The new U.S. economic stimulus legislation will extend mandatory shareholder votes on executive compensation to almost 400 firms that have received federal assistance, a significant development that should further bolster the investor campaign for such votes. The law also imposes significant new limits on bonuses, which, as some governance observers warn, could undermine pay for performance.

The American Recovery and Reinvestment Act of 2009, signed by President Barack Obama on Feb. 17, directs the Securities and Exchange Commission to issue final rules on non-binding “say on pay” votes within one year. This provision would apply to all companies that have received funds under the Troubled Asset Relief Program (TARP) until they satisfy their financial obligations to the government.

Pay vote advocates expect that the SEC--under the leadership of new chair Mary Schapiro, who has endorsed the concept--will have final rules in place before the 2010 proxy season. Commissioner Elisse Walter also has expressed her support, saying such measures “can help restore investor trust,” and lead to “increased shareholder participation,” according to the Reuters news service.

It remains to be seen how the stimulus legislation will impact the more than 100 shareholder proposals this proxy season that ask companies to adopt pay vote provisions voluntarily. Some financial firms may agree to conduct advisory votes but hold off on setting the terms until the SEC releases its rules.

James Cox, a securities law professor at Duke University, expects the new legislation will help generate greater support for “say on pay” resolutions and other shareholder proposals related to executive pay. While agreeing that the new pay limits were “probably not as well-targeted as they should have been,” he said Congress was trying to respond to the public outcry over the bonuses paid by Merrill Lynch and other taxpayer-supported firms. “People are really disillusioned with corporate America,” he said. “Bonuses have become a nasty world in this economy.”

Richard Ferlauto, director of corporate governance and pension investment at the American Federation of State, County, and Municipal Employees (AFSCME), said the legislation is “another step in creating a market-wide standard for ‘say on pay.’" “We expect to be working with regulators to design specifics for how ‘say on pay’ will be applied,” he said.

New Pay Restrictions
Most of the financial media coverage of the stimulus law has focused on the new pay restrictions for all TARP participants. These limits are far more extensive than those contained in the original financial bailout legislation passed in October or the recent Treasury Department rules for firms that seek “exceptional” assistance in the future.

The new restrictions were added to the bill late in the legislative process by Senate Banking Committee Chair Christopher Dodd over the objections of Obama and the Treasury, according to news reports. Banking industry advocates and other observers warn that the bonus limits will hasten an exodus of executive talent to hedge funds, foreign firms, and others not under the TARP umbrella.

The stimulus law prohibits cash bonuses to certain top executives, other than grants of long-term restricted stock. Such stock grants may not vest until the firm pays back its TARP obligations, may not exceed one-third of the executive’s “total annual compensation,” and will be subject to other limits set by Treasury. This provision would dramatically impact financial industry pay, which traditionally has included cash bonuses and equity awards that far exceed base salaries.

The number of executives covered by the bonus limits will depend on the amount of federal assistance received. At firms receiving more than $500 million in assistance, the bonus limits would apply to the top five senior executives and at least 20 of the next most highly compensated employees. Fewer executives would be covered at companies receiving less assistance.

The legislation also prohibits severance payments for top executives and directs the Treasury to review past bonuses for the 25 highest-paid employees. The law also bars compensation plans that “would encourage manipulation of the reported earnings . . . to enhance the compensation” for any employees. Critics of the bill, such as consultant Marc Hodak of Hodak Value Advisors, say this language could be interpreted to bar any incentives based on earnings per share or other financial metrics.

While the new legislation does not impose an absolute limit on executive pay, the Treasury previously set a $500,000 limit on the tax deductibility of salary for top executives. Firms conceivably could get around the new bonus limits by increasing base salaries and incurring additional taxes, but Ferlauto of AFSCME notes that these companies will be watched closely by regulators and investors.

It’s unclear when these new rules will take effect, but observers expect that the Treasury will issue guidance on these provisions. The law exempts bonuses paid under an employment contract reached by Feb. 11, assuming that contract is deemed valid by the Treasury.

The American Bankers Association warned in a Feb. 18 letter to the Treasury that the stimulus bill may prompt financial firms to delay filing their proxy statements because they are unsure about what they need to include in their pay disclosures or if they need to revise their 2008 results, according to Bloomberg News.

The new limits on bonuses have prompted concern among even well-known critics of executive pay abuses, such as Harvard University law professor Lucian Bebchuk. In a posting on Harvard’s Corporate Governance weblog, he warned that the law would undermine pay-for-performance goals. “Mandating that at least two-thirds of an executive’s total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction,” he wrote. Instead, he argues that pay problems “require tightening the link between pay and long-term performance--not giving up on it altogether.”

Bebchuk expressed concern that the new limits would give bank executives an incentive to prematurely leave the TARP program, “even when doing so would not be in the bank’s best interest.” He also cautioned that the law’s preference for restricted stock would provide executives an incentive to resist additional share issuances that would greatly dilute the value of their shares, even if the bank needed a capital infusion to survive.

Professor J. Robert Brown of the University of Denver voiced similar criticisms and noted that “capping bonuses still does nothing to guarantee that the board approves a compensation package that is commensurate with an executive’s contribution to the company.” In a posting on his weblog, he said, “Until the matter is systematically corrected at the board level, problems of excessive executive compensation will remain.”

While acknowledging that bonus caps don't work, Ferlauto said he believes the new pay curbs will be “temporary” and provide some “breathing room” as financial market participants develop new pay mechanisms--including “hold until retirement” and bonus escrow provisions--that promote long-term share performance.