The back and forth has continued on the Bailout Bill.  But one thing is for certain, Paulson and the White House have caved on executive compensation provisions, as we predicted they would.  As the WSJ reports:

• In give-and-take on Capitol Hill Wednesday, Mr. Paulson signaled his intention to relent on another key Democratic demand: that limits should be imposed on the compensation of executives at firms participating in the program. Mr. Paulson had previously argued against pay limits, suggesting they might deter companies from participating in the bailout. That argument proved to be a political loser.

• "We must find a way to address [executive pay] in the legislation, but without undermining the effectiveness of the legislation," Mr. Paulson told the House Financial Services Committee\

Said another way, Congress will to a limited extent preempt Delaware law in the determination of executive compensation, a reflection of the utter frustration with the escalation of pay and the lack of standards under state law.  A prediction?  The Delaware courts will suddenly start taking a harder line on executive compensation.  The Delaware courts are quite consccious of the surrounding dynamics and the risk of greater federal intervention (either by adopting addtional restrictions or by extending the ones in the Bailout Bill to other public companies).  The courts became slightly more flexible in the immediate  post-Enron era when there was significant risk of federal intervention.  The shift is, however, only temporary and abates once the risk of federal preemption recedes.   

His compensation included $96,672 for a car and driver.  Over a five year period, he made over $46 million.  As one article put it:

• "Paulson made more than $38 million in 2005, according to Goldman's proxy statement, with most of that, $30.1 million, coming from restricted stock awards, and stock options valued at $7.3 million. He got $29.2 million in stock grants in 2004 and $20.8 million in 2003, on top of his base pay of $600,000 each of the last three years."

But that was only part of the payout received from Goldman in 2006.  He also received $7,390,666 in distributions of profits earned on private investment funds.  By virtue of his resignation from Goldman Sachs, the investment banking firm apparently cashed Paulson out of his options and restricted stock units.

• The authorized officers elected to cash-settle Mr. Paulson’s outstanding RSUs on June 30, 2006 at their fair market value and Options at their intrinsic value, in each case based on the closing price of Common Stock on June 29, 2006 ($152.20), the day prior to the cash-settlement date. As a result, Mr. Paulson received a cash payment of $110,086,998.  
  

• In addition, in accordance with the terms of the applicable Restricted Stock Agreement, Mr. Paulson’s 224,777 shares of restricted Common Stock became fully vested and the Committee approved the removal of transfer restrictions otherwise applicable until January 2009.

• Prior to his departure, Mr. Paulson and his wife held investments in a number of private equity and hedge funds managed by the firm. In order to avoid any actual or potential conflicts of interest due to the firm’s involvement with these funds and Mr. Paulson’s government service, the Committee determined that the firm should purchase these investments from Mr. Paulson and his wife at a price based on the net asset values of these investments. These purchases resulted in cash payments to Mr. Paulson and his wife in the aggregate amount of $45,972,540. In addition, Mr. Paulson’s wife redeemed her investment in a firm-managed hedge fund in accordance with the usual redemption provisions that are applicable to investments in this fund, which resulted in a total payment upon redemption of $5,455,830.

SEC. 17. EXECUTIVE COMPENSATION.

The Secretary shall require that all entities seeking to sell assets through a program established under this
Act meet appropriate standards for executive compensation and shareholder disclosure in order to be eligible,
which standards shall include—

(1) limits on compensation to exclude incentives for executives to take risks that the Secretary deems
to be inappropriate or excessive;
(2) a claw-back provision for incentive compensation paid to a senior executive based on earn6
ings, gains, or other criteria that are later proven to be inaccurate; and
(3) such limitations on the entity paying severance compensation to its senior executives as are determined to be appropriate in the public interest in light of the assistance being given to the entity.

Yesterday, we noted talk about the inclusion in the bailout bill of corporate governance provisions.  We attributed the sentiment to the utter failure of state law to impose meaningful regulations with respect to executive compensation and the resulting impetus for federal preemption.  The preemption process has moved close to reality. 

The working draft of the House bailout bill has some significant corporate governance provisions. The provisions would apply to companies "seeking to sell assets through the program." Specifically, those companies would be required, for two years, to limit compensation to exclude incentives for executive officers to take risks that the Secretary deems to be inappropriate or excessive during such participation; to permit recovery of incentive compensation once it is proven that the financial statements were false or inaccurate; and to prohibt the payment of severance compensation during the period.

For companies where the Secretary makes a direct purchase, they must provide an advisory vote on executive compensation and must provide access to the proxy statement for 3% shareholders. In addition, the ban on severance remains in effect. These requirements remain as long as the Secretary retains an equity position. The precise language is below.

The provisions are, therefore, temporary.  The most significant is the direct interference in the calculation of executive compensation and the imposition of access.  With financial institutions providing access, it will be hard for the SEC to avoid adopting the same requirement.  Moreover, the access provided in the draft is broader than what the SEC considered back in 2007.  Rather than address whether shareholders can insert in the proxy statement a bylaw that would provide for access, the draft statute provides direct access for 3% shareholders.  In other words, by failing to adopt the access proposal that it had under consideration, a very limited version of access, the result will likely be some federal mandate for even broader access for shareholders. 

9. EXECUTIVE COMPENSATION AND CORPORATE GOVERNANCE.

(a) IN GENERAL.—The Secretary shall require that all financial institutions seeking to sell assets through the program under this Act meet appropriate standards for executive compensation and corporate governance in order to be eligible.

(b) CRITERIA FOR STANDARDS.—The standards under this section shall include with respect to any financial institution participating in the program under this Act, and effective for the two years after entry by the financial institution into such participation—

(2) a provision for the recovery by the financial institution of any bonus or other incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be false or inaccurate; and (3) a prohibition on the financial institution paying severance compensation to its senior executive officers during such period.

(c) ADDITIONAL STANDARD FOR DIRECT PURCHASES.—The standards prescribed by the Secretary under this section shall include additional standards with respect to financial institutions in which the Secretary makes a direct purchase from an individual financial institution. Such standards shall be effective for the duration of the holding by the Secretary of such equity position, and shall include—

(1) a requirement that the financial institution permit any shareholder or group of shareholders holding, in the aggregate, equity securities of the institution representing three percent or more of the equity securities of the financial institution, access to the proxy solicitation and shareholder vote for any election of the board of directors of the institution for the purposes of nominating and electing a designated individual to the board of directors of the institution;

(2) a requirement that the financial institution afford all shareholders the opportunity to cast a non-binding vote, in any annual proxy solicitation and shareholder vote, on the executive compensation to be provide to the executive officers of the financial institution; and

(3) a prohibition on the institution paying severance compensation to its senior executive officers during any period in which the Secretary continues to hold an equity position in the financial institution.

(d) SEVERANCE COMPENSATION.—For purposes of this section, the term ‘‘severance compensation’’ means any compensation that is awarded to a senior executive officer on the basis of the termination of such executive officer’s service with the financial institution, other than a pension plan or a retirement plan in which the executive officer’s rights were fully vested prior to the entry of such financial institution into participation in the program under this Act.

As we have discussed often, and at length in the paper, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty, the Delaware courts do not ensure that the procedural requirements are meaningful.  Directors approving compensation are not necessarily independent (both because of a definition that does not screen for all disqualifying relationships and because of excessive pleading standards) and are not necessarily informed.  As a result, Delaware courts have effectively removed all limits on executive compensation (waste, an impossibly high standard, the only exception).  

By refusing to impose meaningful standards, the Delaware courts have invited federal intervention.  Yet they have remained largely oblivious.  As one member of the Chancery Court said publicly:

• "There's a lot of things that keep me up at night related to my work, but the possibility of [a federal corporate law] isn't one of them."
  

Pressure for federal preemption, however, has continued to build.  Say on pay legislation has already passed the House, been sponsored in the Senate by Barak Obama, and is part of the Democratic Platform.  Things, however, have escalated a notch higher.  According to the WSJ, the bailout for the financial system may include limitations on executive compensation.  

• As the U.S. Treasury asks Congress for about $700 billion to bail out troubled financial firms, key Democratic lawmakers including House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd say they want the bill to include curbs on what executives can earn.

While Treasury has pushed back, even Secretary Paulson has admitted that "there had been 'excesses' of executive pay, adding, 'Pay should be for performance, not for failure.'" 

Whatever happens, the financial crisis and the renewed spotlight on excessive compensation has provided fresh impetus for allowing shareholders greater opportunity to elect their own nominees to the board.  In short, the crisis has made some form of access to the company's proxy statement inevitable, either because the SEC puts it in place or because Congress commands.  Indeed, as Richard Ferlauto, head of corporate governance and pension investment at the American Federation of State, County and Municipal Employees, indicated, "AFSCME will push harder for legislation that will require public companies to put executive compensation packages to a shareholder vote, as well as laws that would make it easier for investors to nominate independent directors to corporate boards."   

Ultimately, if Congress commands access, it will likely result in far greater shareholder authority than the limited access proposals debated by the Commission.  In other words, those like former Commission Paul Atkins who spearheaded the effort to prevent the SEC from adopting the limited form access proposed in 2007, may have ultimately provided the impetus for far greater shareholder rights.  It is, as we have called it here, the rule of unintended consequences.

In that regard, Risk Metrics has a nice post on the latest in the "say on pay" and noted that a proposal at Valero Energy passed with 53.7% of the vote.  It was the tenth say on pay proposal to pass, with the proposals averaging 42%, roughly the same as last year.  In other words, there has not, as some have suggested, been a significant decline in support for the proposals. 

The Valero vote, however, demonstrates clearly the need for federal legislation.  It is the second year in a row that the proposal has passed and so far there is no indication that the company will implement the proposal.  This is the case even though any vote would be advisory.  Thus, shareholders have to go through the logistical process of obtaining approval by shareholders.  Even then, because many such proposals are advisory (a result encouraged by the Delaware Court's decision in the CA case), board are legally free to ignore them, and they do.  With federal legislation, however, the proposals will become mandatory.

• Reforming Financial Regulation and Corporate Governance.  We have failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practices. We have let the special interests put their thumbs on the economic scales. We do not believe that government should stand in the way of innovation, or turn back the clock to an older era of regulation. But we do believe that government has a role to play in advancing our common prosperity: by providing stable macroeconomic and financial conditions for sustained growth; by demanding transparency; and by ensuring fair competition in the marketplace. We will reform and modernize our regulatory structures and will work to promote a shift in the cultures of our financial institutions and our regulatory agencies. We will ensure shareholders have an advisory vote on executive compensation, in order to spur increased transparency and public debate over pay packages.  (emphasis added)
  

It is always dangerous to predict what changes a new administration may bring, but the push for say-on-pay seems strong. Companies that have not yet adopted say-on-pay provisions would be well-advised to consider the issue. Getting ahead of the curve might enable them to craft policies that work to their best advantage and would give them time to work with the advisory groups that will lead the voting on say-on-pay proposals. Further, knowing that such proposals may become mandatory might influence the structure of executive compensation packages in advance of shareholder votes on the issue.

Federal adoption of say on pay illustrates several themes that have been developed at length on this Blog.  First, the say on pay bill gives to the SEC the authority to define the compensation plan put forward for a vote.  In other words, it thrusts the SEC right into the corporate governance process and moves the Agency further away from the traditional role of disclosure and towards the substance of corporate governance.  This is a theme developed in the piece, Corporate Governance, the SEC, and the Limits of Disclosure.  This is a trend that was evident in the provisions of SOX and looks to continue. 

Second, the need for federal intervention reflects frustration with the anti-shareholder law that has developed in Delaware.  The courts have not provided meaningful standards for the adoption of executive compensation.  Compensation, as a result, continues to escalate.  The absence of meaningful standards provides growing impetus for federal preemption of areas traditionally left to the states.  It is the states that determine the standards for executive compensation and the matters that are subject to shareholder approval.  Say on pay strips some of that authority away from the states.

In the end, the excessively anti-shareholder nature of Delaware law will prove to be self defeating.  The Paulson proposals on reorganizing the financial system called for a dramatic expansion in the type of entities that should be subject to federal incorporation.  Say on pay is only the latest effort in this area, another trend that is likely to continue. 

• As reported previously, “say on pay” proposals have received majority support at Apple, Lexmark International, PG&E, South Financial Group, Tech Data, Motorola, and Alaska Air this year. Most recently, industrial manufacturing company Ingersoll Rand reported that investors gave 54 percent support to a pay vote proposal, while dissidents at computer server firm Rackable Systems said a similar proposal received the support of a majority of votes cast. The average support for pay vote proposals is also higher this year. With the Ingersoll Rand and Rackable results, the average support for “say on pay” has reached 43.4 percent over 46 meetings where preliminary or final results are known, according to RiskMetrics Group data. In 2007, about 50 pay vote proposals averaged 42.5 percent support.

The companies from last year?  Ingersoll (not a typo, the proposal has been approved by shareholders twice at this company), Motorola, Verizon Communications, Blockbuster, Activision, Clear Channel Communications, and Par Pharmaceutical.

Say on pay in the end has some modest value, giving shareholders at least an advisory voice in compensation.  The need for a shareholder voice demonstrates the complete failure of state law and the reliance on independent directors to control executive compensation.  The focus has therefore shifted away from the board to shareholders.  While companies will slowly see the number of say on pay proposals increase, the main area of interest is federal legislation, with Congressman Barney Frank and presidential candidate Barak Obama favoring legislation to mandate say on pay.