The final version of the Financial Services Bailout Bill was released late this afternoon, with votes by the House and Senate expected to take place tomorrow. Components of the bill as they relate to executive compensation are detailed below:

Any company that sells assets to the US Treasury through the program will need to meet the following requirements. These standards apply to the top five compensated executives as defined under the SEC disclosure rules:

Companies from whom the federal government takes an equity stake:

• Adopt limits on executive compensation that exclude incentives to take unnecessary and excessive risk (as defined by the Treasury)

• Recoupment of bonus or incentive compensation based on earnings or other criteria later proven to be materially inaccurate

• Prohibition of golden parachute and certain severance payments during period assets held by the treasury

Companies that sell at least $300 million in assets to the Treasury are subject to the following requirement:

• Prohibition of any new employment contract that provides certain golden parachute or severance payments

• Provision does not apply to previously set contracts

• A 20% excise tax will apply to golden parachute or severance payments triggered in the event of involuntary termination, change in control, bankruptcy, insolvency or being taken into receivership

Subsection 162(m) was amended to cap the tax deductibility of executive compensation for executives earning more than $500,000 in compensation and more than $500,000 in deferred compensation. This standard applies to only the CEO, CFO and top three compensated executives but the limitation continues to apply to payments to these individuals after they retire or leave their posts.

Say on Pay off the Table

As advocated by the Center the ‘say on pay’ mandate that was under serious consideration by both the House and Senate was eliminated in the final version. A shareholder vote would not have assisted in turning around financial services companies, and in the Center's view, would have encouraged some to eliminate pay tailored to their business objectives.

In addition, the Center was instrumental in advocating that a narrower definition be applied in determining which executives would be impacted by the first set of restrictions. As it stands, only the top five highest compensated executives will fall under the requirements of the bill, in contrast to initial drafts that called for the inclusion of a much broader group of management. This limitation is important, because the broader limitations would have limited the ability of companies to recruit management talent to help turnaround the companies participating in the program

Text of Bill

Final Bill Section By Section Description

Summary of the Bill

Final Text of Senate Bill

Because of the crisis in the nation's financial industry and the necessity for the largest taxpayer bailout in history, it is understandable why Congress would want to give the pay of the executives leading financial institutions close scrutiny. However, the executive compensation restrictions proposed by the House and Senate Majority as part of the financial services industry bailout legislation would give unprecedented authority to the federal government to structure executive compensation and would raise several crucial questions about the effect of those provisions on the purpose of the legislation:

• How would the restrictions impact the ability of companies to recruit the top talent they need to turn their businesses around?
• Would the limitations on compensation enhance or reduce pay for performance?
• Would the Federal government be subject to conflicts of interest if a shareholder vote on executive compensation is permitted?
• Overall, would the executive compensation provisions encourage or discourage participation in the program?

The Center On Executive Compensation is concerned that the standards in the proposal are overly broad and vague, and that they would unnecessarily undermine pay for performance at a time when both the industry and the nation needs it most. As discussed below, the proposal’s restrictions are likely to discourage companies from participating to maintain flexibility in staffing.

Background on the Center

The Center On Executive Compensation seeks to provide a principles-based approach to executive compensation policy from the perspective of the senior human resource officers of leading companies. The Center is hosted by HR Policy Association and currently has 42 corporate subscribers representing a broad cross section of industries. Because the senior human resource officers play a unique role in supporting the compensation committee chair, we believe that our Subscribers’ views can be particularly helpful in understanding how executive compensation plans are constructed and executed.

Unlike the restrictions adopted for Fannie Mae and Freddie Mac, two quasi-governmental agencies whose oversight authority already had the ability to regulate compensation, the financial services proposal would require Treasury to scrutinize the executive compensation of hundreds of companies. This would set a precedent for federal regulation of executive compensation generally that would undermine performance-based pay. The Center believes that there are meaningful mechanisms for enforcing pay for performance without requiring the federal government to get in the business of setting pay. We believe boards of directors and their compensation committees should have the primary source of authority over pay decisions and that clawback or recoupment policies, are an effective means of enforcement.

The Center’s Position: Link Federal Policy Changes to Pay for Performance

One of the core principles of the Center On Executive Compensation is that executive compensation is best designed on a pay for performance model. Under this framework, the board of directors is responsible for developing compensation packages that drive executives to achieve strategic and economic objectives of the company. Well-structured incentives play an important role in achieving these ends by paying executives commensurate with performance. Likewise, stock ownership guidelines and retention requirements align executives’ and shareholders interests, as demonstrated by the dramatic decrease in value of financial executives’ stock holdings over the past year.

At the same time, we also believe that pay for performance plans should have enforcement mechanisms to be effective. Some of these are required by law, such as the tax law requirement that the board verify that requisite performance levels are achieved and the appropriate amounts are paid by the company. Others, such as clawback or recoupment policies broader than those required by law have been introduced by companies.

Clawback or Recoupment Policies

The adoption of clawback or recoupment policies is rapidly becoming a best practice. These policies apply when a company determines that initial financial results were not accurate and restatement of those results is required. In these situations, the Center believes that, regardless of the reason, if the restatement would have affected the incentive payments, the amounts that would not have been paid if the correct information were used should be recouped (or “clawed back”) from the executive. In other words, the executive returns those amounts to the company. Additionally, Boards have the ability to recoup pay if they determine that pay was not properly awarded for other reasons. Currently, 28 of the Dow 30 companies have clawback mechanisms, and the number of companies is growing rapidly.

Severance Prohibition Would Freeze Financial Services Executive Talent Market

The proposal would appear to prohibit a company from paying severance to “senior executive officers” in companies that participate in the program for three years. The Center believes the provision could have the following effects:

• The definition of severance is extremely broad – and could be read to include any payment other than qualified retirement or pension plans in the event of termination, voluntary or involuntary. As a result, financial services executives, especially those near retirement, may be inclined to resign before their company enters the program to ensure that they could receive amounts earned during their time with the company, and potentially leaving a talent void.
• Financial services companies would find it more difficult to attract talented executives to help execute a turnaround because if the new position did not work out, or the company was acquired, the executive would receive no payment for up to three years after termination.
• As a result of the previous point, companies would provide more cash compensation to incoming executives at time of hire to compensate for the inability to address the risk premium of joining a company in a troubled industry, which is normally accomplished through severance.

The full ramifications of these provisions are not known, but the impact would certainly increase the level of executive compensation and blunt the desired effect of the legislation. Many troubled companies would be likely to refrain from participating unless they had no other choice to ensure flexibility in staffing during these highly volatile times.

Inappropriate or Excessive Risk

The Center believes that the executive compensation provisions under consideration in the financial services proposal would be far broader than a simple clawback provision and would undermine pay for performance. Without any guidance, the legislation would prohibit companies from adopting incentive plans incorporating “inappropriate or excessive” risk. From the language of the provision it is impossible to discern which incentives would be considered to encourage executives to take appropriate risks and which would encourage “excessive” risks.

In addition, given that many financial services companies have multiple business lines and that non-financial services companies may have divisions that provide financial services, it would appear that this authority may apply to all elements of incentive plans, even those that were not related to classes of assets covered by the proposal. Thus, the Treasury Department would need to become knowledgeable in effective incentive plan design for a wide range of industries beyond the financial services industry. This would subject executives that have nothing to do with the financial industry to regulation by the Treasury Department.

Pay for Retention, Not Pay for Performance

The Center believes that the incentive provisions would likely have the opposite of their intended effect because Boards will seek other ways of compensating top talent: Rather than encourage sound pay for performance, the provision would encourage Boards to pay talented executives through non-incentive forms of compensation, such as greater salaries, to avoid the uncertainty that some compensation may be deemed inappropriate. While such an approach to compensation would serve the Board and shareholders in retaining top talent, it would do little to motivate executives to achieve corporate objectives and give rise to charges of pay regardless of performance, both of which are at odds with the purpose of the legislation.

Say on Pay, Proxy Access

The latest draft of the proposal would mandate a nonbinding shareholder vote on executive compensation (say on pay) and proxy access for all companies in which the Secretary of the Treasury bought a direct stake. The Center is concerned about the impact of both these initiatives, but focuses on the shareholder vote mandate.

With respect to Say on Pay, the Center believes that its inclusion in the package would undermine the authority of the Board and compensation committee. Shareholders are not privy to the confidential and strategic information that the committee considers when setting pay. Whether binding or not, votes have the feel, intent and effect of requiring the board to take a certain action, which may the give undue weight to interests of activist shareholders and thus undermine the board’s fiduciary duty to manage the company on behalf of all shareholders.

In addition, a mandatory vote could cause boards to adopt “me too” compensation practices that have been approved by shareholders at other companies to ensure a positive vote, even though the practices may not be in the company’s best interests, especially for a company in a distressed situation. Noted governance experts and activists, including University of Delaware Professor Charles Elson, former TIAA-CREF Governance Counsel Peter Clapman and Carpenters’ Union Governance head Edward Durkin have expressed concern about the effect of the vote on good corporate governance. A recent survey conducted by Dr. Kevin Hallock of Cornell for the Center found that the vast majority of the largest investors did not support say on pay as an effective tool in the governance arsenal.

The governance aspect is amplified in the situation where the Federal government could be a major shareholder. Shareholder activists intent on adopting a shareholder vote would lobby the federal government to support their position. The government would face a decision as to whether it votes in support of other shareholders or the taxpayers. In this respect, the shareholder vote mandate would be redundant, because the Secretary of the Treasury already has the ability to pull back incentive compensation deemed to be excessive and to require clawback of any compensation not linked to performance.

Say on pay is extremely controversial, and in this case would create potential conflicts within the federal government. The debate should be left for a time in which Congress is not in the midst of trying to solve a time-sensitive crisis.

Financial Services Legislation Is Wrong Vehicle for Addressing Executive Compensation

An emergency bill to preserve the failing financial system is not the place to tackle regulation of executive compensation programs. The provisions are impermissibly vague, and they would set a precedent of having the federal government directly regulate executive compensation in a way that has never before been seen. The net effect will be to discourage many companies that could obtain relief to forego doing so in the interest of attracting the right leaders for extremely difficult jobs. If Congress believes it must regulate executive compensation, then it should promote a carefully structured clawback provision that requires companies to recoup pay in the event of a financial restatement.