Perils Of The Pay Crusade

Author: Liz Moyer

If the past is any guide, banks may find ways to interpret the forthcoming guidelines in their favor.
 
Federal regulators are proposing new ways to restrict pay and rein in risk-taking at financial institutions, responding to populist outrage over the still-generous compensation on Wall Street after trillions of taxpayer dollars were used to shore up the financial system.

Pay consultants characterize it as the biggest government intervention yet into the day-to-day operations of publicly traded companies, but if the past is any guide, the government's efforts to rein in pay could have unintended (and counterproductive) consequences.

One plan, by President Barack Obama's pay czar Ken Feinberg, focuses narrowly on seven major U.S. companies that have taken billions in money from the Troubled Asset Relief Program. The other, put forward by the Federal Reserve, proposes to review the pay policies of 28 of the largest U.S. banks and, separately, smaller and regional banks, and make that review part of the regular exam process.

"Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability," said Federal Reserve Chairman Ben Bernanke on Thursday.

Neither of the proposals prohibit outright the seven-, eight- or even nine-figure pay packages that have become the stuff of legend on Wall Street, especially if they are terms of employment contracts entered into before February, when the pay czar's office was announced.

The head of the Phibro commodities trading group at Citigroup ( C - news - people ) stands to make a $100 million bonus because of his strong performance in the last year. Citi is selling Phibro to Occidental Petroleum ( OXY - news - people ) rather than pay that, and the executive can't get paid until the sale is completed, but there's nothing in Feinberg's proposals that says he can't get paid, period. He just has to move to a firm that hasn't taken government money.

At the trading division of American International Group ( AIG - news - people ), the insurer that has taken $180 billion in government assistance, no employee will be paid more than $200,000 this year. But a controversial $198 million retention pool still exists, and the next installment, due in 2010, is still up for grabs.

Some have worried that strict pay rules for a limited group of companies may encourage an exodus of traders and other highly paid workers to less regulated firms like hedge funds or to foreign banks.

What tends to happen, however, is companies find a way to interpret guidelines in their favor. For example, in the 1980s, the government changed the taxation of so-called golden parachutes for executives leaving a company, trying to curtail excessive severance. What happened was the government's set ceiling--a parachute worth three times or more an executive's annual pay would be subject to excise tax--became the standard for Main Street when determining exit pay. Pay packages rose so that exit packages wouldn't be subject to the tax.

In the 1990s, Washington set a limit on the deductions companies could take for any executive compensation greater than $1 million in cash. So executives got paid less in cash but began to benefit--big time--from huge awards of equity not counted under the new rules.

"There are always unintended consequences when you lay down strict rules like this," says Laura Thatcher, a compensation lawyer at Alston&Bird in Atlanta. "If you push on something here, it bulges out somewhere else."

Companies subject to the pay czar's special rules have been busy reassuring employees. The pay caps don't begin until November, are limited to the 25 top earners at the company and there aren't claw backs.

"It is important that all of you know that the Special Master's jurisdiction is quite limited," said a memo to American International Group employees from Chief Executive Robert Benmosche on Wednesday. The company was in "direct, near-daily discussions" with Feinberg, who has told AIG he will not seek retroactive pay changes.

Rebounding revenues, and strong results from bond trading and other market activities, have enabled Wall Street firms to amass huge bonus pools for this year, and life will seemingly return to semi-normal when "the numbers" are revealed in the coming months. That will almost certainly reignite public outrage over the Wall Street bailout.

Treasury Secretary Timothy Geithner said Thursday, "We all share an interest in seeing these companies return taxpayer dollars as soon as possible, and Ken today has helped bring that day a little bit closer."

Wall Street's main lobbying group, the Securities Industry and Financial Markets Association, issued a conciliatory statement Thursday. "Ensuring pay is tied to sufficient risk management, long-term performance and shareholder interests are goals we share."

The Fed's proposal, which will be open to public comment, doesn't set official caps on pay. It says it wants to make compensation review part of a regular exam process to ensure banks aren't paying employees in a way that threatens banks' safety and soundness. This could potentially have a much bigger sweep than Feinberg's plan since it could include thousands of banks, even those that didn't take TARP money.

Fed Gov. Daniel Tarullo said it's part of a bigger plan to overhaul the Fed's regulation of the industry. "Today's proposal is but one part of a broad program by the Federal Reserve to strengthen supervision of banks and bank holding companies in the wake of the financial crisis."