Requests for Preferred Shares
For some investors, the most immediate TARP-related issue they will face is whether to approve requests by participating financial firms to issue preferred shares.

Under the CPP, these shares are not convertible and are generally non-voting other than class voting rights on matters that could adversely affect the preferred shares, such as a merger. These senior preferred shares will rank senior to common stock and carry a liquidation preference of $1,000 per share. As long as these preferred shares are outstanding, the company’s ability to declare or pay dividends on common shares will be subject to limitations. The warrants will have a 10-year term and will be exercisable immediately. While the government has agreed not to exercise voting power on common stock it acquires through warrants, other common shareholders will suffer a dilution of their economic rights upon exercise of the warrants.

While participation in the CPP does not require shareholder approval, firms that do not currently have authorized preferred shares must obtain shareholder approval to issue preferred stock. As of Nov. 20, 58 firms had filed proxy statements for special meetings for that purpose. Most of these firms likely will request “blank check” preferred stock, which gives a company's board the power to issue preferred stock at its discretion, with voting, conversion, distribution, and other rights to be determined by the board at the time of issue. Issuers seeking approval will likely indicate if the preferred shares are intended for use in the CPP. However, issuances of “blank check” shares do raise a concern that they could be used as a takeover defense if they are placed with parties friendly to management. To address this concern, companies can create “declawed” preferred stock, which cannot be used as a takeover device. (For details as to how RiskMetrics Group will assess such requests, please click here.)

Compensation Rules
The government’s new pay rules will apply to firms as long as the Treasury holds equity. Under the CPP, senior executive officers (i.e., the CEO, chief financial officer, and next three highest-paid executives) will be subject to the following compensation limits:

--Incentive compensation for the senior executives may not “encourage unnecessary and excessive risks that threaten the value of the financial institution.” While this is perhaps the most far-reaching of the provisions, it is also the most ambiguous, as it does not define what constitutes such “risky” pay.

--Any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate would be recovered--this confirms the policy that some shareholder activists have also been encouraging, i.e., “claw backs” that do not require fraud or malfeasance but are intended to recoup performance-based awards that are not actually earned.

--The financial institution is prohibited from making any “golden parachute” (i.e., severance) payment to a senior executive. That restriction will be based on current tax code provisions that, among other things, limit corporate tax deductions of severance packages that exceed three times the executive's average annual W-2 compensation. That fairly generous limit is only applicable in connection with a change in control under current regulations.

--The company may not take tax deductions for compensation in excess of $500,000 for any senior executive. However, Garland and activist investors expect that companies will forgo tax deductions rather than lower pay, meaning that shareholders will foot this bill.
In addition, the compensation committees at TARP participants will be required to meet with the firm's senior risk officers to ensure that the incentive compensation arrangements do not encourage senior executives to take "unnecessary and excessive risks that threaten the value of the financial institution." The committee also will need to meet with the senior risk officers annually and certify in the proxy statement's "compensation disclosure and analysis" section that they have done so.

Furthermore, the Securities and Exchange Commission plans to review the compensation disclosures by major financial firms. In an Oct. 21 speech, Corporation Finance Division chief John White also said that non-financial firms also should address executive pay risks when preparing their next proxy statements.

Investors Respond
Activist shareholders have criticized the TARP pay rules as “weak.” CtW’s Garland points out that the “claw back” provision is insufficient because it is only is triggered by a restatement of past financial results. Most of the recent write-downs of toxic mortgage-related assets by financial firms will not trigger restatements, and thus, the record bonuses earned in the past few years will not be recoverable, he explains. However, Garland notes that some of the pay provisions are “vague” and could be used by the Obama administration to discourage risky incentive pay.

Meanwhile, two CtW-affiliated unions--the Laborers’ International Union of North America and the International Brotherhood of Teamsters--plan to file proposals at 50 TARP firms seeking stricter compensation limits than required by the government. (For more details, see this week’s “In Brief” section.) Other investors plan to file proposals that seek extended holding periods for executive equity grants.

Connecticut State Treasurer Denise Nappier has urged the Treasury to clarify key terms in the TARP pay rules and adopt a tougher enforcement mechanism. “Without significant changes to both the . . . substantive standards and the mechanisms used to monitor and enforce compliance with those standards, the compensation provisions will have little or no impact on company behavior,” Nappier wrote in a Nov. 19 letter. She called for the Treasury to:

--Define “incentive compensation arrangements” to eliminate uncertainty over which kinds of plans and programs are covered.

--Establish meaningful enforcement to ensure that companies do not take on unnecessary and excessive risk.

--Eliminate ambiguity concerning the “claw back” provision and what constitutes “materially inaccurate” financial statements and performance metrics.

--Impose a substantial excise tax on the income of covered executives that exceeds the $500,000 threshold.

Other observers have noted that the TARP failed to address the payment of “tax gross-ups” by firms to cover executives’ income tax liabilities. Some compensation consultants warn that chief executives still could receive tens of millions of dollars if they receive stock grants and their firm's shares later rise.

Companies React
Notwithstanding the provisions of TARP, companies are voluntarily taking steps to reform their executive pay policies. More than two-thirds of Fortune 100 firms now have “claw back” provisions, up from 42.1 percent in 2007, according to a recent study by the Equilar research firm.

Aflac’s CEO has dropped his $13 million “golden parachute” package, while Gannett’s chief executive accepted a 17 percent cut in base pay, according to news reports. Goldman Sachs, UBS, and Barclays have said they will not pay year-end bonuses to top executives. New York Attorney General Andrew Cuomo has called on Citigroup and American International Group to do the same, and governance observers expect that other firms will follow.

“After four consecutive quarterly losses, it seems only fair that top executives should shoulder their fair share of these difficult economic times. It would send exactly the wrong message for Citigroup’s top brass to collect bonuses while investors, taxpayers, and now Citigroup's own employees suffer,” Cuomo said in a Nov. 17 press release after the firm announced that 50,000 more jobs would be cut.

Thomas J. Lehner, director of public policy at the Business Roundtable, said Goldman has “set a good example,” and shows how executives and boards have become more sensitive to the pay concerns of regulators and the public. He said most financial firm executives readily accepted the pay restrictions of TARP because they wanted to ensure the survival of their companies. “At the end of the day, what’s most important to CEOs is the success of their companies, employees, and shareholders,” Lehner told R&GW.

The University of Delaware's Elson said companies already are adopting pay reforms on their own that are based on TARP provisions. “It’s like ink dropped in water--it is spreading through osmosis,” he said.

New Governance Legislation
Executive compensation most likely will get significant attention once the new Congress start works in January. Rep. Barney Frank, who chairs the House Financial Services Committee, said in an Oct. 14 press release that he “will seek to build on [TARP] measures and apply them more broadly.”

Frank, who sponsored legislation in 2007 to mandate annual “say on pay” shareholder votes, likely will introduce another compensation bill in January. The Massachusetts Democrat has not yet disclosed details on such legislation, but it likely will address the independence of compensation consultants and other pay issues.

Most governance observers believe that Congress is all but certain to pass a “say on pay” bill in 2009--the question will be how far it goes. Davis of the Millstein Center said it’s too late now for firms to head off legislation by voluntarily agreeing to hold pay votes. Twelve U.S. issuers have taken that step so far.

Lehner said his group expects to see such legislation again and will lobby against requiring pay votes for all public firms. “At the vast majority of the 10,000 U.S. companies, executive compensation is not an issue,” he noted. Lehner points out that investors already have the ability through the shareholder resolution process to request annual advisory votes, which investors at 90 firms did so this year. “This issue did not cause the current crisis, and ‘say on pay’ will not solve it,” he told R&GW.

Davis said he expects to see legislation that would impose market-wide reforms, which may also include proxy access and provisions to encourage independent board chairs. “For many years, we have been on a slow boat to reform, but now it appears we’re on an expressway,” he noted. “This crisis is so large that there will be multiple pressures to make sure boards are held more accountable.”

Bimal Patel and Carol Bowie of the Governance Institute contributed to this article.