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Article published in Agenda, April 27, 2009 Opinion: Boards Must Prep for Spread of TARP Comp Rules By Jim Barrall U.S. public companies are caught in a violent storm over executive compensation practices. The more than 500 financial institutions that have accepted aid under the Troubled Asset Relief Program and related programs (broadly called TARP) are being pummeled on every front, including by everchanging and ever more intrusive executive compensation rules. Further, it’s becoming increasingly clear that the regulatory backlash won’t be confined to TARP recipients. “Public companies that are not receiving federal aid should realize that the TARP recipients are just canaries in the coal mine.” Jim Barrall, partner, Latham & Watkins Last October, the TARP limitations emerged as relatively benign corporate governance and tax rules. The policies targeted the taxability of golden parachute payments and compensation in excess of $500,000 for the five most highly compensated company officers. However, after a succession of bailout waves, these rules now flatly prohibit any parachute payments, any bonuses not paid in restricted stock, any bonuses greater than 50% of salary, and any cash compensation in excess of $500,000 for larger groups of top employees. Further, TARP recipients have agreed to accept yet unknown additional limits in the future and are expected to renegotiate existing agreements. Finally, in a populist fit triggered by American International Group’s payment of contractual bonuses, the House passed retroactive legislation that would impose retaliatory income taxes on bonuses paid by TARP recipients; a similar bill is pending in the Senate. Public companies that are not receiving federal aid should recognize that the TARP recipients are just canaries in the coal mine. The government’s regulation of executive compensation likely will broaden to cover all U.S. publicly traded companies, survive and go beyond the TARP limits. As evidence that the rules will spread, consider the following: • Critics of U.S. pay practices, ranging from legislators to shareholder activists, have been discussing similar approaches for years for all public companies and are capitalizing on the moment. • As the government needs to muster public support for additional bailout funding, it’s recognizing that making piñatas of TARP recipients’ executive compensation is bad public policy. They see that this approach could diminish the recipients’ ability to repay their obligations and destroy their global competitiveness. So given the need to assuage public anger in order to raise more bailout funds, Congress is likely to direct its efforts to enact broader executive compensation regulation. • Many Americans, who have felt the pain of the recession in their 401(k) plan accounts, are angry at compensation practices beyond those of the financial sector. Non-TARP companies likely will be spared TARP’s pay caps and most intrusive governance restrictions, but it’s very likely that Congress will enact a Say on Pay law (as proposed in the Senate by then Senator Barack Obama and as passed by the House in 2007), which would require every U.S. public company to submit its executive compensation policies to annual shareholder approval. While companies would not be required to implement these “advisory” votes, they would set the stage for powerful proxy advisory firms to unseat directors and annually expand their lists of targeted practices. The SEC is also likely to adopt shareholder proxy access rules that will allow hedge funds and activists of all stripes to attack boards and run their own slates. In addition, the SEC’s 2006 proxy rules are likely to be amended to require even more disclosure of compensation practices. Finally, the tax code likely will be used to target disfavored practices and raise revenue. So boards and compensation committees should act for the long-term good of companies and their shareholders, as well as stay out of harm’s way in these turbulent times, by: • Judiciously using compensation that’s not performance-based (other than salaries). • Designing performance compensation that’s truly based on the company’s business plans and aligned with shareholders’ interests. 2 • Implementing programs that do not encourage excessive risk-taking by using vesting schedules, holdbacks, clawbacks and equity holding requirements. • Planning for succession and avoiding the risks and expenses of filling officer vacancies from the outside. • Ensuring that compensation policies are persuasively explained to shareholders. • Opening direct dialogues with key shareholders and not abdicating this important arena to the proxy advisory firms. • Monitoring developments and not designing compensation based on past practices. • Understanding which new or continued practices could expose directors to attack when adopting new plans or amending old ones. With careful thought and planning, conscientious boards and companies should be able to navigate this storm. Those who have not been paying attention to which way the wind is blowing will likely pay the price. Disclaimer: This article expresses the author’s views and does not necessarily reflect those of Latham & Watkins. 3