductibility is another looming possibility. “Given the populist outrage, I wouldn’t be surprised to see the Obama Administration push the hard cap concept through without loopholes for deductibility,” Mc Gurn says. “For one thing, it would raise federal revenues and do away with the unintended consequences connected with §162(m). The downside is that if companies lose the deductibility, it comes out of shareholder pockets.

With regard to severance pay, consultants say an outright ban would incur federalism and constitutionality issues. The government already took the glint off golden parachutes in 1986 with §280(g) of the Internal Revenue Code, which imposes a 20 percent income tax on severance pay in excess of three times an executive’s last salary. The same regulation also made severance non-tax deductible for employers. “I’d be surprised if the Administration seeks to totally prohibit golden parachutes, simply because as you go into the broader employee population severance pay is a reasonable practice to give people a cushion for a softer landing after an unexpected termination,” says Miller.

As for perquisites like country clubs, swank office suites and company cars-the legislation requires their disclosure (the “name and shame” provision, the Obama Administration calls it)-their perceived social unacceptability has already compelled many companies to restrict their use. Company planes are another matter. “They save so much time and hassle if you have to visit a remote location,” says Swin-ford. “For many executives, they’re also a legitimate security issue. Still, it should still be kept to a minimum.”

Is Uncle Sam Needed?

Perquisites aren’t the only practice companies have curtailed. Median CEO and board director compensation is much leaner-a factor linked to falling stock values and other performance metrics. “We valued [Citicorp CEO] Vikram Pandit’s pay package last year at $38 million, but the equity awards that formed the bulk of this package have since fallen tremendously, to the point where we now value that package today at about $2.9 million,” says Cwirko-Godycki at Equilar. “Of course, this doesn’t change the fact that the board gave him what they thought at the time would be worth $38 million. It’s just a reality that things have gotten worse, which in a way shows that the system is working.”

An analysis by Hay Group for The Wall Street Journal indicates Pandit’s experience is playing out across the landscape-an 8.5 percent decrease to $2.24 million in the median salaries and bonuses for the chief executives of the 200 largest U.S. companies in 2008. While median salaries increased 4.5 percent, this was offset by a 10.9 percent decline in bonuses, as profits decreased by a median 5.8 percent. Equilar has its own statistics. Its latest study of S&P 500 CEO pay trends shows that over-all compensation levels declined by 6.8% from 2007 to 2008. This is the first significant drop in CEO pay since 2001-2002. Bonuses, which fell by 20.6%, drove the decline in overall compensation. “The drop in compensation demonstrates that in many cases companies do have a true pay-for-performance program,” says Miller. “Specifically, many annual bonuses were hit due to the results for 2008, and maybe more importantly, the value of equity granted in the past has significantly fallen in value along with the stock price.”

With respect to outside directors, 43 companies reduced their pay last year, up from seven in 2007, says Cwirko-Godycki, “marking what may be a trend away from the double-digit board director pay increases recorded in the last several years.” It also appears that board compensation committees are becoming better at doing their jobs. According to a study by Dolmat Connell & Partners, an executive compensation firm, the frequency and length of compensation committee meetings are increasing. “Two to three hours has become the norm these days, compared to less than an hour,” says Jack Dolmat-Connell, CEO of the firm.  

Compensation committees are evaluating innovative ways to put the brakes on egregious executive pay, without halting corporate growth. One is to examine the amount of accumulated CEO wealth over the long term, via cashed-in stock options, awards and pension credits, before adding to the package with new stock grants and greater severance. “Boards should look at the big picture-a table that shows every-thing the executive is entitled to, projecting forward on such things as future stock grants,” says David Lynn, former chief counsel of the division of corporate finance at the SEC, and a partner at law firm Morrison & Foerster, at present. “You need to do some scenario planning to get a sense of what you’re agreeing to and the possible amounts involved. Then, you’re in a position to revise the package accordingly.”

Others want board directors to have more skin in the game, “more meaningful stakes” in the companies they serve, says Elson, who suggests a minimum stock investment of $100,000. He also believes paying directors solely in restricted stock that vests and cannot be sold until they leave the board offers similar merit. “The key to solving this dilemma isn’t the amount of compensation, it’s who negotiated it, and that is the board,” he says.

To enhance the overall skill of the compensation committee, SEC Chair Mary Schapiro is reportedly considering requiring boards to disclose more about their directors’ background and experience to determine if they have what it takes. Shareholder activist Nell Minow likes the idea: “It bothers me that the hundreds of stories written about the AIG bonuses provide the names of the recipients when it isn’t their fault they got them-it’s the bozos on the compensation committee that made that decision,” says Minow, editor of The Corporate Library, an independent research firm that specializes in corporate governance. “We see the same repeat offenders go from company to company, perpetuating the same problems… All this other stuff is the frosting on the cake; the cake is the board of directors.”

Ellig agrees: “It’s time for boards and comp committees to get up and say, ‘This is our responsibility and we will take control of it. We know how to solve it, not the government.’ This shouldn’t be the government’s focus. As history proves, when the government steps in it fosters unintended consequences, making things worse.”

Cutting executive pay to the bone or devising an incentive compensation structure that discourages prudent risk-taking will only back fire. “You don’t pay the rank and file a hair over minimum because you can get away with it,” Swinford says. “The same applies to an executive salary should be the median of the marketplace and fair; and the bonus should have teeth in it, with a very realistic possibility that it could be zero if that’s what the performance deserves. On top of that should be a long-term incentive plan that holds somebody accountable for their career; if they perform, their retirement will be secure.”

Whether or not compensation committees have the time and gumption to calm the public furor before it culminates in strict and punitive legislation is uncertain. The train has left the station. Until then, “Who Got What?” will remain the parlor game of the decade.


Russ Banham is a Pulitzer-nominated journalist and author of 18 books, including “The Ford Century,” an award-winning centennial history of Ford Motor Company, translated into 13 languages.