February 04, 2009
Executive Compensation: Negotiated Covenants v. Regulation
Posted by Christine Hurt

The hills are alive with the sounds of grumbling and cheering at news that the next recipients of bailout money will have tighter reins on executive compensation.  Not disclosure.  Caps.  Here are thoughts of co-blogger and bailout guru David Zaring below and my colleague Larry Ribstein, complete with links.

If I were on the Obama team, I would separate out acceptable negotiated covenants from any new proposal from general theories of corporate regulation.  What does that mean?  As a needed supplier of an infusion of capital, the U.S. Treasury has both the ability and I would say the obligation to act like one.  If a company were nearing insolvency or was in other financial straits and approached a commercial lender, who would lend money pursuant to a loan agreement, or an angel investor, a venture capital fund, a private equity fund, or some other preferred shareholder who would infuse capital pursuant to a negotiated agreement, then that capital provider would negotiate for some pretty stiff protections.  If the borrower/issuer seems like it is in financial distress, then the party doing the bailout wants to negotiate some affirmative and negative covenants to make sure that any money is not wasted.  So, a good attorney would negotiate covenants against capital expenditures, dividends, salaries and bonuses.  A new preferred shareholder might become comfortable by taking a position on the board.  Either way, the U.S. Treasury demanding assurances that money that a company is begging for will not be frittered away is the right thing to do.  If the company borrowing or issuing shares then needs to make a capital expenditure or hire a new CEO at a higher wage, then negotiations for a waiver can commence.  This isn't a nanny state; this is just good business.

But the proposed Treasury rule has a lot of stuff that looks more like regulation mucking up what should merely be hardball covenants that seem reasonable given the credit profiles of the bailees.  The first is in the terms of the restrictions -- executive compensation structure and strategy must be disclosed to shareholders and subject to a "say on pay" shareholder resolutions.  Well, that's sort of hands-on, isn't it?  Would a lender or a new preferred shareholder ask for this type of covenant?  No.  The government should be acting as a market participant here, not a social engineer.  If the Obama administration is really excited about shareholder proposals, then go to the SEC and talk about it there. 

Worse, the proposed rule has an entire section that begins "Even as we work to recover from current market events, it is not too early to begin a serious effort to both examine how company-wide compensation strategies at financial institutions – not just those related to top executives – may have encouraged excessive risk-taking that contributed to current market events and to begin developing model compensation policies for the future."

OK, nice, but talk about it somewhere else.  Let's not screw up fixing an immediate problem because we see it as an opening to make very big, and very controversial changes.  Let's leave the debate over the right level and the right kind of corporate governance regulation and executive pay regulation to another day.  President Obama is right to be outraged and disappointed at Wall Street bonuses as a provider of capital to those institutions.  But keep your outraged lender/private equity hat on for awhile and negotiate a better deal in the future.  The Treasury does not need to try to map regulatory change at the same time; hopefully, the Treasurer will not be a market participant forever and can then let those still in the game make their own rules.

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