Do Caps on Executive Compensation Really Work?

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The idea of clamping down on executive pay before a firm is allowed to take part in the proposed $700 billion toxic-asset bailout program seems eminently reasonable. After all, we're talking about the very well-compensated execs — hello, eight figures — who ran the firms that drove the demand for the securities that caused the problems in the first place.

The catch is, legislating restrictions on CEO compensation, while politically enticing, doesn't have the best track record of working. The good news: shareholders may be able to do something about it.

It's not yet clear what sorts of limits on executive compensation will be included in the bailout bill. Ideas being batted around include a temporary elimination of golden parachutes (payouts that executives collect when they lose their jobs); a lower limit on the amount of an executive's base salary that companies can deduct from their taxes (currently $1 million); "clawback" provisions to help recoup bonuses paid based on earnings or other metrics that later prove to be inaccurate; and limits on incentives for "excessive" risk-taking.

Treasury Secretary Henry Paulson had been warning that such measures could prevent companies from participating in the program, but on Sept. 24 he relented in the face of political pressure. "The American people are angry about executive compensation, and rightfully so," he told the House Committee for Financial Services. "We must find a way to address this in legislation without undermining the effectiveness of the program."

But Congress should be the first to know that dictating what executives can get paid doesn't always work as expected. In 1984, Congress passed a law eliminating the tax deductibility of golden parachutes that exceeded three times base salary. Corporate America took that to mean anything below that multiple was fine: golden parachutes worth 2.99 times base salary proliferated, where before there were none at all. In 1993, Congress said only $1 million of an executive's salary would be tax deductible. So companies began paying their CEOs massive amounts in other forms, like stock options and deferred compensation.

"It's the law of unintended consequences," says Charles Elson, who runs the John L. Weinberg Center for Corporate Governance at the University of Delaware. "I think pay is completely out of control, but this isn't the way to get at it."

There has also been mixed success with legislating clawbacks. The Sarbanes-Oxley Act, passed in 2002 in the wake of accounting scandals at Enron and other companies, required CEOs and CFOs of companies that have to restate earnings because of financial misconduct to pay back bonuses and incentive compensation. But that provision proved largely ineffective. The SEC didn't bring a case under this provision for four years, and when it finally found success — UnitedHealth's former CEO was forced to pay back more than $400 million worth of stock options gains, unexercised options and retirement pay after a stock options backdating scandal — the courts ruled that shareholders on their own couldn't sue under the law, setting a narrow precedent for who is allowed to reclaim pay after the fact.

The broader lesson, corporate governance experts say, is that companies are best prodded into behaving differently not by the government but by their owners. "The most powerful force in the marketplace that has a direct interest in keeping pay aligned with performance is shareholders," says Stephen Davis of Yale University's Millstein Center for Corporate Governance and Performance. "Why not use them?" He points to a law passed in 2002 in the U.K. that gives shareholders an up or down vote on executive pay packages. Even though the vote is only advisory, and doesn't bind a board of directors to act, the mere threat of getting a vote of no confidence has better aligned executive pay with the performance of companies.

Researchers at Harvard Business School studied the British system and found that it achieved one of its major goals — reducing big paydays at companies that aren't doing well. That was especially true at firms handing out the most compensation, a particularly relevant finding considering the size of some Wall Street packages.

A similar law was introduced in Congress last year by Barney Frank in the House and Barack Obama in the Senate. It currently sits in a Senate committee.

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