Randomly pick a law, regulation or section of the tax code dealing with executive pay and chances are you could accurately describe it as superfluous, counterproductive, or inconsistent. My reaction when first hearing that the Troubled Asset Relief Program (“TARP”) would include executive compensation provisions was to wonder what kind of regulatory torture the government was going to inflict on the poor shareholders of financial institutions already sunk low. While there is a good deal of the aforementioned waste and counter-productivity in the TARP provisions, there is also some executive compensation wisdom that companies not partaking of TARP might consider.
As a recap, financial institutions seeking relief under one of several TARP programs implemented by The Emergency Economic Stabilization Act of 2008 (EESA) must enforce four broad rules around the pay of the chief executive officer, chief financial officer, plus the next three most highly compensated executive officers.
The rules along with commentary are as follows.
- Companies agree not to deduct executive compensation in excess of $500,000 for each senior executive. This limit does not include the exception for performance-based compensation that is part of the existing executive compensation provision of the tax code limiting deductability to $1.0 million. It does not matter whether the deduction limit is a million or half a million. This rule will no doubt raise some needed tax revenue but otherwise it only serves to limit the flexibility and increase the costs for financial institutions trying to attract and retain the executive talent they need to get them out of their self-created mess. Conclusion: Counterproductive
- A prohibition against making any golden parachute payment to a senior executive. This provision is more restrictive than the existing IRC Section 280(g) rules on golden parachutes that merely increase the cost of golden parachutes by disallowing deductions and imposing excise taxes. The TARP rules prohibit payments in excess of three times pay and define a parachute payment as due to any separation
of service - not just those due to a change-in-control. The rule is not bad but somewhat superfluous as most companies do not pay out severance benefits in excess of three times compensation. Conclusion: Feels Good but Superfluous. - Executive pay programs must include “claw back” provisions requiring the repayment of any incentive compensation based on metrics that are later proven to be materially inaccurate. This rule sounds good on paper but requiring executives to pay back gains made on inaccurate metrics is impossible to consistently enforce outside of the obvious cases of financial restatements. For example, this provision would not have required a payback of the compensation gains made on the sale of mortgage-backed securities that turned out to perform more poorly than anticipated. Conclusion: Okay, but impossible to enforce
- Ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution. This rule includes all sorts of procedures, timetables and CEO and Compensation Committee certifications to try and make it meaningful. It is, however, unenforceable as a practical matter. Risk is purely subjective and at the heart of business investment. A risky investment that turns out well was a “bold” decision and one that turns out poorly was "excessive and unnecessary". But just because the government rule is unenforceable as a matter of policy does not mean that it is not a good idea for compensation committees and Boards to formally review how executive compensation arrangements incent behaviors that may not be aligned with shareholder preferences and risk profiles. For example, I have written on several occasions around how excessive option grants can lead to a misalignment of shareholder interests and management interests. Conclusion: Good Corporate Governance but not an enforceable law.
The misalignment of rewards to risk, particularly in the financial services industry, has been disheartening as many executives who made what turned out to be very poor investment decisions reaped large paydays prior to losing their jobs. Taxpayers have demanded some reassurance that this will not happen again with their TARP investment and Congress has complied about as best as possible. Unfortunately, even the best managed companies cannot create a compensation program (for executives or otherwise) that will be deemed to be perfectly fair and accountable in hindsight. Business is just too messy. While perfection is impossible, improvement is very possible and Owners, Boards and Compensation Committees should take the TARP rules as a reminder to fully test compensation programs against incentives and risks.
