Tax Notes, Sept. 21, 2009, p. 1169
124 Tax Notes 1169 (Sept. 21, 2009)
By Martin A. Sullivan --
Forget rational discourse. Forget economic theory. Forget all that business school blabber about "failed corporate governance." There are some among us (myself included) who just can't help being jealous. While we struggle, those hotshot executives have private marble-lined washrooms, limos with darkened windows, corporate jets, and annual bonuses that will keep them, their children, and their grandchildren in high style for the rest of their natural lives. For pitchfork populists, no explanation is required. It is self-evident that massive executive compensation packages need to be cut.
Still, even after capitalism's near total collapse last year, class warfare is still a tough sell in today's political marketplace. So we try to disguise our fury and rage in a cloak of rationality. Luckily for us proletarians -- so we don't seem too crazed -- there has always been a pretty good policy justification for capping executive salaries. It goes like this: Legal loopholes and institutional inertia have allowed executives to wrest control from shareholders. Corporate executives control the selection of the board of directors. The compensation committee is appointed by the board from its own members, who hire compensation consultants, who are already dependent on executives for other services they provide to the company. The system is rigged. Self-interested executives are able to boost their compensation packages to sky-high levels. As a result, shareholders get lower dividends, and line workers get lower wages.
The usual policy remedies include better disclosure of executive pay packages, increased independence of compensation committees, more direct shareholder input into executive compensation, and more shareholder participation in the election of directors. The SEC has been the government agency traditionally in charge of these matters. Most people believe the SEC has been asleep at the switch.
That's been the state of affairs for the last few decades. The great financial crisis of 2007-2009 puts a whole new light on the issue. For starters, people are madder than ever at overpaid, underperforming executives. It's no longer just shareholders and workers who are paying for overgenerous compensation. The mega-billion-dollar bailout of America's financial and auto giants means that taxpayers are supporting executives' posh lifestyle.
But these are just variations on the old us-versus-them themes. There is a new argument about curbing executive pay that is distinctively different from those of the past. It is not about the fairness and the distribution of corporate wealth, but about efficiency and incentives -- performance-based pay packages have prodded top-level employees to engage in excessive levels of risk. By "excessive" we mean the high level of risk that was in the best interest of employees but not in the best interest of the companies they work for. And because many employers are "too big to fail," these employees' self-interest is not aligned with the best interests of the economy.
This is not a fringe idea. It is the view of regulators in the United States, as reflected in the June 10 comments of Treasury Secretary Timothy Geithner: "This financial crisis had many significant causes, but executive compensation practices were a contributing factor. Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage."
And this is the view of most regulators around the world. Earlier this year, a report from the Financial Stability Board, an international advisory body, stated:
Compensation practices at large financial institutions are one factor among many that contributed to the financial crisis that began in 2007. High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they imposed on their firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system and left firms with fewer resources to absorb losses as risks materialized ("FSB Principles for Sound Compensation Practices," April 3, 2009).
With the benefit of hindsight, everyone now understands that our large and inadequately capitalized financial institutions had poor risk management. Compensation arrangements that fueled risk-taking only put gasoline on the fire. It seems almost a cliché, but the stories are true. Time and again macho superstar traders told wimpy cost-center risk officers to fly a kite . . . until it was too late.
Tax Incentive for Risk
The tax angle of all this is that America's leaders sometimes try to regulate executive pay by changing the tax laws. It started in 1993 when Congress, with strong backing from President Clinton, added subsection 162(m) to the code. This provision capped the deduction for the top five executives of publicly held corporations to $1 million each. A simple pay cap by itself might have been an effective response to the problem of exorbitant executive pay.
But when it came to tax, the Clinton administration never did anything simply. Instead of leaving well enough alone -- after all, Congress had passed a straight cap in 1992 legislation (subsequently vetoed) -- the administration pushed for an exception for performance-based pay. At the time, the popular thinking was that performance-based pay for executives would increase shareholder value and enhance U.S. productivity.
The proposal did not restrain the growth of executive pay. It accelerated it. Compensation consultants laughed out loud at how easy it was to circumvent section 162(m) limits. After 1993 there was a huge shift in executive compensation from straight salary to options and bonuses that qualified for the exception. And in a parallel with the SEC's meager efforts to check compensation, the IRS enforcement was lax.
But now we know the failure of section 162(m) goes beyond its inability to address its originally intended goal of limiting the growth in executive compensation. Contrary to expectations in 1993, the 2007-2009 crisis demonstrated that performance-based pay was not always a good thing. It did not always provide incentives that were beneficial to shareholders and the economy. Instead of helping spur long-term productivity, it encouraged the assumption of massive long-term risks in exchange for short-term gain. And so the performance exception in section 162(m) provided a tax incentive for compensation packages that are widely cited as a major contributing factor to the financial meltdown.
Place Your Bets
How exactly does performance-based compensation encourage excessive risk? The simplest case occurs when there is opportunity for immediate gains in exchange for long-term risk. If you can get a multimillion-dollar bonus for high current-year profitability, you tend to stop worrying about unknown future risks. You may be long gone. You may become rich enough not to care. And there is little to lose on the downside.
In an April 18, 2008, report to shareholders on its extraordinary losses, Swiss banking giant UBS described insufficient incentives to protect long-term franchise value: "Bonus payments for successful and senior [securities] traders, including those in the businesses holding subprime positions, were significant. Essentially, bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings."
Tax Analysts' Lee A. Sheppard describes an example of how Wall Street dealers aggressively loaded up on long-term risk to prop up short-term profits (Tax Notes, July 13, 2009, p. 99, Doc 2009-15310 [PDF], 2009 TNT 131-1). Accounting rules allowed dealers to compress two decades of projected profits from supposedly low-risk AAA mortgage securities into a single year if they were insured by supposedly sufficiently capitalized monocline bond insurers.
Although much is made of the dangers of excessive focus on the short term by executives, risk trade-offs over time are not the only problem. (See, for example, "Overcoming Short-Termism: A Call for a More Responsible Approach to Investment and Business Management," Sept. 9, 2009, Lucian Bebchuk of Harvard Law School describes risky compensation schemes in which the issue is not short versus long term ("Bonus Guarantees Can Fuel Risky Moves," The Wall Street Journal, Aug. 27, 2009).
Suppose a trader receives $1 million in straight salary and a 10 percent bonus on profits expected in the range of zero to $100 million. Now also suppose that because competition is tight for top traders, the trader is guaranteed $5 million of that bonus. As a result, the exec only has incentive to pursue a strategy that gets his unit's profit above $50 million. He will pursue riskier strategies even when less risky strategies have greater expected value. For example, if Strategy A has a 90 percent chance of returning $40 million and Strategy B has a 10 percent chance of returning $80 million, the exec will pursue B because it has an expected value for him of $800,000 compared with zero from A. He will do this even though for his company, the expected value of B is $8 million, compared with $36 million for A.
What would be a good form of compensation that did not encourage excessive risk-taking? That is an open question, but there seems to be a growing consensus that it involves, at least in part, stock that is required to be held over a number of years.
Goldman Sachs CEO Lloyd Blankfein has attained demigod status not only because Goldman survived the crisis but because it has just enjoyed its most profitable quarter ever. He has recommended that senior executives receive most of their compensation in the form of equity subject to future delivery or deferred exercise over at least a three-year period (Financial Times, Sept. 9, 2009). Blankfein himself received $70.1 million in compensation in 2007 despite the 51 percent decline in Goldman's stock price in the 12 months after October 2007 (Tax Notes, Oct. 20, 2008, p. 243, Doc 2008-22061 [PDF], 2008 TNT 201-1).
Blankfein's views are consistent with those in the June statement by the Treasury secretary: "Companies should seek to pay top executives in ways that are tightly aligned with the long-term value and soundness of the firm. Asking executives to hold stock for a longer period of time may be the most effective means of doing this." Geithner added that "directors and experts should have the flexibility to determine how best to align incentives in different settings and industries."
Over the Last 12 Months
Federal government policy on executive compensation has gone through a complex evolution over the last year. Both the Emergency Economic Stabilization Act of 2008 (EESA, P.L. 110-343) and the American Recovery and Reinvestment Act of 2009 (ARRA, P.L. 111-5) have changed the rules. The Bush and Obama Treasury departments have left their own stamps. Both tax and nontax laws have been changed.
Then there is the issue of which companies' executives should have their compensation limited. So far, financial institutions receiving bailout funds have been the focus of attention. But federally assisted automakers also are subject to restrictions. Different limits on compensation apply depending on the type of federal assistance provided.
Many believe restrictions on executive pay should be part of the regulation and risk management practices of all financial companies -- whether or not they receive federal support. Finally, both the Obama administration and Congress are looking to extend executive compensation restrictions outside the financial sector to nonfinancial firms.
To help you understand this mess, here's a simplified timeline highlighting some of the more important developments:
October 3, 2008. President Bush signs EESA into law, providing the Treasury Department $700 billion to aid distressed financial institutions. At the time, Treasury expected funds would be used to purchase troubled assets from financial institutions. There are new tax rules (under section 302 of EESA) and nontax rules (under section 111) applying to executive compensation of financial businesses receiving federal assistance. Section 302 adds paragraph (5) -- "Special rule for application to employers participating in the Troubled Assets Relief Program" -- to subsection 162(m) of the code. It prohibits a deduction for annual "executive remuneration" in excess of $500,000 paid by "applicable employers" to "covered executives." Executive remuneration subject to the limit includes bonuses, stock options, and other performance-based pay excepted under the general rule. Applicable employers are companies from whom Treasury has purchased more than $300 million in assets under EESA. Covered executives are the CEO, the CFO, and the next three most highly paid employees. EESA's section 302 also expands the golden parachute penalties of section 280G for firms receiving bailout assistance.
October 13, 2008. Treasury Secretary Henry Paulson summons the chiefs of nine leading financial institutions to Washington and forces them to accept a total of $125 billion in capital injections from Treasury.
October 14, 2008. Treasury formally announces the creation of its Capital Purchase Program (CPP). The CPP is characterized as a part of Treasury's Troubled Assets Relief Program (TARP) authorized under EESA. Under the CPP, Treasury will purchase up to $250 billion of senior preferred shares (including the $125 billion agreed to the previous day) of financial institutions. Participants must adopt the Treasury Department's standards for compensation for their top five executives. Those standards include: (1) ensuring that incentive compensation does not encourage "unnecessary and excessive risks"; (2) requiring clawback of any incentive compensation paid based on statements of earnings or other criteria that are later proven to be materially inaccurate; (3) prohibition on any golden parachute payments; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000. Treasury also announces similar compensation rules for two other smaller TARP programs, the Troubled Assets Auction Program and the Program for Systemically Significant Failing Institutions. By the end of 2009, Treasury would purchase a total of $177.5 billion in senior preferred shares from 214 financial institutions under the CPP. The IRS issues Notice 2008-94, 2008-44 IRB 1070 explaining the new tax rules for executive compensation under EESA section 302 for TARP participants.
October 20, 2008. Treasury publishes application guidelines for the CPP and an interim final rule detailing mostly nontax executive compensation rules for the CPP. It sets forth a standard requiring any financial institution receiving assistance to forgo any deduction for compensation in excess of $500,000 for each executive as if section 162(m)(5) applied to the financial institution.
December 19, 2008. Bush says automakers GM and Chrysler will be subject to tax provisions limiting executive compensation.
January 16, 2009. Treasury announces amendments to the October 2008 interim final rule to include reporting and record-keeping requirements under the executive compensation standards for the CPP. However, these amendments are later withdrawn and never become effective.
January 20, 2009. Barack Obama becomes the 44th president of the United States.
January 23, 2009. In written responses to a question from Sen. Carl Levin, D-Mich., concerning the limitation on tax deductibility of executive compensation, Treasury Secretary nomineeGeithner says he would "consider extending at least some of the TARP provisions and features of the $500,000 cap to U.S. companies generally."
February 4, 2009. The Obama Treasury issues new guidelines on executive pay for financial institutions receiving aid. The guidelines divide the institutions into those receiving aid under the CPP and those receiving "exceptional assistance," like AIG, Citi, and Bank of America. They do not directly change tax rules. Most notable among the rule changes is the limitation (not just a deduction disallowance) for the compensation (except for restricted stock awards) paid to each of five senior executives in excess of $500,000 annually. For companies that are not receiving exceptional assistance, the $500,000 cap may be waived if the compensation is fully disclosed and submitted to a nonbinding shareholder vote. Treasury also announces its intention to explore long-term regulatory reform of compensation practices at all financial institutions -- not just those receiving government assistance. Treasury expresses interest in say-on-pay and in requiring executives paid with stock to hold that stock for several years before it is cashed out.
February 17, 2009. After its congressional enactment on February 13, 2009, President Obama signs into law ARRA. The act includes a more comprehensive set of rules for companies receiving TARP assistance. The executive compensation provision in the new law that gets the most attention is an amendment sponsored by Senate Banking Committee Chair Christopher J. Dodd, D-Conn., restricting bonuses for the 25 highest-compensated employees at companies that receive more than $500 million from TARP. The tax rules in sections 162(m) and 280G are not amended.
June 10, 2009. Treasury issues the 123-page interim final rule on TARP standards for compensation and corporate governance. These are mostly nontax rule changes. This new interim final rule continues the October 2008 interim final rule requirement that all TARP recipients forgo any deduction for annual compensation in excess of $500,000 for each covered executive. Geithner also announces five principles that will guide Treasury's efforts to manage reform of executive compensation beyond that paid by financial institutions receiving assistance. He also endorses legislation that would grant shareholders say-on-pay and provide board compensation committees greater independence. Geithner explains: "We are not capping pay. We are not setting forth precise prescriptions for how companies should set compensation, which can often be counterproductive. Instead, we will continue to work to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives."