Limits on Pay Left Unclear in New Law

Executive-pay restrictions in the economic stimulus package could reach much further into the ranks of affected companies than previously believed, depending on how a crucial but confusingly written provision is interpreted, lawyers and compensation consultants said.

Meanwhile, consternation about the new pay restrictions continued to grow, with some financial-industry insiders predicting an upheaval in industry compensation structures and a slow brain drain from affected firms.

The stimulus bill, which was signed into law Tuesday by President Barack Obama, contains a provision that limits bonus payments to no more than one-third of annual total compensation at banks and other companies that have taken federal bailout money. For the biggest such institutions, the limit affects the five top officers, plus the 20 next most highly compensated employees -- effectively the 25 highest-paid people at an institution.

But the law doesn't define how those 25 are to be identified. It leaves the details to the Treasury Department, which is supposed to announce interpretive rules in the coming weeks.

One possible interpretation, according to lawyers, results in an oddly circular effect that could cap pay for everybody. If a bank identifies the 25 people it intends to pay the most this year, then restricts their pay, that group no longer would be this year's 25 highest paid. Then 25 new people would become the highest paid, and their bonuses will have to be capped, and so forth.

Another possibility is that a bank could cap the pay of the 25 who earned the most in 2008. Those people likely would no longer be the highest paid in 2009. But that means a different group would have that distinction, and this second group's pay would then be capped the following year, while the first group's pay would be uncapped.

The result could be a "weird game of leapfrog" in which groups of 25 executives trade places as the highest paid every year, said Christian Chandler, an executive-compensation attorney at Hogan & Hartson LLP in Washington.

A senior executive responsible for human resources at an investment bank that has taken federal bailout money pointed out that many of the 25 people at his firm who made the most in 2008 no longer work there. "This [provision] is completely unworkable," the executive said. "It's creating mass confusion."

Other lawyers predicted potential gamesmanship, in which affected institutions quietly promise to pay capped executives more in coming years, or pick sacrificial executives to be this year's "highest paid." One said the Treasury might have to issue anti-abuse legislation.

A Treasury official said details of the executive-pay plan were still being worked out, but added that the administration thinks there's enough wiggle room in the law to prevent unintended consequences or damage to the broader goal of restoring stability to the nation's financial system.

Some experts and industry insiders predicted unintended consequences nonetheless. Typically, big banks and Wall Street firms have paid their top earners a small salary, but offered the potential to earn a large bonus depending on performance. By being forced to cap bonuses, banks will have no choice but to ratchet up salaries, some predict.

"To be put in a situation where you're limiting performance-based compensation is the dumbest thing you can do," said the senior executive at the investment bank. "Everything that shareholder advocates have been seeking for years is thrown out the window."

This executive offered a hypothetical example of a head of commodities trading paid $10 million in 2008, only $250,000 of which represented salary. "If you want to keep this commodities trader, you have to increase his salary to $8 million," he said. But the trader collects that substantial sum even though "you have no idea about his total performance for the year" -- and the firm can't recoup his salary if his performance falls short, the executive said.

Alan Johnson, managing director of Johnson Associates Inc., a New York compensation consultancy that advises Wall Street firms, predicted that the legislation as written would result in a mass exodus of top earners. "Who would stay for a 90% pay cut?" Mr. Johnson asked.

James F. Reda, another New York pay consultant, agreed that there could be a talent exodus, but he said it would likely be a "brain trickle, not a brain drain." There aren't many firms hiring, he said, and ex-bankers who want to strike out on their own may find it difficult to raise capital to back them.

Write to Mark Maremont at mark.maremont@wsj.com and Joann S. Lublin at joann.lublin@wsj.com