As the global economy disintegrates and dystopian nightmares abound, a wee bit of pleasure was provided by the machete taken to exorbitant executive pay by the American Recovery and Reinvestment Act, signed by President Obama last month. The legislation prohibits cash bonuses and incentive compensation other than restricted stock for the five most senior officers and 20 highest-paid executives of companies receiving federal TARP (Troubled Asset Relief Program) dollars. Until the greenbacks are repaid, TARP recipients cannot award bonuses to the 25 executives exceeding one-third of their annual compensation. While the regulations fail to cap salaries at $500,000 as originally proposed, the President seems committed to the idea. There's also talk of extending several TARP compensation rules to embrace all U.S. companies. Small wonder why the phone is ringing off the hook in the office of Russell Miller, managing director of Executive Compensation Advisors, a division of executive search firm Korn/Ferry International. Consulting magazine's One-on-One caught up with Miller recently.
Consulting: What do you think about these new compensation rules—the good, the bad and the ugly?
Miller: There are a few things that are good about them, starting with appeasing a very angry public and showing that the Administration is trying to take control of the situation. I like the idea of clawbacks, which was part of the Sarbanes-Oxley Act. The new rules make them more specific, insofar as applying to the 25 most highly compensated employees. The whole underlying premise of a bonus is 'pay for performance.' If there is no `performance,' the bonuses should not have been 'paid.' It's straightforward and a good provision. The challenge is to determine when financial results, and therefore compensation, are based on materially inaccurate statements of earnings, revenues, and so forth. Sometimes a restated result is not the fault of anyone; it could be an accounting change. That will be tough, but overall this is a very reasonable policy.
Consulting: What's your view on other new pay provisions, such as the requirement that incentive compensation must be paid in the form of restricted stock and not cash; that the value of this incentive cannot be greater than one-third of the employee's annual compensation; and the restricted stock will only vest once the government obligations are repaid. Like 'em or loath 'em?
Miller: The provision about the vesting of restricted stock only after the government is repaid passes the common sense test. These are pay for performance rewards and part of performance is repaying the government loans. This is very reasonable and very taxpayer-friendly. The President is saying to taxpayers: 'These executives are only going to get paid in restricted stock after we get our money back.' This makes complete sense, but there are some potential flies in the ointment. By limiting the restricted stock to one-third of annual compensation, you potentially create a situation where unless you limit the other portion of annual compensation—cash salary—you could have a situation where companies make up the difference by increasing base salaries. With the $500,000 cap not part of the new law, it creates the unintended consequence of possibly driving up salaries not directly related to performance. Obviously, that begs the question of revisiting the $500,000 cap or some other salary restriction.
Consulting: So caps are king in your opinion?
Miller: Not necessarily. While a cap is good from the perspective of irate taxpayers saying 'Why are we paying these executives such high salaries when we're bailing out their employers?' the downside is if a company's compensation is uncompetitive vs. the marketplace because it is subject to these regulations, it may experience a shift in talent to other companies when it needs these people most to mount a turnaround.
Consulting: Seems several provisions have both upsides and downsides. Any others come to mind?
Miller: I'd call them good sides and problematic sides. For example, the "say on pay" provision giving shareholders the opportunity to provide non-binding votes 'for' or 'against' the company's executive compensation program, sounds like a positive since the shareholders are the owners of the company and should have a say in how it's run. The problem is that they are being asked to vote 'yes' or 'no' on the entire program. It becomes a very blunt instrument that does not allow for a view on each element of the compensation program based on its merits. Instead of a 'yes' or 'no' vote, what is really needed are ways to promote effective dialogue on compensation issues among shareholders, board compensation committees and management.
Consulting: What's your position on the new compensation rules writ large for all companies?
Miller: There's a strong chance that some additional regulations are coming down the pike as it relates to the broader marketplace, but they'll be more limited than what we're seeing with TARP recipients. The government must be cautious—each time it mandates executive compensation regulations it runs into unintended consequences and, in some cases, the opposite effect. Take the IRS 162(m) rule, which says any compensation that is not performance-based, such as cash salaries, will not be tax-deductible over $1 million. The goal, of course, was to put a limit on executive compensation, but companies found a way around it. They stuck to the $1 million limit—notice how many CEOs are paid that figure—and then increased the performance-based compensation piece of the pie. In theory this is a good thing since performance based-compensation by its nature has greater upside potential for earnings. As we've learned with the Wall Street bonuses, however, this performance was illusory. That said, I do think a potential area the government may tinker with is 162(m), perhaps lowering it to the $500,000 cap as proposed by the Treasury Department and/or taking away the performance exception, saying all compensation, whether performance-based or not, is no longer tax deductible above $500,000.
Consulting: What should smart companies be doing now?
Miller: This is a perfect opportunity for them to review their total compensation levels to determine if they are appropriate to retain and attract talent and are consistent with profitability—not disproportionately draining the profits going to shareholders. You want to align performance-based compensation with near term and long-term strategy, and ensure it does not promote executives to take excessive risks that put the value of the company in jeopardy. What concerns me about potential new regulations are those companies that are doing things right will be required to change their programs to comply with the new rules. As a result, good compensation programs may become less effective. For example, a company required to rethink compensation to maximize tax deductions may alter compensation for the worse.
Consulting: So is your phone really ringing off the hook?
Miller: We are certainly seeing a continuing increase in engagements by board compensation committees on these issues. They want to be sure they're getting this right for both their companies' management teams and shareholders. Given the economic environment we're all living through, they also want to be sure the compensation programs designed in the prior era continue to make sense, or if they should instead begin revamping the programs for the new reality.
—Russ Banham
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