February 04, 2009
Two quick workarounds on executive pay caps
Posted by Victor Fleischer

The guidelines on executive pay will present an interesting drafting exercise for the lawyers at Treasury.  Off the top of my head, I can think of a couple of possible workarounds:

1.  Hedging.  The challenge for the banks will be to reduce the riskiness of compensation to counterbalance the cap on salary (since salary is normally the risk-free portion of compensation).  The obvious way to do this is to increase the restricted stock awards, but allow the executives to hedge (for example, by buying put options or entering into an equity swap or short forward contract).  Corporate and securities law restrictions may make it difficult to hedge directly by buying puts on employer stock, but executives might be able to buy a put option or enter into a total return swap on a basket of financial stocks. 

Treasury could respond by placing restrictions on executive's ability to monetize or substantially reduce the risk of loss associated with holding restricted stock.  This is going to get complicated.

2.  Management companies.  A bank could set up a management company (or series of management companies) alongside the holding company to employ top managers.  In lieu of salary, the parent holding company would pay uncapped "management fees" to the management company, which in turn would divide up the fees among the executives.  Investment banks already do this, to some extent, for their "merchant banking" fund managers; it seems feasible to extend this structure to any executive group whose compensation could be tied to the performance of underlying portfolio assets.  It might be more difficult, but not impossible, to do this for managers who provide services to a wide variety of corporate functions.  For example, the managers could migrate to a newly-formed consulting partnership with a long-term service contract with the company.

Treasury could create an "anti-abuse" rule extending the cap on pay to affiliates of the parent holding company, but it's going to get tricky:  if you define affiliate too broadly, no one--including lawyers, accounting firms, and consulting firms--will want to do business with the bank for fear of getting infected with a cap-on-pay. 

3.  On an unrelated note, an observation:  we normally think of restricted stock as less risky (and less likely to make executives overly risk-seeking) than at-the-money stock options.  If the salary cap means that restricted stock only vests once the government gets paid back, the effect is more like an at-the-money or slightly out of the money stock option. 

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Comments (7)

1. Posted by fedgovernor on February 4, 2009 @ 17:24 | Permalink

#2 is functionally no different than money illegal laundering.

Look dude, you better tell your banking buddies that the jig is up. Either pony up your own damn capital and refund the taxpayers our money, or accept that your job just got a lot less cushy.

You work for the government now. And the government don't pay too good.

Figuring out how you can outmaneuver the President of the United States by creating shell companies to launder executive pay is just going to land your asses in jail.


2. Posted by Vic on February 4, 2009 @ 18:53 | Permalink

Fedgovernor is not well informed. I no longer have any banking buddies.


3. Posted by fedgovernor on February 4, 2009 @ 20:08 | Permalink

Heh.


4. Posted by Jake on February 5, 2009 @ 19:12 | Permalink

Vic is dead on the money when he observes that bank officers seeking to evade TARP executive compensation limits could set up management companies as he describes. There is nothing novel about the idea. The IRS and DOJ Tax Division deal with this sort of scheme in many incarnations. And the law provides many tools to defeat such scams -- nominee and/or transferee and/or alter ego liability, veil piercing, constructive fraud, constructive trusts, etc.

Anyone who has ever litigated a tax collection case (or any kind of debt collection suit) should recognize this plain fact, and will attest that anti-abuse rules ultimately boil down to the same kind of proof that wins or loses cases based on the common law doctrines I mention above.

Fedgovernor evidently hasn't done too much litigation and thus doesn't ken how things work when real money is on the line, and you must convince a judge or jury to give it to you.

Personally I think a hefty excise tax on executive compensation above $500,000 for companies receiving TARP assistance is preferable to an illusory regulatory "ban" on the practice.


5. Posted by MHodak on February 5, 2009 @ 21:53 | Permalink

As someone who designs comp plans, I can tell you that Vic is right. Even if they got rid of the mechanisms he described above, we could come up with a half dozen more.

To the extent we couldn't, it would be time to kiss our investment good-bye. I'm not saying the government has no right to demand what it wants, but it seems foolish to demand things that would actually undermine our investment in these firms.

BTW, Jake, an excise tax for the "excess" comp will simply penalize the shareholders, which kind of defeats the purpose of limiting executive pay. Unless the purpose is simply to make a political statement while raising corporate taxes. Hmmm.


6. Posted by Jake on February 6, 2009 @ 19:40 | Permalink

MHodak, you raise a very good point. But enjoining the company from paying compensation exceeding $500,000 to its executives would also harm the shareholders, no?

It's like rationing intelligence according to what the investor is willing to pay the owner of such intelligence. Price caps on executive intelligence would work about as well as price caps on gasoline did in the 1970s.

It thus seems to me that whether "excess" executive pay is "forbidden" or taxed heavily, the shareholders take it in the shorts.

Taxing the heck out of the "excess" executive compensation at least has the virtue of returning some dollars to the Treasury -- and the long suffering taxpayers of this Nation who must foot the bill in the long run for the kind of regulatory safari the Congress and new Administration are setting in motion.



7. Posted by supra for boy on December 16, 2011 @ 2:24 | Permalink

This is all very new to me and this article really opened my eyes.Thanks for sharing with us your wisdom.

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