The proposed $700 billion federal bailout of the financial services industry that the House and Senate passed and President Bush signed this week has shined a spotlight on executive pay.
Treasury Secretary Henry Paulson first proposed the bailout on September 19, 2008. Ever since, Americans have expressed outrage over footing a bill for what they perceive as a financial crisis brought on by greedy executives who profited while leading their firms to ruin. Taxpayers' anger, along with pressure from Congressional leaders, forced Paulson to address compensation for executives at the firms being bailed out in his proposal. The Treasury Secretary initially resisted making executive pay restrictions a condition of the bailout.
MORE ON EXECUTIVE COMPENSATION
The question is: Do the restrictions on executive pay that legislators added to the bailout bill, also known as the Emergency Economic Stabilization Act of 2008, go far enough? Or will executives find ways to capitalize on loopholes, as they did with limits on CEO pay that were written into bankruptcy laws in 2005?
Sarah Anderson, director of the Global Economy Program at the think-tank Institute for Policy Studies, says the bailout's provisions on executive pay have both strengths and weaknesses. Anderson sees the restrictions on golden parachutes and caps legislators placed on corporate income tax deductions as positive steps. But she also believes the law gives too much power to Paulson, a former CEO of Goldman Sachs, to define excessive pay. The bottom line is that many executives may still walk away from this crisis with millions of dollars in their pockets.
CIO.com and the Institute for Policy Studies took a look at the bailout bill's fine print to see exactly what it says about executive compensation and to find out if it will have any real impact on executive pay at the firms being bailed out.
What the Bill Says
The Emergency Economic Stabilization Act of 2008 (H.R. 1424) states that limits on executive pay apply to the top five highest-paid executives at financial institutions that sell their "troubled assets" (e.g. bad loans and mortgage-backed securities) to the Treasury Secretary.
When the Treasury Secretary buys a financial institution's assets directly from the institution (as opposed to purchasing the assets through an auction), and the Secretary receives "a meaningful equity or debt position" in the company as a result of the sale, the company has to adhere to "appropriate" limits on executive compensation, according to the bill. But the bill doesn't define what a "meaningful" stake is for those firms that negotiate directly with the Secretary, nor does it specifically state what is an appropriate limit for executive compensation.
"It's up to the Secretary to decide what is meaningful," says the Institute for Policy Studies' Anderson. "We have heard that after the votes, when the bill is enacted, Congress might put in guidelines as to what this means, but they were under pressure to keep the bill as flexible as possible for the Treasury Secretary."
When the Treasury Secretary buys a troubled company's assets through an auction, the executive pay provisions only apply if the assets held by the Treasury Secretary exceed $300 million, says Anderson. So not all executives at firms participating in the bailout will be bound by these restrictions on executive compensation.
The bill does establish some loose restrictions on executive compensation. For one, the bill states that companies can't reward executives for taking "unnecessary and excessive risks" that might threaten the value of the company while the Secretary holds the company's debt or equity. This restriction is designed to prevent the risky behavior that some economists and legislators say led to the financial crisis. But Anderson says it doesn't go far enough because it doesn't define "unnecessary and excessive."
"The Treasury Secretary gets to decide whether or not the awards being given to executive officers are excessive," says Anderson. "The Treasury Secretary made $750 million when he was a CEO on Wall Street. I don't think he's the right person to decide what's excessive."
The bill also states that if a financial institution's earnings turn out to have been grossly misstated, the executives who earned bonuses based on those earnings will have to forfeit their bonuses.
The final provision on executive pay pertains to severance packages or golden parachutes. It prohibits financial institutions that sell their assets directly to the government from "making any golden parachute payment" to senior executives while the Secretary holds stake in the company. In other words, if one of the top five highest paid executives in the company leaves after the Treasury Secretary takes control of the company's assets, that executive won't get the golden parachute that might have been laid out for him in his severance package. New executives who join the company after the Secretary buys its assets and who are among the highest paid won't get a golden parachute either, during the time the Secretary holds those assets.
For firms that sell their assets to the government through an auction, only new executives who join the company after the government buys their assets won't be given golden parachutes. On the other hand, executives who presided over companies that collapsed in the financial crisis could conceivably coast away with millions of dollars in severance if the assets the government acquired through auction were valued at less than $300 million.
Anderson says these restrictions on executive pay only apply for two years after the Secretary takes over a company's assets.
The Strengths and Weaknesses of the Bill
The presence of the executive pay provisions in the bailout bill is a small victory in and of itself, says Anderson. Secretary Paulson originally resisted adding limits on CEO pay to his proposal, saying Wall Street would never participate in the bailout if such limits were a condition. Anderson says Secretary Paulson caved on executive compensation because he realized his bailout would go up in smoke if he didn't make some concessions. Still, he managed to beat back tougher proposals introduced by Rep. Barney Frank (D-MA) and Senator Christopher Dodd (D-CT), Anderson adds. Senator John McCain called for capping CEO pay at bailed out firms at $400,000.
Anderson says the prohibition of golden parachutes is the strongest part of the bill. "That is one piece of the legislation that I do see as quite positive and very clear," she says.
She also identifies as an important step a cap that the bill imposes on corporate income tax deductions, even though it only applies to firms whose assets the government purchases through auction. Financial institutions participating in the bailout through auction purchases will not be allowed to deduct executive pay that exceeds $500,000 a year from their corporate income taxes, as they're currently allowed under the tax code. "There has been theoretically a $1 million cap on tax deductibility, but it's been meaningless because it gave an exception for performance-based pay. The bailout eliminated that exception so stock options and all kind of compensation will be covered in that $500,000 tax deductibility cap," she says.
The bill's major shortcoming is that it doesn't set a hard and fast limit on executive pay, says Anderson. It's up to Paulson to determine what compensation is excessive and rewards unnecessary risks.
"There's nothing here that would stop a company from giving out a $10 million pay package that includes a variety of bonuses and stock awards unless Paulson decides to intervene and decides that that poses an excessive risk," she says.
Past Efforts to Limit Executive Pay
Previous bailout efforts have attempted to address excessive CEO pay.
The Emergency Economic Stabilization Act of 2008 isn't the first time lawmakers have tried to impose limits on executive pay. The Institute for Policy Studies notes that the legislation Congress passed to save the airline industry after 9/11 prohibited the airlines affected by the bailout from giving raises to certain executives (those who earned more than $300,000 during the year 2000) for two years.
Other subsequent efforts to restrict executive compensation have been less clear and less effective. In 2005, Congress put the kibosh on excessive retention and severance bonuses for executives whose companies had filed for bankruptcy, but lawmakers failed to address performance-based bonuses, which proved to be a multi-million dollar loophole that executives could cash in on.
More recently, the bailout package for Fannie Mae and Freddie Mac contained language to ensure the "reasonableness and comparability of compensation" for leaders of those lenders, but the Institute for Policy studies notes that the law does not define reasonable compensation. Notably, Sarbanes-Oxley, which was enacted after the accounting scandals in 2002, contains no restrictions on executive compensation. It does, however, require CEOs and CFOs to give up bonus money, incentive compensation, equity compensation or profits they earned from selling company stock if they have to restate their company's earnings as a result of financial malfeasance.