Loophole in Bailout Provision Leaves Enforcement in Doubt

By Amit R. Paley
Washington Post Staff Writer
Monday, December 15, 2008; A01

Congress wanted to guarantee that the $700 billion financial bailout would limit the eye-popping pay of Wall Street executives, so lawmakers included a mechanism for reviewing executive compensation and penalizing firms that break the rules.

But at the last minute, the Bush administration insisted on a one-sentence change to the provision, congressional aides said. The change stipulated that the penalty would apply only to firms that received bailout funds by selling troubled assets to the government in an auction, which was the way the Treasury Department had said it planned to use the money.

Now, however, the small change looks more like a giant loophole, according to lawmakers and legal experts. In a reversal, the Bush administration has not used auctions for any of the $335 billion committed so far from the rescue package, nor does it plan to use them in the future. Lawmakers and legal experts say the change has effectively repealed the only enforcement mechanism in the law dealing with lavish pay for top executives.

"The flimsy executive-compensation restrictions in the original bill are now all but gone," said Sen. Charles E. Grassley (Iowa), ranking Republican on of the Senate Finance Committee.

The modification reflects how the rapidly shifting nature of the crisis and the government's response to it have led to unexpected results that are just now beginning to be understood. The Government Accountability Office, the investigative arm of Congress, issued a critical report this month about the financial industry rescue package that said it was unclear how the Treasury would determine whether banks were following the executive-compensation rules.

Michele A. Davis, spokeswoman for the Treasury, said the agency is working to develop a policy for how it will enforce the executive-compensation rules. She would not say when the guidance would be issued or what penalties it might impose. But she said the companies promised to follow the rules in contracts with the department.

The final legislation contained unprecedented restrictions on executive compensation for firms accepting money from the bailout fund. The rules limited incentives that encourage top executives to take excessive risks, provided for the recovery of bonuses based on earnings that never materialize and prohibited "golden parachute" severance pay. But several analysts said that perhaps the most effective provision was the ban on companies deducting more than $500,000 a year from their taxable income for compensation paid to their top five executives.

That tax provision, which amended the Internal Revenue Code, was the only part of the law that contained an explicit enforcement mechanism. The provision means the IRS must review the pay of those executives as part of its normal review of tax filings. If a company does not comply, the IRS can impose a tax penalty. The law did not create an enforcement mechanism for reviewing the other restrictions on executive pay.

If a firm violates the executive-compensation limits, department officials said, the Treasury could seek damages, go to court to force compliance, or even rescind the contracts and recover the bailout money. "We therefore have all the remedies available to us for a breach of contract," Davis wrote in an e-mail.

Legal experts said those efforts could be complicated if the Treasury outlines the penalties after companies have received bailout money. David M. Lynn, former chief counsel of the Securities and Exchange Commission's division of corporation finance, said courts have sometimes placed limits on the government's ability to impose penalties if there was no fair warning.

"Treasury might find its hands tied down the road," said Lynn, who is also co-author of "The Executive Compensation Disclosure Treatise and Reporting Guide."

Congressional leaders are also concerned that the Treasury might simply choose not to enforce the rules or be unwilling to impose financial penalties that could further weaken a firm and send the economy deeper into a tailspin.

The Bush administration at first opposed any restrictions on executive pay, congressional aides said. The original three-page bailout proposal presented to lawmakers in September contained no mention of such limits. "Treasury was pretty clear that they thought doing this exec-comp stuff would limit the effectiveness of the program," said a Democratic congressional aide involved in the negotiations, who, like others interviewed for this story, spoke on condition of anonymity. "They felt companies might not take part if we put in these rules."

Congressional leaders disagreed. By the morning of Saturday, Sept. 27, the final day of marathon negotiations on the bill, draft language relating to taxes and containing the enforcement provision applied to all companies participating in the bailout programs, Democratic and Republican congressional aides said. But then Treasury Secretary Henry M. Paulson Jr. and his deputies began pushing for the compensation rules to differentiate between companies whose assets are purchased at auction and those whose assets or equity are purchased directly by the government, the aides said.

Congressional leaders from both parties thought Paulson wanted the distinction for extraordinary cases like American International Group, which the government seized in September. He wanted to be able to push executives out of companies that the government controlled and have the flexibility to bring in strong new executives, said one senior congressional aide.

"The argument that they were making at the time is that the direct investment was going to be used only in circumstances where the company was AIGed, so to speak," said a senior Democratic congressional aide.

Davis, the Treasury spokeswoman, confirmed that the Treasury pushed to place fewer restrictions on executives at companies receiving capital infusions, but she gave a different explanation. She said many of those firms are more stable and are being encouraged to participate in the bailout to strengthen the overall system. "The provisions for failing institutions should come with more onerous conditions than those for healthy institutions whose participation benefits the entire system," she said.

Lawmakers agreed to the Treasury's request that the measure apply only to executives at companies whose assets were bought by the government through auctions. In the executive-compensation tax section, a new sentence saying that eventually was inserted.

Meanwhile, Paulson repeatedly told lawmakers that he did not plan to use bailout funds to inject capital directly into financial institutions. Privately, however, his staff was developing plans to do just that, Paulson acknowledged in an interview.

Although lawmakers hailed the rules as unprecedented new limits on executive pay, several were unhappy that the law was not stricter.

Under pressure from Congress, the Treasury issued regulations in October on executive compensation and applied the tax-deduction limits to all companies receiving bailout funds, although the legislation did not require it for firms that received direct capital injections. But the Treasury failed to issue guidelines requiring the IRS or any other agency to enforce the rules, and it also failed to explain how the restrictions would be enforced.

The Treasury's regulations also instructed firms to disclose more compensation information to the Securities and Exchange Commission. But officials at the SEC do not think they have the authority to force companies to disclose the kind of pay information required by the bailout law, according to people familiar with the matter, though they hope companies will cooperate. John Nester, an SEC spokesman, declined to comment.

Senators on the Finance Committee have expressed concern to Paulson and are now considering whether they should amend the law to apply the enforcement mechanism to all firms participating in the bailout.