What to Expect from the New Pay Czar

Upper Saddle River, NJ - June 12, 2009 - Earlier this week, the Administration selected Kenneth Feinberg, an attorney who oversaw the reparations to families of the 9-11 tragedy, to be the new "Pay Czar."  His new responsibility to monitor and set the rules for Executive compensation is expected to attract as vocal and contentious an audience of critics, as that of his previous position. 

The function is currently limited to determining the Executive compensation arrangements for the top 25 executives in seven (7) large companies that have received TARP (Troubled Asset Relief Program) funds.  A group of banks that also received TARP monies have indicated their intention of repaying those funds, and have therefore been exempted from review or control by the Pay Czar. 

The spotlight, however, will clearly be on the seven (7) companies and their Compensation Committees, as they attempt to comprehend what they can and cannot do, and how best to design appropriate compensation programs that will be acceptable to the government.  This is a very tall order since the government has created legislation that is conflicts with the typical objectives of compensation programs, and is contradictory when viewed in light of existing tax regulation and accounting rules.  The four (4) main objectives to building a well-structured compensation package are referred to as “FARM”.  This stands for Focus, Attraction, Retention, and Motivation.  If the non-performance-based compensation is limited to $1,000,000, as called for in IRC §162M, that means that that the total current compensation package would be limited to salary plus an annual incentive of no more that 1/3 of salary, or $1,333,333.  This amount is certainly not very motivational, and it is highly questionable whether this would enhance any company’s ability to attract and/or retain its key executives.  Of course, the companies could grant huge amounts of Restricted Stock, which would only be payable if and when they repaid the borrowed TARP monies.  The public and media, however, may be uncomfortable with so much stock being awarded in this manner. The other drawback to this alternative comes from the accounting charge for large grants that will have a huge negative impact on the company’s profit and loss statements. 

Executive compensation is an extremely complex concept.  Adding arbitrary and conflicting limitations and rules makes it even more difficult to create a workable pay program that will achieve the FARM objectives.  The complexity in this circumstance is only enhanced by the need to address the critics in government, media, and the public at large.

What can Mr. Feinberg do to bring about the controls that will restrict excessive Executive compensation arrangements and, at the same time, appease both the members of Congress and their constituents? 

Suggestion One – Enforce the existing regulations by putting “Teeth in the Tiger.”  This means adding penalties into the tax code (like those in place for the not-for-profit sector) that will impact for-profit organizations.  Currently, if a publicly-traded company exceeds the million dollar cap (IRC §162M), the only penalty is to deny the tax deductibility of the excess over the cap.  This only impacts the shareholders, posing no harm to the executives, the members of the Board, or to the Compensation Committees.  Adding a penalty similar in nature to those imposed on not-for-profit organizations under IRC §4958, which calls for penalties in instances of excessive compensation for both the executives and the Board, could constitute the Tiger’s Teeth.

Suggestion Two – Require that a “circuit breaker” provision be added to all incentive plans that would prohibit the payment of any awards if critical and fundamental performance measures are not met.  For example, insufficient cash flow or pending bankruptcy would suggest that bonuses should not be paid.  If the company is in financial meltdown, it would be prohibited from paying any bonuses; and any awards that were paid within a specified period would have to be returned.

Suggestion Three – Recognize the strong likelihood of the “Law of Unexpected Consequences” to inevitably play its part.  All angles must be considered and weighed in constructing the pay programs in question.  Perhaps, if more Compensation Committees had considered the ramifications of rewarding executives for making short-term gains when we can only measure the real impact of their actions over an extended timeframe, the banking industry might not find itself facing such dire times. 

Suggestion Four - Reinstate and reinforce the concept of Pay-for-Performance into the design of future Executive compensation programs.  Don’t stifle the entrepreneurial spirit by putting artificial limits on salary potentials.  Rather, reward the executives for their efforts and successes, as they seek the best and most effective ways to develop and grow their companies.  The final, crucial element is to provide adequate checks and balances and make sure that Suggestions One, Two, and Three are carefully applied.

As previously stated, Executive compensation is an extremely complex subject, and there is no single, simple answer or “silver bullet” that will address each of the issues and satisfy all critics.  Achieving an appropriate balance of control over Executive compensation, while still providing the appropriate opportunity for rewards, is a task that will require a considerable amount of work.  This hard work must also be accompanied by a complete understanding of all relevant rules and influences.  We believe that a significant part of Mr. Feinberg’s job will be to keep critics and Congress at bay, to explore alternative and their implications, and to embrace the opportunity to fully understand the complexities of Executive compensation.  Good Luck!