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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