TARP and the Future of Executive Compensation

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by Irv Becker and David Wise
from Hay Group

The
Troubled Asset Relief Program (TARP) has the Compensation Committees of
participating financial institutions scrambling to understand and adapt
to its rules and restrictions affecting executive compensation.
However, Board members at other companies should be watching how
organizations subject to TARP are changing their programs to satisfy
the new requirements - as many of these provisions may likely become
relevant for non-TARP companies in the not-too-distant future.

There
are four key provisions that apply to the Senior Executive Officers
(SEOs) of TARP institutions over the course of their participation in
the program. Even at this early stage, we can foresee that non-TARP
companies will be affected as some of these practices will become
either required or considered part of “best practices” in an
organization’s compensation governance process.

1. Risky incentives

The mandate: Avoid incentives that may promote executives to take unnecessary and excessive risks.

What’s the issue?:
The risk profile of certain incentives has come under fire, as many
executives at organizations subject to TARP have participated in
incentive programs that reward exponentially for outstanding company
performance – which many believe motivate executives to take excessive
risks. The classic example involves an incentive with a highly
leveraged upside and with limited (if any) downside. Compensation
Committee members must meet with the company’s senior risk officers to
assess whether the structure and design of these programs motivate
excessive risk-taking. TARP requires the Compensation Committee to
certify that it has taken reasonable steps to make sure that SEOs’
incentive pay arrangements do not promote unnecessary and excessive
risks.

Future implications: Given the open-ended nature of
this requirement, it is not clear what types of incentives will be
considered too risky. While some likely outcomes – like greater
requirements to hold shares and increased use of risk-adjusted
performance measures – appear to be common sense, others may actually
reduce the performance orientation of many programs. Some of these
outcomes paradoxically may include (1) less use of vehicles linked to
shareholder value (e.g., stock options or plans that measure total
shareholder return), (2) higher base salaries as a way to reduce
leverage in a compensation package, (3) setting the bar lower when
establishing absolute performance targets, and (4) less emphasis on
formulaic incentive payouts. While we do not necessarily expect this
provision to become mandatory for non-TARP companies, involving risk
officers in the discussion is likely to be perceived as a “best
practice” going forward.

2. Clawbacks

The mandate:
Implement “clawback” provisions that allow the company to recoup
incentive payments that are later deemed to be based on inaccurate
financial or performance information.

What’s the issue?:
Several of the TARP companies did not have clawbacks – something that
watchdogs believe are necessary to ensuring accuracy in short-term
performance assessments. Companies will need to be focused on crafting
appropriate provisions as well as creating an infrastructure to enforce
any resulting clawback rights.

Future implications:
Clawbacks are perceived to be common sense, and it is likely that all
public companies will be made subject to this type of provision.

3. Golden Parachutes

The mandate: Eliminate “golden parachutes” upon any form of termination.

What’s the issue?:
In the wake of well-publicized situations where high profile executives
left their damaged companies with significant payouts, shareholders
increasingly want to cap any walk-away payments that appear excessive.
While golden parachute payments typically refer to severance in a
change-in-control (CIC) situation, under TARP this provision covers
most other severance payments that exceed three times an affected
executive’s average W-2 compensation for the past five years.

Future implications:
This is another area that we anticipate could be extended to non-TARP
companies - so that there will be no different treatment for CIC and
non-CIC terminations.

4. Limit deductibility of compensation

The mandate:
Limit a corporation’s income tax deduction for any SEO compensation
exceeding $500,000, regardless of the form of compensation.

What’s the issue?:
IRC 162(m) currently limits to $1 million the deductibility of
compensation that is not objectively “performance-based.” The new rule
cuts that amount in half, and, more significantly, does not
differentiate between performance and non-performance pay. In essence,
it’s Congress’ way of ensuring that taxpayers are not funding
“excessive” compensation levels.

Future implications: This
provision is less likely to be made effective for non-TARP companies
than the others we have discussed. In the near-term, it could result in
higher levels of guaranteed forms of compensation, and in Compensation
Committees making greater use of discretion in determining incentive
payments –since performance-based pay no longer would be exempt from
the deduction limits of section 162(m).

TARP appears
destined to affect executive pay significantly over the next few years;
many of our non-TARP clients have already inquired on what they should
be doing to plan for the expected impact on their programs. As we go
forward, attention will be focused on those companies participating in
TARP to see not only how they navigate these shoals, but how
shareholders and regulators respond to the changes they make. 

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