Confusion Reigns Over Pay Restrictions

Companies that are (or were) planning to take government bailout money are

anxiously awaiting guidance from the Treasury Department on how to comply

with strict new pay limits imposed by the economic stimulus package, which

experts say could turn pay practices at those companies upside down.

Just weeks after the Treasury issued its executive pay limits in the second

round of the Troubled Asset Relief Program, Congress struck an eleventh hour

deal that re-inserted strict new pay rules back into the American Recovery

and Reinvestment Act, signed by the president on Feb. 17.

Depending on how they’re put into practice, observers say the rules could turn the current pay-for-performance model of many financial institutions on its head and may have unintended consequences.

“This has the potential to significantly reshape the delivery of executive

compensation,” says David Gordon, a principal at compensation consulting

firm Frederic W. Cook & Co. “Companies are praying to get quick guidance.”

So far, experts say far more questions than answers remain on how the

executive pay restrictions will actually operate.

“There are so many questions and such a lack of clarity,” says Susan O’Donnell, a managing director at compensation consulting firm Pearl Meyer & Partners. “Companies are struggling with what many of the terms mean.”

The law itself doesn’t tell companies how to comply with the limits. Instead, it directs the Treasury to adopt implementing rules for the standards. Until companies get detailed guidance, observers say it’s unclear

how many of the provisions will be applied.

While some aspects of the Recovery Act codify the Feb. 4 Treasury guidelines on executive compensation, some notable differences exist. For one, there’s no mandatory cap on total compensation in the Act. However, the standards are much tougher in other respects, and they apply to all TARP recipients.

Feller

“There’s a lot of uncertainty,” says Sean Feller, a partner in the law firm Gibson, Dunn & Crutcher. “There are a lot of fine points that are still open.”

O’Donnell says a troubling aspect is that the law “takes a broad-brush approach and puts all of the banks in the same group,” unlike the Treasury rules, which differentiated between healthy firms and those that need “extraordinary assistance.”

The restrictions essentially “eliminate pay for performance and eliminate the ability of compensation committees to make pay decisions other than base pay,” O’Donnell says. Under the new restrictions, she says, “Even small, local community banks with conservative pay programs will see pay cuts.”

Questions abound about exactly which employees the limits apply to and the types of payments that are prohibited under the law. For example, the law includes a provision that limits incentive compensation to restricted stock equal to no more than one-third of annual total compensation at companies that take or have taken TARP money.

The strict limits could “cause some companies to bail out from the bailout.”

— Sabino Rodriguez,

Partner,

Day Pitney

Incentive compensation typically comprises the bulk of executive pay at larger companies, while salary is generally less than 25 percent of total compensation and often less than 15 percent of compensation, says Gordon.

By effectively making salary two-thirds of the pay packages, the incentive compensation limit “throws the pay-for-performance model into disarray,” says Feller.

Reda

Compensation consultant James Reda of James F. Reda & Associates, says it’s also “not quite clear what ‘incentive pay’ means and whether that might include other long-term incentives.”

Another question is what constitutes “total annual compensation” for purposes of the limit on incentive compensation—W-2 compensation, the amount of total compensation reported under the Securities and Exchange Commission’s proxy disclosure rules, or something else.

The number of employees to whom the limit applies is based on the amount of money the company takes. For companies that get $500 million or more, the limit applies to senior executive officers and the 20 next most highly compensated employees, or a higher number determined to be in the public interest by the Treasury Secretary.

Experts say it’s unclear what basis companies are supposed to use to identify the executives covered by the limit, or what the effect will be of a provision that grandfathers in arrangements under written employment agreements executed on or before Feb. 11.

Feller notes that the provisions refer in many cases to the most highly paid employees, which would sweep in non-executive officer employees who don’t hold policy-making positions.

The law also prohibits all severance payments for named executive officers and the next five most highly compensated employees for departure from a company for any reason, except for payments for services performed or benefits accrued.

That prohibition is “written very broadly,” says Gordon. “We’re puzzled about how that plays out.” For instance, he says, it’s uncertain whether that ban includes death or disability benefits.

Rodriguez

Sabino Rodriguez, a partner in the law firm Day Pitney, says the incentive pay and severance limits are “so out of step with what general industry does, it may be difficult for these companies to attract talent.”

And, unlike the limit on incentive compensation, there’s no grandfather provision for existing employment contracts that provide severance. “That’s a big question mark,” says Rodriguez.

COMP STANDARDS

Below are some excerpts of the compensation restrictions mandated by the Recovery Act:

(A) Limits on Risk Exposure Incentives. Limits on compensation arrangements that foster the taking of unnecessary and excessive risks that threaten the value of the TARP recipient, thus codifying the similar requirement contained in the initial guidance under the CPP.

(B) Bonus Clawback. An arrangement to recover any bonus, retention award or incentive compensation based on earnings, revenues, gains or other criteria that are later found to be materially inaccurate. The amendment codifies the provision included in the Initial Guidance under the TARP CPP but now extends the clawback beyond amounts paid to any SEO to include the next 20 most highly compensated employees.

(C) Prohibited Severance. A prohibition on "golden parachute" payments, defined to include any payment to an SEO and the next five most highly compensated employees for departure from a company for any reason, except for payments for services performed or benefits accrued. The Stimulus Package Act expands the definition of "golden parachute" to extend to all severance and not just severance that would not be deductible for federal income tax purposes.

(D) Limit Incentive Compensation Except for Certain Restricted Stock. A prohibition on paying certain executives any bonus, retention or incentive compensation other than certain long-term restricted stock that meets the following criteria:

(i) does not fully vest during the TARP Obligation Period,

(ii) has a value not greater than one-third of the total annual compensation of the employee receiving the stock, and

(iii) is subject to such other restrictions as the Secretary of the Treasury may determine are in the public interest. However, the scope of executives subject to these limitations on incentive compensation depends on the magnitude of the federal assistance received by the TARP recipient …

(E) Ban on Plans that Encourage Earnings Manipulation. A prohibition on any compensation plan that would encourage manipulation of the reported earnings of a TARP recipient to enhance the compensation of any of its employees.

(F) Required Compensation Committee and Functions. The Stimulus Package Act requires that TARP recipients have a compensation committee that satisfies the following:

(i) is comprised entirely of independent directors (except that the functions can be performed by the board of directors as a whole for a TARP recipient who has received less than $25,000,000),[20] and

(ii) meets at least semiannually to discuss and evaluate employee compensation plans in light of any risks posed to the TARP recipient by such plans.

Source

Day Pitney Alert on Executive Pay Limits (Feb. 15, 2009).

Unintended Consequences

“There’s no doubt that the restrictions are going to drive unintended consequences, one of which is driving up base salaries,” says O'Donnell.

Likewise, Reda says the restrictions are likely to cause companies to come up with “some interesting arrangements” to find other ways to pay executives, such as hiring some employees as contractors or promising to pay executives more in later years when they’re no longer bound by the TARP restrictions. Feller says companies may also try to find ways to pay top executives more during their years of service if they can’t pay any severance.

Poerio

Mark Poerio, a partner in the law firm Paul, Hastings, Janofsky & Walker, says financial companies are most concerned about an exodus of top talent to firms that aren’t bound by the rules.

“Companies are trying to figure out how to retain and motivate executive talent in the face of such stunning limitations,” he says. “Everyone is terrified that the impact of this will be brain drain.”

Moreover, observers say the limits are likely to discourage companies from participating in TARP going forward and to drive those already in the program to repay the money to get out from under the restrictions.

The strict limits could “cause some companies to bail out from the bailout,” says Rodriguez.

O‘Donnell says some TARP participants have already contacted regulators about getting out, “not only because of the restrictions, but because of the level of uncertainty.”

“They feel that the government is running their business,” she says.

Reda says bankruptcy could be a more attractive option for some companies. “Under the bankruptcy rules, they could more effectively run their company,” he says.

Among other things, the Act provides Treasury the ability to review prior payments of bonus and other awards to SEOs and the 20 next most highly compensated employees and to negotiate repayment if they’re determined to be inconsistent with TARP.

As a result, Poerio says TARP participants should prepare to provide that information and “should be ready to defend the payment of any bonuses.”

As expected, the Act also requires TARP recipients to give shareholders an annual, non-binding “say on pay.” While observers say that provision was expected, it’s unclear when companies will have to comply with the measure.