How TARP Is Totally Changing the Executive Pay Debate

by Joanna Ossinger

The executive compensation debate has already been shifted by the recent financial crisis and the Treasury Department’s bailout program, and even more changes are expected in the coming months.

What’s more, the changes could be coming to a lot more companies than just those financial-services firms participating in the Troubled Asset Relief Program, as there’s talk of putting similar restrictions on a broad swath of companies – perhaps even many or all of those based in the U.S.

The changes range from advocate proposals, which are shifting to look at long-term performance metrics rather than immediate measures such as the stock price, to how compensation consultants and board compensation committees are approaching executive pay packages.

“We actually tore up our game card for proxy season,” said Rich Ferlauto, director of pension and benefit policy for the American Federation of State, County and Municipal Employees union, who is a longtime advocate of corporate governance reform.

Much of the difficulty stems from the language in the Treasury’s provisions for limits on executive compensation that prohibit “excessive risk.”

“We believe that it is critical to provide more guidance on the meaning of such unnecessary and excessive risk,” said Richard L. Alpern of executive-compensation consulting firm Frederic W. Cook & Co. in a letter to the Treasury Department on this issue. “In the absence of guidelines, many compensation committees may be reluctant to adopt programs that encourage an appropriate level of risk taking.”

Frederic W. Cook isn’t the only firm wondering how to interpret the new guidance.

“How do you measure whether this pay program is going to cause excessive risk?” asked Steve Seelig, executive compensation counsel at consultancy Watson Wyatt. “There are easy ways, and more analytical ways. The easy thing to say is just to give salary and restricted stock. It’s probably going to make your behavior extremely conservative.”

Seelig gave the example of just one dilemma: “Perhaps it is the right thing to do, if you’re choosing a single industry, to say ‘my pay package in the same as everyone else in the industry, and I can attest that this is no more risky than anyone else’s.’ It also is equally plausible that you need to look at the entire market and compare your programs to the rest of the marketplace.”

The lack of clarity from Treasury could simply leave the interpretation of the regulations to be done by others.

“We liked the proposal, but it was rather vague, and we’re interpreting that through shareholder proposals,” Ferlauto of AFSCME said.

It might not be only financial companies participating in TARP that have to pay attention to these rules.

“I would also think that there will be broader follow-on legislation early in the next Congress,” Ferlauto said, that might extend these Treasury TARP rules out as far as “to any U.S.-based company.”

In particular, Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, has mentioned the possibility of introducing legislation to broaden the list of companies subject to these executive-pay limits.

It isn’t just the companies themselves that are being affected.

The Treasury’s rules could run counter to the efforts of corporate-governance activists, who have sought in recent years to link CEO pay to the company’s performance.

For example, it’s been suggested often that CEO pay levels be based on the stock price, or on some measure of earnings. But, would incentives to boost the stock price and earnings encourage executives to take “excessive risk?” Risk-taking, after all, is what gave so many companies their soaring stock prices and eye-popping profit increases for so long.

In response to these rules, corporate-governance advocates are moving away from linking pay to total shareholder return “and focusing on concepts like having long-term focuses in their pay metrics,” said Patrick McGurn, special counsel at RiskMetrics group, which owns Institutional Shareholder Services. He said provisions such as clawbacks and hold-to-retirement are being considered.

Ferlauto of AFSCME said the union, in response to these new rules, is now looking at two types of proposals they hope to get companies to implement.

“One requires long-term holding of any equity award for two years past the executive’s tenure with the company, so they couldn’t walk away with tens of millions of dollars and leave a mess. It puts the executive in the same position as the shareholder, as being a long-term equity holder,” he said.

The second, which Ferlauto noted was implemented by Swiss bank UBS earlier this week, would “require a short-term cash bonus incentive to be escrowed for three years, only paid out over time and only paid out if there’s continued performance at a benchmark level.”

Even though some companies have started to talk about reining in executive pay, a lot more needs to be done. For instance, Goldman Sachs (GS) recently announced that its seven top executives would get no bonus for 2008, just their $600,000 annual salaries.

“With Goldman, they’re sharing the pain -- but if you’re talking about tools to measure risk, forgoing pay is simply a weather vane,” McGurn of RiskMetrics said. “It’s showing that the wind blowing from Washington to Goldman is saying this year is not a good one.”

“We’ve yet to hear U.S. corporations, even those covered under TARP, really address the long-term focus versus short-term focus,” McGurn continued. “This issue is likely to come up in shareholder votes on board members -- I think you will see [shareholders] taking a closer look at the actual compensation plans.”

“The smart companies are the ones that are beginning to address this immediately,” he said.