Paying the piper: anything is possible as congress takes aim at corporate compensation.

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 de coeur of the moment.

[ILLUSTRATION OMITTED]

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 S162(m). In fact, it is considering the Treasury Department's idea of lowering 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 S162(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 McGurn, 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."

[GRAPHIC OMITTED]

Next up is clawbacks, 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 clawbacks achieve their intended purpose."

Print Get the Mag Weekly Updates