Financial crisis puts executive compensation under the microscope
It shouldn’t come as a surprise that many people in the financial community seriously doubt whether the efforts to address the financial crisis will be effective. Much of the criticism is directed at Congress’ efforts to rein in ‘excessive’ compensation paid to senior officers of the investment banking firms and other institutions that are participating in the federal bailout.
In general, compensation experts are skeptical as to whether the relevant provisions of the Emergency Economic Stabilization Act of 2008 (EESA) will have any real impact on how financial executives are compensated. A widely held view is that the provisions are the product of political expediency intended to appease the public’s outrage. Fine, but is the criticism warranted?
Under the compensation provisions of the Treasury Department’s Capital Purchase Program (CPP), a participating financial institution must: impose limits on the compensation of its senior executive officers (SEOs) to exclude incentives for such officers to take ‘unnecessary and excessive risks’ that threaten the value of the financial institution; provide for the recovery or ‘clawback’ of any bonus or other form of incentive compensation paid to its SEOs based on materially inaccurate financial statements and/or any materially inaccurate information relevant to payout of incentive compensation in accordance with specified performance measures; not make any golden parachute payments to any of its SEOs; and agree not to claim a deduction for US federal income tax purposes for remuneration of any of its SEOs greater than $500,000.
The institution must comply with all of these conditions throughout the period that the Treasury holds an equity or debt position in the institution acquired under the CPP. If you are not employed by or associated with an institution that is or may consider participating in the CPP and, as a result, think these provisions have no relevance to you, think again. Representative Barney Frank, chairman of the House Financial Services Committee, has predicted that in the next Congress his committee will ‘seek to build on these [executive compensation] measures and apply them more broadly.’
What is excessive?
Each of the compensation conditions bears closer examination, however. Firstly, the rules do not define what would constitute ‘unnecessary and excessive risks’. The Treasury states that ‘each financial institution faces different material risks given the unique nature of its business and the markets in which it operates.’ Instead, the rules set forth a corporate governance process to be followed to identify and limit SEO incentive compensation arrangements that could lead SEOs to take unnecessary and excessive risks. The process requires the compensation committee of a participating institution’s board to review with the institution’s senior risk officers the SEO incentive compensation arrangements to ensure that the SEOs are not encouraged to take such risks. The first review occurs within 90 days after an infusion of capital under the CPP, with subsequent reviews at least annually while the Treasury holds the financial institution’s equity or debt securities.
The compensation committee must also certify that the committee completed the reviews, made part of the compensation discussion and analysis (CD&A) included in the financial institution’s proxy statement, if it’s an SEC-reporting company. If not, the certification is to be provided to the institution’s primary regulator.
The Treasury’s guidance for recovery of bonus payments distinguishes the condition from SOX Section 304, which requires the forfeiture by a publicly held company’s principal executive officer and principal financial officer of any bonus, incentive-based compensation or equity-based compensation received, and any profits from sales of the company’s securities during the 12 months after a materially non-compliant financial report. In contrast, the CPP clawback provision applies broadly to the top five highly compensated executive officers, and also goes beyond just listed companies to include all private institutions participating in the program. Furthermore, clawback is triggered by material inaccuracies in the levels of performance with respect to the metrics used to award bonuses and incentive compensation, not just with respect to accounting restatements.
Pulling the ripcord
The rules also provide that a golden parachute payment is any payment in the nature of compensation to (or for the benefit of) an SEO on account of his/her applicable severance from employment to the extent that the aggregate present value of such payment(s) equals or exceeds three times the SEO’s base amount.
A payment that is on account of an applicable severance from employment refers to a payment that would not have been payable if no such severance had occurred, or has been accelerated on account of the severance. Payments on account of an applicable severance from employment would not include amounts paid under a tax-qualified retirement plan.
An applicable severance from employment is defined as a severance in connection with an involuntary termination of employment, or any bankruptcy filing, insolvency or receivership of the institution. An ‘involuntary termination of employment’ would encompass: the non-renewal of an SEO’s employment contract upon expiration if the SEO was willing and able to enter into an extension on substantially similar terms; the SEO’s termination of his/her employment for good reason due to a material negative change in the SEO’s employment relationship; and the SEO’s resignation if the SEO knew that, absent such resignation, the employer would have terminated the SEO’s employment. The base amount is the average annual compensation payable by the employer includible in the SEO’s gross income over the five taxable years before the taxable year in which the applicable severance from employment occurs.
Reducing tax deductions
Internal Revenue Code Section 162(m) generally limits the otherwise allowable deduction for compensation paid to a covered employee of a publicly held company to no more than $1 million per year. Under Section 162(m), certain types of compensation generally are not taken into account in determining whether the compensation exceeds the $1 million cap. This would include incentive compensation payable solely on account of the attainment of one or more performance goals.
CPP rules lower the cap to $500,000 and include performance-based compensation. But this condition only limits the amount of the deduction, not the amount of compensation paid.
Vague and unwieldy
Complaints regarding compensation tend to focus on the right or wrong of the actions of those involved in the market crisis. One complaint that especially bears more detailed examination is that the ‘unnecessary and excessive risks’ phrasing is vague, which makes it unclear as to how the Treasury will enforce the provisions. It also makes it challenging to identify the features of compensation arrangements that could lead SEOs to take such risks. In the current climate, if SEOs are using derivatives for speculative purposes to enhance the institution’s rate of return or profitability, this would seem to fall squarely within what Congress and the Treasury had in mind as an unnecessary and excessive risk.
What if executives are using derivatives for hedging purposes? Southwest Airlines – admittedly not a financial institution – recently reported a net loss of $120 million in the third quarter of 2008, its first quarterly loss since 1991. The net loss was attributable to accounting charges to reflect the decreased value of its jet fuel hedging contracts. Although it is not clear there is any linkage between Southwest’s reporting of the decreased value of jet fuel hedging contracts and the price of its stock, Southwest’s share price dropped roughly 25 percent in October. Assuming Southwest’s executives have incentive compensation arrangements tied to the company’s financial performance, the company’s hedging of jet fuel prices – as part of its risk management practices – could arguably be viewed as engaging in unnecessary and excessive risks that threaten the value of the company. While clearly Southwest’s hedging activities (and similar risk mitigation strategies utilized by other companies) are not what Congress had in mind in referring to ‘unnecessary and excessive risks’, this example highlights the perils of the vaguely-phrased standard.
In reviewing existing or contemplated incentive compensation arrangements, compensation committees and senior risk officers will need to consider the ability of creative minds to assert, after the fact, cause and effect relationships between financially oriented performance measures triggering SEO incentive compensation and actions taken that prove ill-advised. With this in mind, it will be interesting to observe whether SEC reporting institutions participating in the CPP determine to seek shareholder approval of new or amended compensation plans and/or revised performance measures during the upcoming annual meeting season.
Compensation committees of CPP-participating institutions must assess the targeted levels of performance specified in compensation plans. Section 162(m) requires these levels be set so that achievement of the performance measures is ‘substantially uncertain’, necessary for compensation to be considered ‘qualified performance-based compensation’ and to be excluded from the annual $1 million deduction limit. To fulfill their obligations under the new rules, the compensation committees, together with their senior risk officers, will likely need to have a more comprehensive understanding of management’s internal forecasts, and the assumptions underlying those forecasts and how actual performance compares with targeted levels.
No matter how conscientiously compensation committees perform their newly-imposed roles, they face the risk of the Treasury – or shareholders – determining they came up short in efforts to comply with the vaguely-worded standard. This risk alone might prompt compensation committees to shy away from pay for performance. And if the EESA provisions do turn out to have little impact on the levels of compensation paid to financial executives, many will view this as a step in the wrong direction.
