Secretary Paulson talked tough about holding executive pay in check under Treasury's rescue plan. But don't expect execs to give up much
It was clear early on, as Congress debated legislation to rescue the U.S. financial system, that public anger over the excesses of the financial-services industry would lead lawmakers to impose limits on executive compensation for companies seeking government aid. Now, with the Treasury Dept. laying out its new plan (BusinessWeek.com, 10/13/08) to invest as much as $250 billion in U.S. banks and thrifts, the first glimpse of those pay restrictions are becoming clear. They are somewhat tougher than Congress required, but don't expect them to make much immediate difference—and in the end, it probably won't cost most executives a cent.
So far, Treasury has only issued a broad description of the rules it will impose on companies in which it invests. Detailed regulations are still to come. But Treasury generally hewed closely to the bill Congress passed, providing little additional detail. As long as Treasury holds preferred shares and warrants issued under the new program, companies must:
Make sure incentive pay for top executives "does not encourage unnecessary and excessive risks that threaten the value of the financial institution."
Establish "clawback" provisions requiring top executives to repay bonuses and other incentive pay that were "based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate."
Ban certain "golden parachute" packages for departing executives.
Limit tax deductions on top executives' pay to that which doesn't exceed $500,000.
No Change in Pay Practices
Strictly speaking, that last item wasn't necessary—Congress included a similar measure under a different provision of the bill, but Treasury officials said they chose to apply it under the capital-purchase program. Compensation attorneys say it remains unclear whether Treasury is simply extending an existing limit on tax breaks for executive pay, which normally limits non-incentive compensation to $1 million a year for top executives, or limiting a much broader range of pay that includes bonuses and some stock.
Either way, the rules aren't likely to affect pay for most executives. Consultants and attorneys say the specific restrictions mostly apply to unusual circumstances, like mergers or financial fraud. Even the tax-deduction provision, which could cost companies millions of dollars, probably won't change fundamental pay practices.
To understand why, consider JPMorgan Chase (JPM), which is expected to receive a $25 billion investment from the Treasury. For 2007, the bank said it paid out some $88.63 million in compensation for James Dimon, chairman and CEO, and four other top executives. That counts salary, bonus, stock awards, and perks likely covered under the tax-deduction provision. Using the company's effective tax rate of about 33%, it comes out to perhaps $29 million in deductions for their pay.
Interpretations of Pay
If Treasury is just lowering the existing $1 million pay limit to $500,000, then JPMorgan would have lost $500,000 in tax deductions in 2007—about $165,000 in tax benefit at its 33% effective tax rate. That's because only one executive, Dimon, earned more than $500,000 in non-incentive pay: His salary was $1 million.
By contrast, if Treasury is taking a much broader interpretation of pay, JPMorgan would lose $28.4 million of deductions, leaving it just $825,000 in deductions. Even that $28.4 million, though, isn't very impressive. Those lost tax breaks would amount to perhaps a fifth of 1% of the $15.4 billion in net income that JPMorgan reported earning after taxes last year.
A JPMorgan Chase spokeswoman had no comment late Tuesday, Oct. 14. "It's not meaningful," says Pearl Meyer, senior managing director of executive-compensation consultant Steven Hall & Partners, speaking generally. Companies "are going to pay people what they need to."
More Companies Have Clawbacks
Meyer says the most problematic pay provision in Treasury's rules may actually turn out to be the vaguest: The prohibition against incentives that "encourage unnecessary and excessive risks."
Particularly in the financial sector, the drive to link pay to financial performance has inextricably entwined risk and reward. Who's to say until after the fact how much risk is too much? Indeed, while companies in many other industries typically cap incentive pay in a given year, financial-services companies usually don't—giving executives incentive to shoot for the moon. "The more you make, the more you get," Meyer says. "Doing that could be deemed to be encouraging risk, because it really is. There's a tension in the system."
Treasury's requirement that companies impose clawbacks probably won't alter corporate compensation practices much, says Sabino Rodriguez, a partner in Day Pitney's executive-compensation practice. For one thing, similar rules already exist under some Federal Deposit Insurance Corp. regulations, and compensation consultants say companies have increasingly adopted clawback provisions covering financial restatements; this could accelerate the process.
"Not Being Forced on People"
As Congress debated the requirement, some compensation attorneys raised the prospect that it could trigger litigation on the grounds that the government was essentially taking something companies had already agreed to pay. But that problem has probably been disposed of neatly: The rule applies only to those companies seeking government funds, and becomes a condition of a voluntary program. "So presumably it's not being technically forced on people," Rodriguez says. It's up to the companies how they negotiate the changes with executives.
Treasury is also requiring companies it invests in to prohibit "golden parachutes" to top executives while the agency holds its shares, using an existing tax-code definition of that term that boils down to anything more than three times the executive's average salary and bonus for the previous five years. Bigger payments trigger a 20% excise tax on the executive.
Yet payments of that size often don't come up unless an executive is fired without cause shortly after a "change in control"—typically a corporate takeover, experts say. Severance in other circumstances often amounts to less.
Triggering the Excise Tax
Moreover, a significant number of companies are willing to trigger the excise tax in acquisitions, and simply "gross up" payments to the executive to prevent them from being diminished. "I don't think the golden parachute provisions are going to have a lot of effect outside of a change-in-control context," Rodriguez said.