The bailout legislation Congress passed last week aims an effective one-two-three punch at executive compensation.

Boards of financial institutions that participate in the bailout program will have to limit executive compensation in a manner that prevents the top five executives from receiving incentives to take "unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary [of the Treasury] holds an equity or debt position."

Furthermore, these boards must reserve clawback rights against these executives for bonus and incentive compensation arising from financial results that are later proven to be materially inaccurate.

Finally, if the Treasury Department purchases more than $300 million of troubled assets, the legislation prohibits "any golden parachute payment" for the seller's top five officers during the period of the Treasury's investment, and it lowers the limit for allowable deductions for their compensation.

What should the executives of troubled financial institutions expect? In a nutshell, severance capped at three years' pay, and incentive pay and stock awards that vest only if there are years of future safe and sound performance by their employer.

Interestingly, neither of these outcomes is hard-wired into the bailout legislation. Its reference to "golden parachutes" goes undefined but probably anticipates the Code Section 280G limit of three times pay, though the severance could be even lower, because of the prohibition set forth under the Federal Deposit Insurance Corp. regulation that applies a one-year severance limit to executives of troubled institutions.

When it comes to incentive pay, annual bonuses will probably need to be de-emphasized. By nature, they depend on short-term operating results, and consequently they have the potential to encourage manipulation. These awards, if a focal point and substantial, could cross into the type of excessive risk-taking the bailout legislation forbids. Compensation committees and boards are likely to shift the emphasis for incentive compensation to long-term awards.

Whether constructed as stock awards or deferred compensation payable in cash, these incentives will need thoughtful structuring, principally to include vesting metrics that only reward solid future performance (such as solid loan quality or favorable bank ratings, e.g., a Camels rating of 1 or 2). It will also behoove decision-makers to consider clawback rights that have a right bite beyond gains from inaccurate results. For example, boards may find it desirable to recapture incentive gains if an executive violates a post-employment noncompetition provision.

The executive pay dynamic promises to get even more complex. The Treasury Department will be aiming new regulations and enforcement actions at the directors of bailed-out financial institutions. Being at personal risk, these directors will need expert counsel — and will be quick to pursue best practices.

A subtle yet prime concern for board members of troubled institutions should be the flight of talent that could result when executives discover that their performance goals are higher, and their severance caps are lower, than those healthy competitors are free to offer.

The most practical solution may need to come from providing the executives of troubled institutions with long-term incentives that exceed market levels but depend on safe, sound, and profitable future performance. The best programs provide boards with the discretion to take into account, or to disregard, extraordinary events.

Overall, directors who see executive talent as a critical asset will need to tread cautiously. The road ahead may seem uncertain, yet troubled institutions should generally be able to find a way to retain and encourage their executives. They will need to do this while protecting the interests of shareholders — including a watchful Treasury Department.

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