There’s a specter haunting the stimulus bill: the specter of pay caps.
The nightmare scenario envisioned by many is that the pay caps included in the stimulus bill Barack Obama is scheduled to sign into law any minute now will amount to a war on talent, driving the best and the brightest away from firms now owned, in part, by the government. This flight of the talented allegedly could cripple the firms, dashing all hopes that the government might make it’s money back on the preferred stock investments. (Although, this might not actually be a bad thing, as we explained here.)
Alternatively, we’re told that bankers may choose the risky path of paying back the TARP money despite still shaky balance sheets. Bankers have different incentives than their institutions. For them the deal being offered is: take the TARP and get paid very little, or pay it off and get paid like the good old days if the firm survives. If the firm doesn’t succeed, you get paid very little. The idea is that there’s no way bankers will take the ‘low pay, no upside’ option when the riskier option with a great upside is available.
This is why we’ve described banker pay as a problem from Hell: every choice seems terrible.
But maybe it’s not all that scary. According to our read of the stimulus bill, the executive pay caps can be easily avoided by financial firms. Although the bill purports to place strict limits on salaries and bonuses at firms taking money from the TARP, it applies rather narrowly to the actual entities that took the TARP money. That might mean that money injected into a bank holding company may not apply to a subsidiary or a joint venture only partially owned by a TARP supported bank.
Let’s use the example of Morgan Stanley’s brokerage joint venture with Citi. Will the TARP pay restrictions apply to the brokers? On a strict read of the language, we’d say no. That entity, which is neither Morgan Stanley itself or Citigroup itself, is not a recipient of “financial assistance” under TARP.
On a looser reading of the law, you could say that since the joint venture is majority owned by Morgan Stanley, it should be combined with TARP and the compensation caps should pierce the corporate form. Could you structure around this?
Of course you could. In fact, you could do this in three easy steps.
- Spin off the profit centres. Spin off the joint venture. Make it a truly independent company. Now it clearly isn’t an entity under TARP. You can spin it off to employees, and since financial stocks are trading at rock bottom prices you don’t have to worry that your shareholders will be able to successfully claim you didn’t get enough for their asset.
- Lend to spin off. capitalise the joint venture with a loan from the parent companies. It’s OK to do this with TARP money. After all, no one is going to argue that making loans with TARP money puts makes all the borrowers TARP recipients.
- Management fees! Arrange for the brokerage to pay a management fee to the former parent company. Obviously, the newly minted brokerage will have lots of back office need that can be performed by Morgan Stanley, and it can pay Morgan Stanley for those services. This is how you extract value back into the parent.
All of this shows that the pay restrictions may end up hastening the dissolution of the conglomerate investment banking-brokerage-trading model as we know it. Remember, conglomerated firms exist in order to reduce transaction costs. The restrictions on pay could change that calculus, making it more beneficial for management to find innovative corporate structures—including spinning off some of their most profitable divisions while finding ways to reclaim the profits through interest payments and management fees.
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