Corporate Governance

Executive Compensation Limits and the Likely Effect

By J. Robert Brown

The Journal has suggested that the compensation limits in the bailout could "cost wall street."  Aside from some tax consequences, the limits involve clawbacks (the return of compensation if it turns out the metric used to determine the amount was wrong) and limits on golden parachutes (payments to departing CEOs).  In addition, there will be limits on compensation formulas that encourage excessive risk. 

The limits, the article speculated, might drive away key employees in the covered financial institutions.  As the article noted:  "In weighing that decision, bank and Wall Street executives will have to consider whether they may drive some top performers to employers not covered by the rules."  Perhaps, but that assumes that in fact compensation will be lower in covered financial institutions and that if someone leaves there will not be an adequate replacement. So before we conclude that there will be an outflow of employees, let's speculate about the likely consequences of the restrictions.

The most likely impact is a reduction in salaries for the top officers.  This will occur because companies will need to put less emphasis on short term metrics that might cause excessive risk taking.  Stock options and performance payments based upon short term earnings will likely fall into this category.  Boards will likely be forced to pay cash bonuses based on a host of factors, with returns and share prices at most a factor.  By paying cash, the board will need to fix the amount of compensation (rather than hand out options and let the market do it).  This will probably result in more conservative numbers. 

It is possible that the board could award stock/options but prevent them from vesting for several years.  That would arguably mean that the CEO must take a longer term approach towards appreciation.   Alternatively, performance compensation could be based upon an average of several years earnings/share prices, again reducing the incentive to increase those numbers in the short term.  Either way, our prediction is that executive compensation for the CEO and top officers in the covered companies will probably not rise as fast as in the past.  Having said that, there are no limits in the restrictions on compensation and no prohibition on paying top officers what ever it takes to prevent them from being lured away. 

The limits on golden parachutes will likely affect only one group of officers, those lured to the company.  A golden parachute provides protection in the event that they lose their job, particularly if the dismissal occurs shortly after joining the company.  In other words, sometimes golden parachutes are designed to allay concern about risk, the risk of job loss.  One way to compensate for the risk of dismissal is to pay more up front to lure employees to the company.  Thus, the actual result of the limits on golden parachutes might be higher compensation to new employees.

There is no evidence that the restrictions applied to the equity purchases will cause an outflow of employees nor is there any evidence that the limits will prevent companies from paying what is necessary to keep good employees.  In fact, the limits show that without comprehensive regulation of executive compensation, boards will simply find other ways to pay large amounts within the applicable rules.  Nonetheless, having said all of that, it is likely that the boards of these companies will not authorize the excessive increases that have occurred in the past.

Full post as published by The Race to the Bottom on October 17, 2008 (boomark / email).