Executive Compensation Essay

Accounting Theory Assignment Executive Compensation [pic] Introduction Executive compensation together with corporate governance systems has received an increasing amount of attention- from the press, corporations, financial academics and also the government. An executive compensation plan is a major application of the agency theory study and, thus, an agency contract between the shareholders and CEO’s of the business, which attempt to align the interests of the owners and the managers by basing the CEO’s or executive’s compensation on some performance measure of the managers expended effort in operating the organization.

Over the last decade scandals such as the Enron and WorldCom have raised many issues and discussion as what went wrong? How did CEO’s walk out with so much money” and are executives overpaid and greedy? Executive compensation plans are present in our daily work lives since they set “parameters” for compensation for executive remuneration. Most plans usually encompass net income and share prices; some plans only include net income. The most common forms of compensation are bonus, shares, salary, and stock options.

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This papers focus is on the effects of performance measures in motivating manager interests. The incentive plan involves a mix of incentive, risk and decision horizon considerations. Executive compensation plans are important to accountants. Because they introduce a second major role of financial report: the role to motivate and monitor manager effort. If net income is informative and reflective of manager effort it improves the operation of the managerial labour markets and motivates productivity. Our main focus are addressed below:

Theory of executive compensation -Discuss compensation committees -Net income -Persistent earnings -Share price -Sensitivity to earnings and share price Incentive Contracts -Are they necessary? -Discuss no and yes for necessary -How do incentive plans align interests of manager with shareholders? -Provide example of incentive contract Role of Risk in Compensation -How do we control risk? -Describe types of risk -Describe effects of too much risk -Describe effects of too little risk Politics of Executive Compensation Attracts political controversy -Are executives overpaid relative to firm performance? -Regulation of increased disclosure of executive compensation Compensation Committees Compensation committees are a corporate governance device whose intention is to design a compensation program that attracts, retains and motivates managers and senior executives. It also designs a plan that delivers an efficient combination of sensitivity to earnings and share price, the precision of measuring earnings and share price, the decision horizon imeframe that the manager is responsible for and the risk regarding compensation to the company and the manger. The composition of the compensation committee needs to be made up of individuals who are not affiliated with the company in order to be objective in it’s planning of the compensation. An example of a compensation committee is included in the Bank of Montreal’s Report on Executive Compensation as outlined below: “A majority of the members of the Committee are resident Canadians who are not affiliated with the Bank for purposes of the Bank Act (Canada).

Each member of the committee is not an officer or employee of the Bank or an affiliate of the Bank; and is “independent” within the meaning of applicable Canadian securities laws and New York Stock Exchange rules. ” Once the committee has been established, then the task of creating an effective compensation plan begins. Compensation plans are generally based on either net income or share price, but a truly effective compensation plan is devised using both net income and share price.

If net income of the company has high precision of information and a great deal of sensitivity to manager effort, then a greater amount of compensation can be based on net income and less on share price. The sensitivity of a compensation plan to net income can be achieved by moving to a current value accounting system, thereby reducing recognition lag. This will result in more payoffs from the manager’s effort in the current period. However current value accounting reduces the precision of the information, which means there is less importance for net income in compensation.

On the other hand, share price is more sensitive that net income sooner to certain events such as acquisitions and mergers or R&D. This sensitivity makes share price a better device for calculating compensation. Share price however is not as precise as net income since it can be affected by events such as changes in the economy’s interest rates or terrorist attacks that has nothing to do with manager effort. An alternative approach to increasing sensitivity in net income is to ensure full disclosure, especially concerning unusual and non-recurring items.

Full disclosure makes it more difficult for managers to shirk by choice of accounting policies and enables the committee to evaluate manager effort and ability as well as earnings persistence. Persistent earnings are a more sensitive measure of current manager effort then price-irrelevant earnings, which may arise independently of effort. Compensation committees tend to value persistent earnings when they are setting manager compensation.

The compensation committee can adjust the relative proportions of the net-income based and share price based compensation for manager effort as well as to ensure that the compensation package is meeting the objectives that the committee intended it to. If the committee wanted to base compensation on short-run manager effort, then it would move the compensation to be based more on net income. Conversely if it wanted to base compensation on long-run manager effort, then it would move the compensation to be based more on share price.

Basing the compensation plan more on share price tends to align the interests of the manager more with those of the shareholders. It is still not a foolproof solution though. As we have seen in cases such as Enron, share price does not always reflect the true value of the business. I believe this is why a good compensation plan should be based on information from both net income and share price. Another important factor for the compensation committee would be to review on a regular basis the compensation plan to ensure that it is still meeting all of the goals and targets that it was designed to.

It should also be reviewed with the compensation that was awarded to ensure that the amounts paid are in line with the intended compensation package. See below for an excerpt from the Bank of Montreal Report on Executive Compensation regarding their Annual Compensation Review Process. Incentive contracts To begin the discussion about incentives the first question that would occur in most of your minds is, are they necessary? Naturally, “human beings need incentives to encourage them to seek and attain goals”. (Dr. A. L. Dartnell, CGA, online lecturer) Incentives for people can cover a wide range of objectives.

A popular notion is presumed by many of us is that promotion and recognition in a firm should be sufficient to encourage mangers not to shirk – and often this is not achieved. A direct measure to reward particular effort expended to reach a goal would be a pay-off. A pay-off is considered a good method to have the manager onside and doing his or her very best. When first introduced to agency model our reaction was that managers don’t need to be motivated by performance measure. One would expect mangers to want to work hard; otherwise, they will not go ahead in the organization and will lose earning power by destroying their reputation.

This is a similar reaction shared by Fama an influential finance academic who assumes in his studies that managerial labour markets work well an the forces of reputation on the managerial labour market are enough to motivate the mangers to work hard. However, if the predictions of the agency model are taken seriously, such reactions needed to be countered. Both analytical and empirical studies (namely Wolfson) suggest that while organization and reputation considerations help to control moral hazard, they do not do so completely – an incentive contract is necessary.

As students the effort you expend depends on your individual ability to pass the course. With particular reference to CGA courses, most of us would most probably not work as hard if the course required only completing assignments to pass the course. No one questions your motivation, and, presumably, a good knowledge of the course material will help you do well in the accounting world. Consequently, you would put some effort into learning the module material but not as much as if you were under the pressure and risk of a final examination.

Since your efforts in studying the course material cannot be directly observed, a moral hazard problem is present. It seems that the incentive device of an examination is still needed. Designers of compensation plans tend to agree. According to research done by Watson Wyatt, most shareholders and regulatory bodies are under immense pressure to align executive compensation with the shareholder interests. This is because CEO’s who earned above- median increases in their cash compensation (this is the bonus plus the base salary) for 2004 delivered a return of 19. 4% -which – more than twice their counterparts who earned below-median increases.

His study also concludes that pay-for-performance philosophy is taking hold. In a recent article published by Management Issues “Executive incentives failing to boost performance” the paper discuss that British incentive plans are so complex that CEO’s fail to perform better. . With this view being conceived most organizations are usually making constant changes to their compensation plans to make shareholders and executives happy. Traditionally, when CEO’s perform well they are rewarded for their performance. However, studies have shown that this also gives rise to anomalies “where performance is anything less than stellar”.

Most compensation plans are not successful at aligning shareholders and executives interests over a sustained period. (Tom Gosling, executive at PWC). Some plans can very complex meaning that executives undervalue them and therefore the incentive to perform better is not effective. . A better alignment of reward would be to delivering more of an executive’s total pay in company shares and stock ownership. Although companies are trying to achieve better pay for performance, remuneration committees are busier than ever and motivating and retaining executive employees “it seems difficult to get it right”.

Currently, most large organizations are now reducing their usage of ESOs and replacing them with other compensation components, such as higher short-term incentive bonuses and the introduction of a 2- year stock based performance award. Presumably, this reduction is due in part to the abuses of ESOs, e. g. , CEOs tendency to manipulate share price upwards so that their ESOs become “deep-in-the-money” and also the “pump-and dump” behavior, which have raised serious questions about ESOs’ incentive value.

Most firms are shortening the decision horizon; however, this creates the possibility of short-term opportunistic manager behaviour such as deferral of maintenance, under investment in R & D etc. The article below explains if there is a magic formula to work out a good compensation plan: “With all the talk lately about the exorbitant salaries of CEOs, there was a good news story that hit the airwaves last week. CEO of Japan Air Lines, Haruka Nishimatsu was reported to receive $90,000 annual salary. Yes, that’s right, not $9 million, not even $900,000, but $90,000.

And there are no bonuses or share options attached. In fact Nishimatsu gets paid less than his pilots – and JAL is one of the worlds top 10 airlines. He doesn’t even get an executive perks and also lines up in the staff canteen with his fellow workers for lunch each day and even catches the bus to work. JAL was going through tough times in 2007 when Nishimatsu was appointed CEO. There were job cuts and early retirement. As he commented “The employees who took early retirement are the same age as me. I thought I should share the pain with them. So I changed my salary. ” Now that’s really “walking the talk”.

In comparison to most CEO’s of US Companies averaged $10. 8 million in total compensation in 2006, more than 364 times the pay of the average US worker. There have been a lot of discussions by governments globally to take measures to limit the pay to CEO’s and senior executives. Although nothing has happened yet, this seems to spark another financial crisis meltdown in the future. Then is there a magic formula? No one seems to have come up with the most perfect formulae to deal with this, since; there is an incorrect management philosophy that you must “pay people to perform”.

When CEO’s get incentives or rewards it’ only natural they will focus almost exclusively on short term, bottom line results. A popular doyen in management philosophy and practice once suggested to his students “CEO salaries should be a maximum of 20 times the salary of lowest paid worker”. A good pay scheme would preferably have the following four components: 1. Base salary. Needs to be in line with industry standards, appropriate to the role and to be seen as “fair and equitable” both within and external to the organization. 2. Share of company profits.

Needs to be calculated on net profit prior to distribution to shareholders. This should be the second highest component of the salary package for CEOs and senior executives. Once again, it would be limited to 20 times the share of profit received by the lowest paid worker (Yes, that’s right, everyone should share in the profits). Shareholders through their reps, the Board, would approve profit share. 3. Team performance rewards. Based on a pre-determined set of criteria and relative to the top team’s performance. This should be the third ranked level of salary package component.

Limited to 20 times the bonus reward for the lowest paid organizational team performance. Up to a maximum of 20% of average individual profit share (as in point 2). 4. Individual performance reward. Based on the achievement of pre-set goals. This should be the least component of salary package. Limited to 20% of base salary. What gets rewarded gets done. This approach to remuneration, rewards; teamwork, a sense of community, a drive for performance, and above all a sense of “we are in this together” – all stakeholders working for the betterment (and rewards) of the organization.

Peter Drucker was right. The magic number is 20! Based on the above article we conducted a thorough research into the Bank of Montreal’s Executive Compensation package. The below plan is somewhat consistent with the predictions of the agency models. It contains several different incentives; based on net income, share price, and individual contribution such as creativity and initiative. BANK OF MONTREAL COMPENSATION PLAN (EXCERPT SUMMARY) Executive Compensation review for implementation in 2008 • This was carried out by the Committee and the President and CEO of the ank • Purpose of the review was to enhance effectiveness and efficiency of the banks compensation program to drive top –quartile performance • Focused on the linkage between levels of pay and levels of performance achieved as measured against target to achieved • It sought to enhance the recruitment, retention and motivation of executive talent through competitive pay opportunities while ensuring alignment of compensation practices with bank strategies for maximizing shareholder value Elements of Executive Compensation: 1. Base salary: • Determined at the market rate Paid in the form of cash annual in cash 2. Short-term incentives: (STIP): about 235 participants A. Cash • -Paid to all executives based on Bank results for one year; • Individual awards are focused to reflect performance against predetermined business and individual objectives; B. Deferred stock units: • Paid to senior executives and selected offices in BMO; • Until executive terminates employment with the bank • Stock units are awarded in lieu of cash payments and payouts are based on the final value of an equivalent number of bank’s shares. For Senior Executives the level of incentive pool funding included relative performance where Total Bank earnings per share and revenue growth are assessed to the other 5 major banks 3. Performance and or restricted share units issued under the mid-term incentive plans • Paid mostly to most executives and selected officers in BMO • For a performance period of 3 years • Attainment of performance on productivity vs. planned performance • Individual awards are based on individual contribution and sustained performance 4. Stock options issued as long term incentives About 190 participants • Performance period is up to 10 years; The complexity and sophistication of the BMO plan is consistent with Holmstrom’s prediction that real compensation plans will include several different incentives. Therefore, are incentive contracts necessary? “Yes”, they are because in the presence of moral hazard incentive contracts are necessary to align shareholders and manager’s interests. When compensation is based on performance measures, the manager is motivated to work hard. This aligns manager and shareholder interests.

Secondly, compensation based on share price motivates a longer manager decision horizon than compensation based on net income. Lastly, the relative proportions of these performance measures control the length of the manager’s decision horizon. An executive compensation plan is an incentive contract between the firm and the mangers that tries to align the interests of owners and mangers. Most executive compensation’s are done basing the manger’s compensation on one or more performance measures, that is, measures that predict the payoff from the manager’s effort in operating the firm.

Compensation plans have come along way and despite all the financial scandals from Enron to the present day mortgage meltdowns and the CEO’s walking away excessive compensation packages; the Regulators, Standard Setter and corporate governances are “still trying to get it right. ” Role of Risk in Compensation Equity-linked compensation has been widely adopted by corporations during the last two decades. This phenomenon characterizes the acceptance and application of agency theory in most business settings.

The theory is concerned with resolving the problem arising from moral hazard and adverse selection in agency relationships and which explicates the modern framework of managerial labour contract. The spirit of executive employment contract is to motivate manager to ‘act’ and ‘think’ like owners through the profit and risk sharing process and hence equity vehicles such as stock option, stock appreciation right, restricted stock units and preferences shares are used significantly in corporations where control and ownership is in separation.

The trend is consistent with agency theory that fixed salaries comprise a declining percentage of total compensation. Equity-linked compensation is granted to manager as an optimal incentive arrangement to properly align manager and shareholder’s interests. Value of these equity-based compensations usually equals to a few times of executive’s annual base salaries. Ultimately, the implication is to link ‘pay to performance’ and which are often measured by firm’s net income and share price. It is undeniable that the level of CEO pay is an outcome of fairly efficient labour market.

However, are these equity vehicles really efficient in attracting and motivating the talent directors who have direct influence over the corporate performance and share price? The success of executive compensation design must be built on the appropriate level of risk and the underlying incentive. In contrast, unable to compromise the risk preferences between shareholders and managers may result in higher compensation costs, higher executive turnover and excessive use of earnings management. Type and impact of risk

Nevertheless risk mitigates the agency problems between the two parties, when risk is beyond manager’s control, the effort incentives declines. Lisa Meulbroek, a professor at Claremont McKenna College said, “rowing (… ) does not affect the boat’s progress very much relative to the effect of (a) hurricane”. Thus, to attain a desired relationship between risk and reward, potential risk must be assessed relative to the size, growth and strategic needs of the companies. Manager is a rational, risk-averse individual who is only willing to undertake a given level of risk for a desired return.

However, manager’s perception of risk differs from shareholders. It is because managers cannot fully diversify their investment risks through balancing portfolios across different industry sectors and companies; as their worth and human capitals are solely tied to their own firms. In addition, manager’s ability to exercise the stock option usually is restricted by years of services, performance thresholds and retention limitations. Stock option may even become worthless to the director during bad times. On the other hand, hedging the stock option often is prohibited to create incentive or ruled specifically by SEC filing.

Consequently, risk-adverse managers are exposed to the firm specific risks. It is not difficult to understand why directors discount the value of the stock options. Hall and Murphy (2000) used an “expected utility” approach to estimate the value stock option. An executive with some risk aversion and 50% of his wealth placed in company stock, a 10-year option granted at the money is worth only 63. 5% of its Black-Scholes value. Meulbroek (2000) also found that a manager of typical NYSE-listed Company values stock options at an average of 70% and for industries that are rapidly growth and entrepreneurial based, its value even drops to 53%.

For instance, internet-based firms may be better off in selling shares externally and reward managers with cash compensation to achieve incentives. When it costs the firm higher than what is valued by the executive, the effect of stock ownerships in aligning the interests of two parties is debatable. Therefore, the trade off between risk and incentive must be further analyzed from the cost and benefit perspective and constantly reviewed by the compensation committee.

Peter Chingos, author of “Responsible Executive Compensation for a New Era of Accountability stated that “Tying their incentive compensation to these factors turns their rewards into a form of lottery where chance dominates actions in determining outcomes”. Another issue arising when pay is substantially driven by net income and share price measure, it enormously inherits executives ought to meet the expectation of share market and investors in order to sustain their positions and remunerations. Indeed, oor performance may be caused by overall, undiversified, systematic risks like financial crisis, change in interest rates, environment, regulatory and technology. Despite managers have no influence on these factors as well as the general, market and industry volatility, managers are sometimes involuntarily blamed, penalized and potentially be held accounted for such economic consequences. In fact, share price is a noisy measurement of performance. Executives in firms with more volatile stock prices will receive less performance-based compensation.

In Aggarwal and Samwick’s analytical research, they used the variation in stock return volatility across firms to test its implication to pay-performance sensitivity of a manager’s compensation. Their findings support the principal-agency model is that compensation contract incorporate the benefits of risk sharing and “… that executives in companies with the lowest variance have pay-performance sensitivities that are an order of magnitude greater than those of executives in companies with the highest variance. Journal of Political Economy (February1999), vol. 107 (1), p. 103 The grant price, exercisable condition and vesting period of various equity mechanisms may be different but their characteristics are tailored for the same purpose – to create loyalty and long term work incentives. Executive normally need to hold the equity stock for a period of time before trading. In reality, some executives may not even have the financial merits to purchase these stocks. Also, the wealth of the executive increases under the condition that stock price appreciates over time.

When executive’s personal wealth is predominately connected to the volatile share price and noisy performance measure and if there is no assurance for downside risk, manager struggles to maintain the financial position and tends to avoid risky projects, focuses on short selling or manipulate earnings to meet financial targets. As a result, conflict arising from this adverse selection jeopardizes shareholders’ return. On the other hand, it is rational to control upside risk, otherwise, shareholder will suffer more losses than the manager.

As managers may feel that they have everything to gain but nothing to lose so it is absolutely worthy to undertake aggressive strategy in order to boost up earnings. This situation is identical to the classic illustration of moral hazard – fire insurance. If the insured individual does not have to pay deductible and additional premium in the future, he will have no incentive of preventing fire damage. Another example is the accounting sandals of Enron, WorldCom, and Tyco that brought executive compensation to the headlines during the past few years.

These companies had similar falling patterns: initially, the greed drove these CEOs to manipulate earnings excessively to fool investors, then their share prices skyrocketed, CEOs gained million/billion of dollars from trading their own companies’ shares, eventually companies filed bankruptcy, CEOs were found guilty of illegal accounting treatments and sentenced to jail. Peter Pearson, Chairman of the Blackstone Group said that stock options temptation contributed to these opportunistic accounting policies. How to control risk

Risk analysis is important in understanding the portfolios of shareholder and managers in order to determine how the underlying incentive influences manager in firm operations. The increasing demand of disclosure by SEC is beneficial to the public as when the compensation becomes more transparent, company is able to utilize this information to perform risk analysis and comparison with peer groups. Such analyses are valuable in creating award package that better fit the incentive purpose and corporate goals. To maintain a manageable pay-for-performance environment is complex and challenging.

Manager must bear risk to enhance incentive; however, their personal risks generated must be protected by a bogey in the compensation plan. For example, the structure of the compensation plan should include fixed salaries, annual bonus, short-term incentive, decision horizon and long-term compensation. The proportion of each component must be carefully weighted according to manager’s risk tolerance. Simultaneously, upside limit must also be set to prevent excessive risk taking. To develop executive pay program with a bias toward creating stock ownership is also essential.

The award process must be governed and reviewed periodically. The committee should compare whether the executive has actually purchased the stock according to the established guideline. Moreover, the firm may adopt other proxies to measure performance other than net income and share price, such as choosing peer group for executive pay and performance comparison, comparing incentive plan metrics with benchmark group of competitors, reviewing others absolute metrics includes ROE in percent, ROI in percent, EPS in dollars) Politics of Executives Compensation

The executive compensation controversy generated important political responses affecting the disclosure, accounting and taxation of top-level executive compensation. While the amounts of senior executive compensation are large, they may not be as large as they seem, due to manager risk aversion and restrictions on disposal of shares and options received as part of the compensation package. The effect of risk aversion on the value of stock-based compensation to the manager was studied by Hall and Murphy (2002), ranging up to a 55% reduction for a highly risk averse individual

Much public criticism of excessive CEO pay focused on comparison of the pay levels of CEOs with pay levels for lower-level workers. “The perception among reporters and other critics that the corner suite is sinecure with huge rewards and little accountability bears no resemblance to present reality. Fully half of the Fortune 1000 companies have replaced their man at the top since 2000. ” [Off with their Heads,” editorial, Wall Street Journal, August 1,2006]. “Each year shocking news of CEO pay greed is made public. Investors are concerned not just about their growing size of executive compensation packages, but the fact that CEO pay levels show little apparent relationship to corporate profit, stock prices or executive performance. How do they do it? For years, executives have relied on their shareholders to be passive absentee owners. CEO’s have rigged their own compensation packages by parking their boards with conflicted or negligent directors. (AFL- CIO’s web site:) Political ramifications of executive compensation • Executive compensation attracts political controversy due to the large amounts of compensation that are often involved. Some argue that executives as a group are overpaid, pointing to low sensitivity of executive compensation to firm performance, especially when performance is poor. • Others argue that executives are not overpaid, pointing out that the amount of compensation received is very small relative to the shareholder values created. Also, managers cannot diversify away their compensation risk. • Regulators have reacted to this controversy by requiring increased disclosure of executive compensation; on the grounds that the managerial labor market and the shareholders of individual firms can act if pay becomes excessive.

Are Executives Overpaid relative to firm Performance? CEOs compensation is far unrelated to their performance. Many potential causes of overpayment are • CEOs with too much power • Inattentive boards of directors • Conflicts of interest by compensation consultants • Use of stock options–the list goes on. Is It Justified- HOW MUCH IS TOO MUCH? John Mariotti, president and founder of The Enterprise Group asks “CEO Pay: How Much is Too Much? ” and answers the question himself. Citing Derek Bok, he points out that as business becomes more complex, the demand for top executives increases and thus they command greater and greater pay.

He also noted that such huge awards do little to motivate these outstanding performers, who are generally more motivated by challenge. Mike Hughlett, Staff Writer for Pioneer Planet, thinks the reason why CEO pay soars so high is that the compensation committee, usually comprised of other chief executives, generally sets CEO’s pay. Some observers have claimed that there is huge gulf between the paychecks of executives and the average workers and some believe that such comparisons are meaningless. Executives shoulder much more responsibility and usually come with degrees from the country’s top universities.

Putting arbitrary caps on executive pay is like putting a ceiling on rock bands’ earnings. Studies show the average CEO was paid $10 million to $15 million in 2005. This includes their salary, bonus, stock option gains, stock grants, and various executive benefits and perquisites. Some data sources indicate the average American worker was paid about $40,000 in 2005 There are various myths and realties as to executives pay only rises. The reality is such that Executives pay rises and fall in tandem with stock prices and the financial performance of the company.

For example, Allan Reyonds an Economists, stated, “ The income of the top 100-500 CEO’s rose unexpectedly with the stock market boom of 1997-2000 then fell by an estimated 48-53& in 2003 “. Such ups and downs of CEOs’ pay can’t be explained by the theory that mangers dominate their boards. Stock price down, but CEOs pay up “Pay for performance? Forget it. These days, CEOs are assured of getting rich — however the company does. ” In light of recent events in the financial markets, which have cast a shadow over expensive executive-compensation packages, particularly at companies that have performed poorly?

Two examples given by the authors are Home Depot and Merrill Lynch. Although Home Depot’s stock was struggling, its chief executive had an executive pay package valued at more than $190 million. When he left Home Depot in 2007, CEO Robert Nardelli received a severance package worth $210 million. Merrill Lynch CEO John Thain was the highest paid chief executive in 2007. Even as the brokerage firm’s slide was well underway, he took home total compensation of $83. 8 million. Billions of dollars have been paid to thousands of executives who have destroyed companies and ruined workers’ lives.

I have seen executives join a company shortly before a takeover and get millions in “change in control” payments. Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers and Bear Stearns are giving out $39 billion in bonuses for 2007 despite posting huge losses in the past year, Bloomberg News reported. CEOs aren’t overpaid Some argue that CEOs are not overpaid, when rock stars make big money, we can look at the ticket and album sales and understand where it comes from. However, when a CEO makes a rock star income, we figure he must be scamming the shareholders.

In other words, CEOs take advantage of their influence over boards to get what they want, regardless of performance. The possibility that executive compensation is largely driven by supply and demand for scarce executive talent is rarely mentioned. But it happens to be the truth. Of course, no candidate has their capabilities flashing on his forehead; that’s part of what makes the board’s job so difficult, and why CEOs don’t get paid more than they do–boards discount pay for uncertainty. Nevertheless, a top candidate, presumably someone with a strong reputation and plenty of opportunities, has significant bargaining power.

Nearly every reform attempting to rein in CEO pay has been based on some version of the managerial power thesis. These attempts have proved ineffective or backfired in exactly the way one would expect if executive compensation were driven by a reasonably well-functioning market for talent. For those of us who work with boards, the managerial power idea is impossible to reconcile with our experience that the vast majority of today’s directors are very conscientious, anxious to exercise their independence, and, if anything, wary about overpaying the chief.

All of this is not to say that the system works perfectly. Managerial influence is real, and occasionally overbearing. There are some weak boards out there. A few CEOs are visibly overpaid. But to continue to recommend and implement reforms based on a theory that directors are lazy, incompetent or corrupt–or that competition for talent is an afterthought in setting pay–only invites policies that impose costs on companies for which there may be no offsetting benefits, and which may create distortions that actually undermine shareholder value. Regulating Executives Compensations

A well-designed compensation program should not need to be modified if performance is not where it is expected to be, because under a well-designed compensation program, poor performance should lead to a relatively reduced payout. The role of monitoring manager performance and enabling efficient compensation contracts is as important to society as the role of communicating useful information to investors. Excessive executive compensation has come under increased scrutiny as countries have resorted to bailout plans to stabilize their domestic banking sectors. Many of these plans incorporate some restrictions on executive pay.

Companies should now review their compensation practices and procedures for executives. In particular, boards of directors and compensation committees should examine closely existing arrangements for incentive forms of compensation, caps on total compensation, and levels of severance and change of control benefits. Transparency Talent managers have a responsibility to executive boards and compensation committees to ensure the level of pay provided to executive teams is based on tangible performance. All pay decisions must be defensible, requiring a high level of comparative analysis in the compensation-design process.

Talent managers’ executive-compensation programs must illustrate how to drive shareholder value, increase share price and be competitive and reasonable. The new proxy-disclosure rules ask compensation committees to detail the connection between executive pay and performance in a compensation discussion and analysis that explains how they make decisions, the process or rationale for those pay decisions and how they link back to actual company performance in a given year. “HR professionals need to think more carefully about the design of these programs,” he said. There’s much more transparency spelling out costs — particularly on change and control and in termination events — understanding from a shareholder perspective more clearly the amount of wealth creation coming from equity and other things. As I design, I need to make sure there is enough stretch to force the executive to perform well, whether it be increased revenue, profitability or things along those lines. ” A company’s performance levels; total shareholder return, or growth in revenue; and profitability, or operating income, all must compare favorably with its overall level of executive payment.

If a poor-performing company still is giving out top-level payment — that compensation committee didn’t do its job. “We’re starting to see more companies say, ‘You’re only going to get your bonus if you meet a financial or business milestone that is going to increase the overall value of the company. ‘ What was criticized over the past couple of years around executive pay — no linked performance, excessive use of options and equity when there was not a lot of value coming from it — those things are being changed,” he said. Benchmarking pay

There is even a demand that the fat cats who had collected disproportionate pay cheque and other perks and benefits in various names from the companies they headed should be forced to return whatever is determined to be in excess of what is computed as their legitimate compensation by applying fair and equitable criteria. Some of the criteria being mentioned are: The equity base, the average return over a given period, the volume of transactions, reasonable ratio between the highest and the lowest paid employee, present and likely future investments and return on them and the prevailing trends in the industry in other industrial countries.

Disclosure Disclosure facilitates better monitoring of executives compensation. Public disclosures effectively ensures the executives contracts in publicly held corporations and not a private matter between employers and employees, but are rather influenced by media, labor unions, investors, creditors and by political forces operating outside and inside company. Disclosure and publicity of pay allows us to identify the egregious situations and apply pressure to fix them, but only when the data seem accurate to reasonable people.

In Canada and the USA the securities commissions recognize the importance of full disclosure of compensation. If the managerial labour market is to work properly to hold mangers to their reservation utility levels, an obvious minimal requirement is that the market knows how much compensation the manager is receiving. These disclosures have recently been expanded. For example the new guidelines for disclosure of pension costs for senior executives issued by Canadian Securities Administrators. Government Regulation/Limiting Tax Deduction

There have been proposals for limiting tax deductions for excessive compensation, requiring shareholder review and/or approval of compensation arrangements, and placing further limits on severance benefits. Recent experience of fraud and misconduct in a number of companies in the US and elsewhere has made it amply clear that self-regulation has not worked and will not work. Therefore, government keeping a wary eye on the enforcement of whatever pattern is arrived at becomes unavoidable. Vexed question Whatever the criteria, the matter of bringing the top executives down to earth, even if it be with a thud, brooks no delay.

The idea of what has come to be known as ‘claw-backs’, meant to recover from former bosses their ill-gotten bonanzas is most alluring and one would like to be personally present and watch their faces as they cough up what they had so brazenly appropriated for themselves without any sense of social responsibility. A salutary outcome of the global financial crisis is the coming into the open of the outrage universally felt over the sky-rocketing amounts in salaries, bonuses and severance compensation misappropriated by the top executives of firms, with the CEOs setting an awfully bad example.

Indeed, some sort of a rule had come to be established that the worse managed a firm, the more serious the malfeasance, the more ruinous the consequences for investors, the more astronomical will be the payments to the top brass. No wonder the state of affairs has earned the apt description of “heads-I-win, tails-you-lose with any answerability, accountability, and guarantee of performance. Salaries and bonuses of CEOs should be based on their success at improving their companies and bringing value to their shareholders References: Aggarwal, Rajesh K, and Andrew A.

Samwick. “The Other Side of the Trade off: The Impact of Risk on Executive Compensation. ” Journal of Political Economy (February1999), vol. 107 (1): 65–105 Brian J. Hall and Kevin J. Murphy, “Optimal Exercise Executive Option”, American Economic Review, May2000, Vol. 90 Issue 2, p209-214 Brian J. Hall and Kevin J. Murphy, “The Trouble with Stock Options”, Journal of Economic Perspectives—Volume 17, Number 3— Summer 2003—Pages 49–70 CGA Accounting Theory and Contemporary Issues, Lesson Notes Module 8: Conflict between contracting parties, 2007 Printing. ttp://www. cga-education. org/2007-08/at1/modsums/modsum08. htm CGA website Audio lectures and hand notes Module 8 Conflict between contracting parties, page 1 to 4 of 16. http://www2. bmo. com/bmo/files/annual%20reports/3/1/ExecCompReport. pdf Charlie Rose – “WorldCom update / Business and Ethics”, 2007 video http://noolmusic. com/google_videos/charlie_rose___worldcom_update_business_and_ethics. php Chingos, Peter T. , “Responsible Executive Compensation for a New Era of Accountability”, John Wiley & Sons, Inc. , Sep 2007, p. 180

Jenter, Dirk, “Executive Compensation, Incentives, and Risk”, MIT Sloan School of Management Working Paper 4466-02. April 2002, page 8 Kay, Ira, “Myths and Realties of Executive Pay”, Cambridge University Press, 2007, P. 154-159 Meulbroek, Lisa K. “The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options,” Financial Management, Vol. 30(2). Summer 2001 Murphy, Kevin J. “Executive Compensation. ” in Handbook of Labor Economics, Ed. O. Ashenfelter and D. Card (NorthHolland: Elsevier: 1999), vol. , chap. 28, pp. 2485–2563. Nemeth, Martin, “Explorations in Executive Compensation – Executive Compensation Risk Modeling” http://www. riskmetrics. com/sites/default/files/RMGExplorationsPayRiskModeling20080520. pdf [Off with their Heads,” editorial, Wall Street Journal, August 1,2006]. William R. Scott, Financial Accounting Theory, Fourth Edition (Scarborough, Ontario: Prentice Hall Canada Inc. , 2007) ———————– Annual Compensation Review Process Each year the Committee reviews the levels of compensation for all xecutives, and in particular for Senior Executives, which includes the Named Executive Officers whose compensation is detailed beginning on page 33. This benchmarking process assesses both “actual” compensation delivered to executives through base salary, short-, mid- and long-term incentive awards, and the policy or “target” levels for these programs. The objective is to ensure that the total compensation position of the Bank’s executives compares appropriately with relevant comparator markets. The impact of the benefits, perquisites and pension programs is also considered.

At the beginning of each year the Committee established business performance targets for funding the executive short- and mid-term incentive plans. These targets are set at a level consistent with the Bank’s business targets, with the objectives of driving desired business results and providing a competitive level of pay relative to the results achieved. Threshold and maximum performance levels are also set, to ensure appropriate limits are placed on minimum and maximum payout amounts and that an appropriate relationship exists between pay and performance.

On at least a quarterly basis, the Committee reviews the year-to-date forecast business results and the incentive pool funding that would result. To provide the Committee with the full context in determining annual incentive pool funding for short- and mid-term incentive plans, consideration is given to the achievement of the business performance goals that were established at the beginning of the year. Judgment is then applied to increase or decrease the formula-derived level of pool funding in order to determine the appropriate level of incentive compensation pool funding.

In determining annual compensation decisions, a total compensation tally sheet for each Senior Executive is reviewed by the Committee. These tally sheets attribute a dollar value to each component of compensation, including: salary; short-term cash incentives; vested, unvested and previously paid equity awards; benefits; perquisites; pension including annual increases to liabilities, accumulated liabilities and projected payouts at retirement; and potential change in control severance payments.

The Committee reviews and recommends to the Board for approval the compensation of the President and Chief Executive Officer. The Committee reviews and approves the compensation of the other Senior Executives after considering the annual performance assessments and recommendations of the President and Chief Executive Officer. In addition, the Committee reviews and approves the aggregate annual awards of salary; short-, mid- and long-term incentive plans for executives, other than Senior Executives.

The President and chief Executive Officer is responsible for reviewing and approving all recommendations for the executives, other than Senior Executives, within the Committee approved aggregate award amounts. Any modifications to compensation design features being considered are first validated through a stress-testing process. An analysis is conducted to demonstrate to the Committee that the revised design should provide an appropriate result in future years.

Executive Compensation Essay

COMMENT EXECUTIVE COMPENSATION DURING ECONOMIC TURMOIL Student[1] I. INTRODUCTION The economic downturn in late 2008 brought forth the resurgence of an interesting topic – executive compensation. This topic was bound to bring much controversy as a result of the dramatic increase in executive compensation over the last decade[2] and the recent massive failure of many large companies. [3] Adding to the public interest was the 2008 United States Presidential Election, which featured two candidates taking very strong stances on executive compensation. 4] As a result of the recent economic downturn, the government stepped in to try to prevent the economy from an even greater downturn, and as a result, restricted the compensation allowed for high-ranking executives of companies receiving bailout funds. [5] The banking and investment crisis in 2008, the transition of Presidents, and legislation including the Emergency Economic Stabilization Act of 2008 (“Bailout”) and the American Recovery and Reinvestment Act of 2009 (“Stimulus package”), provide us with a great platform for a discussion on the topic of executive compensation.

The goal of this article is to give a thorough overview of executive compensation as it exists in our society today. This article will examine executive compensation as it was,[6] as it is,[7] and what it might be in the future. [8] Also included in this article will be an examination of who sets executive compensation[9] and how it should be set. [10] II. BACKGROUND ON EXECUTIVE COMPENSATION A. Pre-1993 Law Prior to 1993, “there was no specific limit on the amount of deductible compensation. ”[11] Companies were able to use compensation paid to employees for tax deductions to help save money by paying fewer taxes.

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Also included in this tax deduction was the salary of the top executives, even the chief executives at very large corporations. [12] There was governmental concern about the amount of excessive compensation paid to executives at the time, which lead the government to make efforts to reduce the amount of compensation executives could receive. [13] B. 1993 Changes A tax change in 1993 put a $1 million limit on the deductibility for top ranking executives’ salaries at public companies. [14] These “top ranking executives” included the CEO and the four highest compensated officers not including the CEO. 15] As a result of this change, if an executive makes more than $1 million in a given year in cash or benefits other than cash, then the company cannot deduct the executive’s salary for any amount beyond the $1 million threshold. [16] In order to pay executives more than the $1 million per year cap and still benefit from a tax deduction, companies used other types of compensation that do not count towards the $1 million cap, allowing them to pay executives basically as much as they wanted, but still receive a tax break. 17] C. Types of Executive Compensation There are many different types of executive compensation. [18] With the 1993 tax law changes, companies have been forced to find alternatives to salary (cash) in order to continue paying their high-level executives more than $1 million and still benefit from a tax deduction from the compensation paid to their high-ranking executives. 19] The alternatives that companies have found normally have to do with performance-based compensation because this type of compensation has been deemed to be tax-deductible, even beyond the $1 million threshold set in 1993. [20] i. Salary The most common and recognized type of executive compensation is the executive’s salary (cash). [21] Quite simply put, an executive’s salary is the base amount of cash paid to an executive, and is normally paid on an annual basis. 22] Salary is not based on performance, but is essentially the lowest possible amount that can be paid to an employee over a set period of time (barring severance). [23] Salary is counted towards the $1 million cap, so most companies try to avoid paying too much salary and focus on other forms of compensation when they want to pay their executives more than $1 million. [24] ii. Performance-Based Compensation The main form of compensation that is not counted towards the $1 million cap is performance-based compensation. [25]

Compensation qualifies for the exception for performance-based compensation only if (1) it is paid solely on account of the attainment of one or more performance goals, (2) the performance goals are established by a compensation committee consisting solely of two or more outside directors, (3) the material terms under which the compensation is to be paid, including the performance goals, are disclosed to and approved by the shareholders in a separate vote prior to payment, and (4) prior to payment, the compensation committee certifies that the performance goals and any other material terms were in fact satisfied. 26] In essence, any type of compensation that is paid as a result of attaining some type of goal or achievement can be considered “performance-based compensation” and will be eligible for a tax deduction. [27] a. Stock Options One common type of performance-based compensation is called a performance stock option. “Performance stock options are options that vest if pre-determined performance measures are achieved. The performance goal (revenue growth, stock-price increases…) must be reached for the options to be exercisable or for the vesting to be accelerated. [28] Because this type of compensation is performance-based, it is not included in the $1 million cap and will be tax-deductible. [29] b.

Commissions Another type of compensation that is not counted towards the $1 million cap is remuneration based on commission. This form of compensation rewards employees for making a certain amount of sales or upon the achievement of some sort of goal. This is also considered a performance-based type of compensation because it is only paid out based on the performance of the employee throughout the course of the year and is not a guaranteed payout for the employee. 30] c. Golden Parachutes One particular type of compensation that has been the topic of much debate and outrage recently is called a “golden parachute. ” A golden parachute is “[a] clause in an executive’s employment contract specifying that he/she will receive large benefits in the event that the company is acquired and the executive’s employment is terminated. These benefits can take the form of severance pay, a bonus, stock options, or a combination thereof. [31] A golden parachute typically pays “ousted CEOs three times annual pay, bonuses and pensions and often include perks lasting well into retirement. ”[32] d. Other Types of Compensation Other types of compensation not counted towards the $1 million cap include; payments to tax-qualified retirement, fringe benefits, and any remuneration that was payable under a written contract on or prior to February 17, 1993. [33] With all of these different types of executive compensation, an important spect to explore is whether these tax changes were effective and produced the results that they were created to accomplish. [34] D. Effects of the 1993 Changes According to the Joint Committee on Taxation, the purpose of section 162(m) of the Internal Revenue Code “was to reduce ‘excessive’ compensation” in public companies. [35] Another reason for the tax change is that “Congress perceived that corporate executives were receiving nondeductible dividends disguised as deductible salaries and bonuses. ”[36]

Some studies have actually found that section 162(m) has not decreased executive compensation at all, but increased average executive compensation. [37] One reason stated by the Joint Committee on Taxation is that executives are taking on more risk in that they now have a smaller guaranteed salary and the possibility that they might not earn their performance-based compensation is considered more risky, therefore requiring a higher amount of possible performance-based compensation to offset the risk involved. 38] Another reason stated is that some executives, who were not making $1 million before the tax change, changed their perception of what a “reasonable” salary was after seeing the new law and demanded higher salaries or that the board of directors feared that its executives would go to a difference company where they would receive a “reasonable salary. ”[39] It is as if the government set the minimum wage for executives of large public companies at $1 million and anything less would be insulting to top executives. E. How Executive Compensation is Determined

Throughout the recent executive compensation controversy, many people, including some executives have declared that executives are making too much money. [40] This begs the question – who sets their compensation packages in the first place and how do they do it? The answer to that question is not an easy one, but there are a few sources to give us an idea as to how these packages are set. An older case gives us some basic factors that should be considered when determining whether an executive’s compensation is reasonable. [41] This list includes: t]he employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with the employer’s gross income and net income; the prevailing general economic conditions; a comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the salary policy of the taxpayer as to all employees; and in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years. 42] Even though these guidelines are not binding, they are a good starting point when looking at the salaries of employees, including the executives at large public companies. Taking a look at each of the nine factors, one can gain a better understanding of the reasoning why an executive makes the amount he or she does. The first factor on the list, an employee’s qualifications, is one of the fundamental elements as to whether an employee is even capable of performing the job function. 43] The more one is qualified, the more one should be paid because it is understood that the employee has more experience to perform his or her greater responsibilities as he climbs the corporate ladder. The nature and scope of an employee’s work shows what an employee is expected to do according to their job description. [44] The more an employee is expected to do, the more an employee should be compensated. The more an employee is expected to work, the more an employee should expect to be compensated.

If an employee works 80 hours a week and is expected to lead an entire company or at least a large portion of that company, then the employee should expect to be compensated accordingly. The less the employee is expected to work, the less they should expect to be compensation. The next on the list is if the company is more complicated, then executives will be expected to understand the complexities of the company in order to run the company accordingly. [45] Of course the more complex the nature of the company, the more one is expected to be compensated.

If a company has higher net profits, then it is reasonable for the executives of the company to expect a larger salary. [46] If a company is running well and expanding, it is expected that the employees would be rewarded for their good work, including the executives. The economy should be a major factor in determining how much an executive should be compensated. [47] For example, Exxon Mobil Corp. ’s CEO, Rex Tillerson’s compensation rose 18% in 2007 after Exxon Mobil had the largest profit ever for a U. S. company. 48] If a company is doing well in a good economy, it is likely that it will reward its employees with salary increases or bonuses. Another factor on the list is comparing executive pay with other companies in similar circumstances in the same industry. [49] Comparing salaries is a good way to please employees because they will know that they are valued at their company and will have incentive to stay. Of course if the company is paying them a much lower salary than a similar competitor, it will give the executive or employee incentive to leave the company and find employment elsewhere where they will be able to find higher pay.

The salary policy to the taxpaying company compared to all employees is relevant to help set executive compensation to make sure the company is paying according to their tax plans. [50] If they omit their tax policies, the company may have a higher tax obligation due to the executive’s compensation. Previous salaries are also a major factor in determining compensation. [51] If an employee takes his prior year’s compensation, it would not be logical for that same employee to expect to be paid more the following year. [52]

Each of these factors is helpful in determining reasonable compensation for employees, including executives, but due to the fact that this list is almost 50 years old[53], a newer set of guidelines would be helpful. In 2007, there was a gathering of about 160 Chief Executive Officers from various large public companies. [54] During this meeting, the officers published a list of principles on how to best set executive compensation according to the best interest of the company: 1) Executive compensation should be closely aligned with the long-term interests of shareholders and with corporate goals and strategies.

It should include significant performance-based criteria related to long-term shareholder value and should reflect upside potential and downside risks. 2) Compensation of the CEO and other top executives should be determined entirely by independent directors, either as a compensation committee or together with the other independent directors based on the committee’s recommendations. 3) The compensation committee should understand all aspects of executive compensation and should review the maximum payout and all benefits under executive compensation arrangements.

The compensation committee should understand the maximum payout and consequences under multiple scenarios, including retirement, termination with or without cause, and severance in connection with business combinations or sale of the business. 4) The compensation committee should require executives to build and maintain significant continuing equity investment in the corporation. 5) The compensation committee should have independent, experienced expertise available to provide advice on executive compensation arrangements and plans.

The compensation committee should oversee consultants to ensure that they do not have conflicts that would limit their ability to provide independent advice. 6) The compensation committee should oversee its corporation’s executive compensation programs to see that they are in compliance with applicable laws and regulations and aligned with best practices. 7) Corporations should provide complete, accurate, understandable and timely disclosure to shareholders concerning all elements of executive compensation and the factors underlying executive compensation policies and decisions. [55]

The first item on the list focuses on setting the executives’ salary being aligned with the long-term interests of the shareholders and according to the goals of the company. [56] This is very general of course and can be interpreted on a company by company basis. It also suggests that the compensation should be significantly based on performance-based criteria. This is most likely due to section 162(m) of the Internal Revenue Code. Having a significant performance-based compensation package will hopefully give incentive to executives to do what is in the best interest for the company.

If the executive’s performance-based package’s goals are in the best interest of the company, and the executive’s compensation depends on meeting those goals, it is in the best interest of the company. The second factor suggests that the executive’s compensation should be determined by an independent committee of directors,[57] or a “board of directors. ” This means the executive’s salary will be determined by a group of objective people who are not employees, but represent the company and have the best interest of the company in mind.

If it is in the best interest of the company, a higher or a lower salary should be set. The third factor simply suggests that the independent committee of directors should have a very good understanding of the payout possibilities to the executives and to make sure that in all realistic scenarios, the executives will not be compensated too much or too little. [58] The fourth factor, in my opinion, is the best suggestion for executive compensation. By requiring the executives to have equity in the company, it makes the executive’s best interest the same as the best interest for the company. 59] If an executive owns a large portion of stock in the company, the executive will do everything he or she can to make sure the value of that stock increases. By having independent consultants,[60] the fifth suggestion serves as something similar to checks and balances. A knowledgeable third party can check to see whether the executive’s compensation is in the best interest of the company, is reasonable compared to other companies, is supported by the market, and is consistent with past performance.

The sixth suggestion is that the committee should establish that the executive’s compensation complies with all laws and regulations, especially with tax laws that have to do with deductibility of the executive’s compensation. [61] The final recommendation suggests that the executive’s salary should be made aware to all shareholders in the company. [62] The shareholders are, in essence, the owners of the company, so if the executive compensation packet is not in the best interest of the company, or shockingly high, the shareholders can influence the salary or suggest changes to better suit the company’s best interest.

It is quite evident that this list varies significantly from the first list, but that does not mean that the first list should be discarded. The second list focuses on an independent board of directors, or an independent committee designed to determine what executive compensation should be. [63] The focus is that the committee should do what is in the best interest for the stockholders and to independently decide what the executives should be paid. [64] With an independent board of directors, or committee, executive compensation can be calculated in the best interest of the company.

The committee is able to take into account all of the factors in the first list, such as the economy, comparable positions in other companies, and previous compensation to better find a suitable compensation package for the executives. One would think that an independent committee would do what is best for the company and would not need government supervision in how it pays its own executives. If the board adheres to these suggestions, it can set executive compensation at the level that is in the best interest of the company and its stockholders.

The group that put this list together also stated that: [T]he executive compensation program of every publicly owned corporation should adhere to two fundamental characteristics. First, it should reflect the core principle of pay for results. Although this concept is not new, it means that a corporation’s executive compensation program not only rewards success, but also incorporates a meaningful element of risk. Additionally, it should reflect the performance of the corporation, not just the stock market in general.

Second, the executive compensation program of every publicly traded corporation should be established and overseen by a committee comprised solely of independent directors who, among other things, set the goals and objectives for executive compensation and determine whether those goals and objectives have been achieved. In doing so, compensation committees should be aware of all aspects of their corporation’s executive compensation and see that the compensation arrangements are in the best interests of shareholders. [65]

There are many factors that go into determining how much an executive should be paid, but there is not a ranking of which factors should carry more weight than the others. Every company has its own unique factors that differentiate from other companies, even ones that are in the same industry and sell a similar product. If an independent committee would follow these guidelines, it will be able to set reasonable compensation packages for its executives that put the company and the stockholders in the best position to increase profits.

Another source gives us a good glimpse at how each of the different types of executive compensation should be determined. [66] A well-run public company invariably has a compensation committee of its board of directors. That committee usually meets at least annually and in some cases more frequently. The task of that committee is to set executive compensation based upon achieved positive results and goals. By actually specifying what goals must be met, an element of objectivity and fairness is injected into the process.

Needless to say, when such compensation procedures have been established and imposed, the board of directors is at less risk of a shareholders’ suit. The following are some key elements in setting executive compensation: 1. Base salary: A prudent board of directors will set a comparatively low base salary for its CEO. It wants the chief executive to be “hungry” to earn additional wages. The logic is that if the base salary is set too high, the executive might feel too comfortable in his job and might not be as focused on profits as he might otherwise be.

Setting the base salary, then, is a rather tricky gambit for the board. The challenge is to set a base salary high enough to attract a competent executive. On the other hand, some executives have the confidence that they can deliver outsized profits and, therefore, don’t mind having a comparatively low salary. 2. Short-Term Incentives: Short-term incentives are usually tied to performance and are sometimes formula-driven. In this case, the executive is given a benchmark to achieve, be it a certain level of sales, a quantifiable reduction in expenses, or a target figure for the bottom line — net profits.

This type of incentive is often effective because it focuses the executive on a specific short-term task that, if achieved, will bring substantial rewards. Some boards utilize short-term incentives on an ad-hoc basis. If they see an urgent short-term need, they will come up with an incentive package that would reward the executive if the need is filled. 3. Long-Term Incentives: This type of incentive usually applies for periods ranging from one to three years, or sometimes even longer. The incentive pay is commonly a combination of cash and shares of the company’s stock.

The goal that the executive must achieve to earn the incentive is often based upon incremental sales or incremental profits. The shares that are given as part of this incentive normally have a vesting term attached to them. In other words, the shares have to be held for a specific period of time before the executive can sell them. A long-term incentive does two things: It keeps the executive’s eye on the goal to be achieved in order to earn the incentive, and it increases the chance that the executive will stay around at least long enough for the incentive shares to become fully vested. . Employee Benefits: Items under this category include various non-wage compensations such as health, dental and life insurance as well as sick leave and vacation. A good executive and a good board of directors usually realize that this category should never become the tail wagging the dog. That is, it shouldn’t be outsized, and it shouldn’t include so-called hidden benefits that unreasonably and unjustly expand the executive’s compensation package. Normally, when an executive compensation scandal erupts on Wall Street, it doesn’t involve employee benefits. 5.

Perquisites (Perks): This is where some companies get into trouble. There have been cases where the perks to executives far exceed reasonable boundaries. Examples of perks are chauffeured limousines, executive jets and housing. There have been cases where these perks have amounted to a substantial portion of the executive’s salary, especially if expensive housing is thrown into the mix. Many of these perks go unnoticed or unreported until a company gets into trouble. Then, the press is all over the story, citing how much a company paid for an employee’s birthday party or, for that matter, an expensive umbrella rack.

This can only let the board of directors look bad and expose them to stockholder suits. [67] This list by Theodore di Stefano gives good suggestions for committees on how to set each type of standard for executive compensation. For base salary, he recommends finding a balance between setting it too low and too high. [68] If the committee sets it too low, it will be a disincentive for incoming executives to try and work at the company, but if it is set too high, the executive might be content with the salary and might not have any motivation to achieve higher profit margins. 69] Short-term incentives are a must for any compensation package. [70] If an employee or executive has incentive to reach certain goals, such as profit margin or revenue, then he or she is likely to try much harder to do a good job and meet those goals. [71] If the short-term incentives are not there, then similar to a high base salary, the employee will have less incentive to work hard. [72] This is similar to long-term incentives in the third suggestion. The higher the possible payout, depending on achieving goals, the better an executive is likely to work. 73] Employee benefits and perquisites are important to note because if a company hides or puts too much emphasis on benefits or perks, the companies may be reaching outside of being reasonable for its executive compensation[74] and might face taxation issues down the road if it is not too careful. This list should be taken into consideration by any committee that determines executive’s compensation packages for its company. If followed, this list will give any committee a great basis for determining its executives’ compensation.

A recent development for determining executive compensation happened in May 2007. The United States House of Representatives voted to give shareholders a non-binding say on executive compensation. [75] This was a worthwhile, timely, and necessary step in the compensation making decisions of a company. This vote gives the shareholders the opportunity to at least voice their concern and let the executives and the board of directors know if they are displeased with how the company is being run.

If the executives work for the shareholders, this is a great stepping stone in allowing the true owners of the company to have at least voice their opinions and have it be heard by the people actually running the company. III. CURRENT EVENTS The last few years have been filled with great controversy regarding executive compensation, especially recently with the economy struggling, huge executive compensation packages, and so many large companies being bailed out. A. Examples of Recent Compensation Packages

In the recent economic downtime, there has been a lot of publicity about public companies that have been struggling and turning in record losses. When a company starts to go under, the executives of that company will normally be under much scrutiny because people often point the finger at the people in charge and will try to find any reason why the company is not performing well. This scrutiny often starts with their compensation due to the fact that they make so much more than the average American. [76] Most high-ranking executives make about 400-fold more than the average worker, which is 20 times larger than it was in 1965. 77] In 2007, the average CEO from the Standard ; Poor’s 500 made about $14. 2 million in total compensation including salary, bonuses, stock options, and other types of compensation. [78] With a struggling economy and many workers being laid off, it is not surprising that there would be public outcry about how executives have been making millions while the public is suffering. Some other examples of compensation packages that have brought a lot of public interest are mostly packages that include an extraordinary amount of money upon exiting the company.

These packages are called golden parachutes. [79] Lee Raymond of ExxonMobil had a $400 million retirement package. [80] Also included in Raymond’s package was a “pension, stock options and other perks, such as a $1 million consulting deal, two years of home security, personal security, a car and driver, and use of a corporate jet for professional purposes. ”[81] Another example is that in 2007, the year when Merrill Lynch had a net loss of $7. 8 billion, former CEO E. Stanley O’Neal received $161. 5 million in retirement benefits. 82] Also, after an unexpected poor third quarter performance, Charles Prince, CEO of Citigroup, left with a $38 million payment package. [83] There has especially been widespread outcry regarding executive compensation of corporations receiving government assistance from the bailout in 2008. [84] When a company receives billions of dollars in bailout money from the government, it is assumed that the company will do everything it can to save money and not spend the bailout money on lavish expenses. In the two years prior to Lehman Brothers’ bankruptcy, CEO Richard Fuld was ompensated a total of $71. 9 million in 2007[85] and $122. 67 million in 2006. [86] In 2008, Merrill Lynch received $10 billion in bailout money. [87] John A. Thain, the CEO of Merrill Lynch, who, in the previous year, had been ranked second on the list of highest-paid CEOs of the S;P 500 after earning $83 million,[88] requested a $10 million bonus[89] the same year Merrill Lynch reported a third quarter loss of $5. 1 billion[90] and had a net operating loss of over $12 billion for the year. [91] The public is justified in not being too happy with these numbers as the economy struggles.

Something here is actually overlooked on behalf of the executives. These executives can arguably claim that they performed well for the companies they represented in that they minimized company losses. Take Merrill Lynch for example. Instead of a $7. 8 billion loss, O’Neal could have arguably claimed that Merrill Lynch would have lost much more money that year, so he should be compensated accordingly. John Thain of Merrill Lynch asked for a bonus of $10 million because he claimed he “’helped avert what could have been a much larger crisis at the firm. ”[92] These executives could argue that their services in preventing their companies from losing less money than they would have is just as good as if the company had made even more money because of them. Whether these executives are justified in their earnings is up for debate. There truly is not a correct answer. The executives could be correct in asserting that they deserve their compensation because they are one of a kind and that nobody else could have done their job as well as they did in assisting the company or preventing further loss. B. Pre-bailout

In September 2008, Fannie Mae and Freddie Mac, both struggling greatly with the economy, were placed under U. S. government conservatorship. [93] As part of the deal engineered by Treasury Secretary Henry M. Paulson, the boards and chief executives would be fired and the Federal Housing Finance Agency would appoint new directors. [94] By replacing these executives, the government effectively warned other CEOs of struggling companies that they needed to do their jobs well and get their companies to a profitable level, or else they could suffer serious consequences similar to these ousted executives.

American International Group (AIG) recently suffered a similar fate as Fannie Mae and Freddie Mac. [95] The U. S. government was to provide $85 billion in bailout money to rescue AIG. [96] What AIG did in the year before the bailout and with the bailout money itself is quite unbelievable. A handful of AIG officials took a $90,000 hunting trip to England after it had received bailout funds, AIG had a luxury suite at Madison Square Garden that cost hundreds of thousands of dollars, and “[t]he board awarded its chief executive officer (Martin Sullivan) a cash bonus of over $5 million and a golden parachute worth $15 million. [97] “Similarly, in February 2008, a top-ranking executive who was largely responsible for A. I. G. ’s collapse was terminated, but still permitted by the board to keep $34 million in bonuses. This same individual apparently continued to receive $1 million a month from the company until recently. ”[98] Amazingly, not all CEOs think they deserve their earnings. Former AIG CEO, Robert Willumstad, served as CEO for three months and as part of his sign-on package was entitled to $22. 5 million in severance pay. 99] After being terminated, as to the reason why Willumstad rejected his severance package, he stated, “I prefer not to receive severance payments while shareholders and employees have lost considerable value in their AIG shares. ”[100] Hopefully more CEOs will follow Willumstad’s example and forego excessive compensation packages when they feel like they did not earn them. C. Emergency Economic Stabilization Act On October 3, 2008, the United States House of Representatives voted in favor for the Emergency Economic Stabilization Act (EESA), which was later that day signed by President Bush. 101] The EESA included the Troubled Assets Relief Program (“TARP”), a $700 billion bailout plan which was intended to be used to purchase troubled assets from financial institutions that were struggling at the time due to record home foreclosures. [102] Many of these institutions were losing billions due to the increased rates of foreclosures on the homes they had interests in. [103] In order to curb the free-falling economy and stock market, the government initiated TARP. [104] With TARP came some limitations to executive compensation for companies that use TARP funds to sell troubled assets. 105] The text of section 111 of the EESA, which includes the limitations on executive compensation, is as follows: SEC. 111. EXECUTIVE COMPENSATION AND CORPORATE GOVERNANCE. a) Applicability. —Any financial institution that sells troubled assets to the Secretary under this Act shall be subject to the executive compensation requirements of subsections (b) and (c) and the provisions under the Internal Revenue Code of 1986, as provided under the amendment by section 302, as applicable. b) Direct Purchases. 1) In General. —Where the Secretary determines that the purposes of this Act are best met through direct purchases of troubled assets from an individual financial institution where no bidding process or market prices are available, and the Secretary receives a meaningful equity or debt position in the financial institution as a result of the transaction, the Secretary shall require that the financial institution meet appropriate standards for executive compensation and corporate governance.

The standards required under this subsection shall be effective for the duration of the period that the Secretary holds an equity or debt position in the financial institution. 2) Criteria. —The standards required under this subsection shall include— A) limits on compensation that exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution;

B) a provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; and C) a prohibition on the financial institution making any golden parachute payment to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution. [106]

The bailout text puts three limitations on executive compensation for companies that have used EESA money, two of which are relatively major limitations. The first major limitation is in subsection (A), which disallows incentives for high-level executives from taking risky and unnecessary risks. [107] This basically prohibits executives from having incentives to take on risky ventures that might put the company at risk of losing money. The second major limitation is in subsection (C).

This limitation disallows any golden parachutes for executives whose companies have used bailout money. [108] This takes a burden off of the already struggling company in that if a top five ranking executive is terminated from employment with the company, the company is not required to pay out a typical golden parachute package. This will help the company save money and hopefully will help it get out of the serious situation which brought it to the point of needing government assistance through the EESA. The third limitation is in subsection (B).

This limitation allows the company to retroactively take back bonus or incentive money paid out to executives due to falsified or inaccurate financial statements that originally gave rise to some sort of performance-based bonus. [109] This takes effect when a company subsequently realizes that an executive was paid a bonus based on false information. It need not be falsified intentionally, but if the executive should not have received the bonus in the first place, then the company will be able to take the money back from the executive.

This of course will provide relief to the company because these bonuses can often reach eight figures, and with a struggling economy, every little bit helps. Will these EESA limitations work? Only time will tell. It can be speculated that these limitations may be a good start and definitely a good example to other companies for the future. Disincentives to take risky ventures and retroactively taking back unearned bonuses are good ideas. These will assist the company financially and reduce the chance of major losses from bad investments.

Taking away golden parachutes could be a good thing, but it doesn’t seem likely that many companies will follow that example voluntarily when they are not receiving bailout funds. Perhaps companies will be wary of giving away massive golden parachutes like the ones listed above due to public resentment and stockholder displeasure. D. The Auto-Bailout In November 2008, amidst an ever decreasing economy, three CEOs of major automakers were called to approach Congress to “provide a ‘credible restructuring plan’ for their f[l]oundering businesses. [110] In the letter sent by Senate Majority Leader Harry Reid and Speaker of the House Nancy Pelosi, the CEOs were asked to provide detailed financial records, forecasts, and plans for the future regarding their companies. [111] Also required by the letter was a detailed plan that would give the tax-payers, who would directly fund their bailout, the best possibility to be paid back first, and also a plan to “[b]ar the payment of dividends and excessive executive compensation, including bonuses and golden parachutes by companies receiving taxpayer assistance. [112] In order to answer Reid and Pelosi’s request, Ford’s CEO, Alan Mulally, Chrysler’s CEO, Robert Nardelli, and GM’s CEO, Richard Wagoner, all flew private jets to Washington D. C. in order to present their plan and ask for taxpayer money to prevent their companies from going into bankruptcy. [113] It was estimated that each of these CEO flights cost $20,000 of company money. 114] If the CEO behavior and compensation packages that received so much media attention during the initial bailout warranted public outcry for CEO behavior, this certainly warranted it when three top-ranking executives of three very large companies each spent about $20,000 just to get to a hearing to beg the government for more money after being asked to present a plan on barring excessive compensation to its executives, which includes corporate perks.

If flying private corporate jets is what they would spend part of the government bailout money on, it does not seem likely that the government or the public would want to spare them from bankruptcy. After some promises by the auto manufacturers to reduce or completely sell off their corporate jets,[115] on December 19, 2008, President Bush authorized a $13. 4 billion bailout plan to provide Chrysler and GM funds from TARP, with another $4 billion that would be available in February 2009. [116] According to the source, the loans “would come with strict conditions.

The money could be called back if the automakers cannot prove they are viable by March 31[, 2009]. Executive compensation and other perks would [also] be limited. ”[117] The automakers had requested $34 billion to survive,[118] but instead of giving them all of the money up front, President Bush decided to give them a fraction of that amount[119] and then allow the government to take a look at their progress and determine whether they will provide more aid to them in early 2009. [120] There are over 2 million auto-related jobs in the United States today. 121] Both parties feel like the auto industry is worthy of saving,[122] but with its saving comes strict conditions, especially with executive compensation. [123] The Bush Administration effectively put a limit on executive compensation that could be received by executives of companies receiving auto bailout funds, and also mandated the elimination of “perks such as corporate jets”[124] and eliminated “’golden parachutes’ severance packages. ”[125] E. The Obama Administration and the American Recovery and Reinvestment Act of 2009

Less than one month after President Barack Obama took office, President Obama imposed a restriction on companies receiving bailout money in that some of their senior executives cannot make more than $500,000 per year in salary. [126] “Obama said the United States doesn’t disparage wealth nor does it begrudge those who succeed, but lavish bonuses for executives at companies seeking taxpayer dollars was unfair. ”[127] On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 into law. 128] This Act included a section regarding executive compensation and the restrictions imposed thereon for companies receiving taxpayer dollars from TARP. [129] Some terms in the Act include; restrictions on golden parachutes,[130] a requirement of a compensation committee,[131] a restriction on taking unnecessary risks,[132] a requirement to pay any bonuses back to the company if it comes to light that the bonus was paid out due to erroneous information,[133] and also defines how many and which executives will be affected if the company does or is expected to receive bailout money. [134]

The requirements under the Obama stimulus plan are very similar in effect to those of the Bush bailout plan. Both plans force top-level executives to avoid risky behavior and also limit the amount of pay they could possibly receive. The plans also restrict any bonuses paid out to executives while any TARP funds are still outstanding to their particular company. [135] This will motivate the executives to pay back the borrowed funds as fast as they reasonably can in order to receive their bonuses. Hopefully the executives will not pay the funds back too early, thereby hurting the company in order for them to receive their bonuses sooner.

IV. IMPACT With so much controversy regarding executive compensation, it is inevitable that changes will occur. The government will want to do everything it can to prevent a future economic collapse similar to the recent one. A. Proposed Sarbanes-Oxley Amendment In September 2008, a bill was presented to Congress which would amend the Sarbanes-Oxley Act of 2002 (“SOX”)[136] and add a relatively short subsection regarding executive compensation. [137] Even though this bill was not passed, this amendment to SOX would have had a dramatic effect on executive compensation, especially in seasons of economic downtime.

When a public company receives money from a taxpayer bailout, any officer, including executives, would be required to pay back any amounts received as a bonus or incentive-based or equity-based compensation over the last two years. [138] Many CEOs are earning mostly performance-based compensation,[139] so if a company has a bad year and was forced to receive bailout funds, even if it had nothing to do with the executives and was completely out of their hands, those executives would be required to pay back much of their last two years of compensation. 140] This change to SOX definitely would not have sat well with executives, but it would definitely have pleased the shareholders knowing that if their company ever reaches the point of a taxpayer bailout, the company would receive additional funds from the executives who were supposed to prevent the company from requiring a bailout in the first place. [141] Shareholders own stock in companies and are essentially the owners of the company. [142] It can be safely assumed that shareholders really only care about one thing, making money.

If a company is going to declare bankruptcy, shareholders want to minimize losses and get back as much money as they possibly can through liquidation. Oftentimes the blame for company failure will be put on the executives because they are, in essence, the people running the show. This change to SOX would have allowed shareholders to either minimize losses, or at least bring more capital back into the company to support it in its time of need. [143] If this bill makes another appearance or if a similar bill passes, it will definitely create changes in the way executives are paid, similar to section 162 of the Internal Revenue Code.

Once the law changes about how an executive can be paid, those same executives will find ways around the law to be paid just as much as they were before. It is just a matter of time until the boards of directors at these large companies find ways to compensate their executives without putting their possible income at risk. B. Should There Be a Law That Puts a Cap on the Tax Deductibility of Executive Compensation? According to the studies by the Joint Committee on Taxation, it seems that section 162(m) of the Internal Revenue Code has actually proven to have had the opposite effect than the effect that was intended. 144] If total compensation has increased because of this law, then it would be arguable that the law should be repealed if it can be shown that higher executive compensation is not good for the economy. Taking a look at what the situation would look like if there were no cap, we can assume that companies would pay executives a higher base salary instead of performance-based compensation. This is due to the fact that most people seem to be risk averse[145] and do not want their salaries, or at least most of their salaries, dependant on outside factors that they do not have complete control of. One study found that, to the extent the substitution of fixed compensation by performance-based compensation occurs, firm profits are reduced because the resulting compensation tends to be higher. Firm profits may also be reduced to the extent that firms decide to forego the tax deduction. ”[146] This would put more money back into the company because they are paying a lower salary and also would be taking advantage of the tax deduction.

This would in turn justify a lower salary for top executives because they would have a guaranteed income and also would not have the risk of not meeting their performance-based compensation requirements in order to earn what was instead substituted as performance-based compensation instead of salary. In my opinion, having a cap on salary unnecessarily complicates a simple concept of any company, that of paying a salary. A cap creates more expenses for companies and prevents executives from having a stable and predictable form of compensation.

It also may give incentive to executives to falsify accounting records so they would benefit more from another form of performance-based compensation called options, like backdating. [147] Section 162(m) of the Internal Revenue Code should be repealed in order to help the market for executives by allowing companies to offer a set salary. This has been shown to oftentimes be a lower overall salary, instead of a higher salary that is dependent on unforeseen market conditions, and one that may give incentive to falsify records and break the law, hurting their companies even more.

C. Restrictions on Executive Pay of Companies Receiving Bailout Money Compensation restrictions at companies receiving bailout money are a great idea and should not have a significant impact on the industry. The only impact it might have on the industry is when a board of directors acknowledges that its company may be in need of bailout money, and might want to set its executives’ compensation plans accordingly. Luckily most companies do not plan to receive bailout money, which should be a last resort. V. CONCLUSION

The controversy regarding executive compensation has many good arguments on both sides. On one side, some argue that the government has no business capping executive compensation because we are, in fact, a capitalistic society, and that we should let the market adjust itself,[148] and on the other side, some argue that excessive executive compensation needs to be regulated and is a leading factor of “many of our nation’s economic ills. ”[149] After the recent economic downturn, it can be argued that both sides have at least found a common ground regarding their stances.

When it comes to executive compensation paid to the executives of companies receiving bailout money, it seems that a majority of people believe that their compensation should be limited or at least restricted in some way. [150] This is a good combination of the two schools of thought. On the one hand, if a company is doing well, the market is able to set the executives’ compensation and they will receive whatever the board of directors deems reasonable.

On the other hand, if a company is not doing well and receives bailout money, the government steps in and limits the amount of compensation available to its executives which has a multipurpose of protecting the stockholders and also the taxpayers in that the company is required to reduce the amount of expenses and put as much back into the company as possible. As to companies not receiving bailout money, it is preferable to allow the market to adjust itself to the optimal amount any executive can receive in compensation. If an industry is in need of highly intelligent business-men, then that industry needs to be able to pay for them.

For example, right now there is a need for highly intelligent business men in the banking and investment industry. If these companies cannot pay a high enough amount to acquire the services of great minds, then the industry as a whole might suffer when the best executives leave and find jobs in other industries where they can earn a higher compensation. On the other hand, if there is an industry-wide cap on the amount of compensation any executive may be paid, then it is likely that the best executives will attempt to find employment in other industries where they can be paid more.

One would hope that after the recent economic crisis and outrage regarding executive compensation, companies would have an idea as to how much they can justifiably pay their executives and still receive public and stockholder support. With a new administration in the White House, there is a good possibility that there will be legislation in the near future regarding limits on executive compensation, but we are just going to have to wait and see what happens. ———————– [1] 2010 Juris Doctor candidate, Pepperdine University School of Law. 2] House Committee on Financial Services, http://financialservices. house. gov/ExecutiveCompensation. html (last visited Feb. 17, 2009) (“According to the Corporate Library’s 2006 CEO Pay Survey of roughly 1400 CEOs (covering pay in FY 2005), the median CEO received $13. 51 million in total compensation, up 16 percent over FY 2004. This came on the heels of a 30 percent increase over FY 2003, 15 percent over FY 2002 and 9. 5 percent over FY 2001”). Id. [3] See Federal Deposit Insurance Corporation, http://www. fdic. ov/bank/individual/failed/banklist. html (last visited Feb. 22, 2009) (Site lists the dates of all of the failed banks in the last decade); see also Wikiinvest, http://www. wikinvest. com/concept/2008_Financial_Crisis (giving an overview of the institutions involved in the 2008 economic crisis including banks and investment institutions, what lead to the crisis, and also gives an overview of the government bailout). [4] See Elizabeth Holmes, McCain Slams Excessive Executive Pay, The Wall Street Journal, http://blogs. wsj. om/washwire/2008/09/22/mccain-slams-excessive-executive-pay/ (“’We can’t have taxpayers footing the bill for bloated golden parachutes like we see in the Lehman Brothers bankruptcy. ’”); See also Debate Reality Check: Obama A Leader On Financial Crisis, Oct. 7, 2008, http://factcheck. barackobama. com/factcheck/2008/10/02/debate_reality_check_obama_a_l. php (Obama’s campaign showing that he called for “controls on executive compensation”). [5]Christopher Dodd, SUMMARY OF THE “EMERGENCY ECONOMIC STABILIZATION ACT OF 2008,” United States Senate Committee on Banking, Housing, and Urban Affairs, http://banking. enate. gov/public/_files/latestversionEESASummary. pdf (last visited Feb. 22, 2009) (Summary of the Emergency Economic Stabilization Act of 2008, which states that the Act, among other reasons, provided funds to stabilize the economy and also limited the amount of compensation executives of companies receiving funds from the Act may be paid). [6] See infra notes 11-12. [7] See infra notes 13-73. [8] See infra notes 134-45. [9] See infra notes 38-72. [10] See infra notes 142-48. 11] Joint Committee on Taxation, Present Law and Background Relating to Executive Compensation, 6, (2006), http://www. house. gov/jct/x-39-06. pdf. The legislative history states that section 162(m) was motivated by then-current concerns regarding the amount of executive compensation in public companies, and that the purpose of the provision was to reduce ‘excessive’ compensation. While not specifically mentioned in the legislative history, the exception to the limitation for performance-based compensation reflects the view that such compensation, by its nature, is not ‘excessive. A provision similar to section 162(m) was also proposed by the Clinton Administration. The rationale behind this provision was stated a bit differently, and focused on the ‘unlimited tax benefit’ provided to executive compensation. This tax benefit was described as particularly inappropriate in cases in which executive compensation increased while company performance suffered. The Administration proposal also had as a stated objective the intent to provide an incentive to link compensation to business performance.

Since the enactment of section 162(m) the appropriateness of executive compensation has remained a topic in the public eye. Id. This report gives a extensive history and explanation of present executive compensation law, including “a description of present-law tax rules and issues relating to certain types of executive compensation arrangements, including the $1 million dollar cap on the deduction for executive compensation, nonqualified deferred compensation, stock-based compensation (including the tax issues relating to backdating stock options), and golden arachute payments. ” Id. at 1. [12] Id. [13] Id. at 6. [14] Id. at 3. “In the case of publicly traded companies, the Code imposes a limit on a company’s deduction for compensation of certain high-ranking employees in excess of $1 million. ” Id. See also 26 U. S. C. A. § 162(m) (West) (Actual Code language). [15] Joint Committee on Taxation at 3. This includes the highest four officers besides the CEO, regardless of their names or titles. Id. [16] Id.

The company may still deduct the first $1 million of the executives’ salaries, but any salary paid above the $1 million threshold is not tax-deductible. For example, if the salary of an executive was $1,000,001. 00, the company would be able to have a tax deduction of $1,000,000. 00, but would then need to pay taxes on the extra $1 because that is the amount his or her salary exceeded $1,000,000. 00. [17] Id. “Studies have indicated that the deduction limitation may have led to some substitution away from salary compensation toward performance-based compensation. ” Id.

Because the companies could no longer use the entire salary as a tax-deduction, companies started to pay their executives in other types of compensation in order to sill benefit from available tax deductions. Id. [18] Justin Kuepper, Evaluating Executive Compensation, Investopedia, http://www. investopedia. com/articles/stocks/07/executive_compensation. asp (last visited Feb. 22, 2009) (Listing different types of executive compensation, including; cash compensation, option grants, deferred compensation, long-term incentive plans, retirement packages, and executive perks).

This list is not all-inclusive, but gives a good overview of the main forms of executive compensation used by many companies today. Id. [19] See supra note 16. [20] Joint Committee on Taxation at 6. Although, if an executive has a right to receive the compensation regardless of accomplishing his or her goals, then the compensation will not be considered performance-based and therefore will not be within the tax exemption and the company cannot use this for a tax-deduction. Id. at 5. [21] In general, most people measure their compensation by their annual salaries.

The vast majority of salaries are paid in cash (or check) and not in options or other types of compensation. Many people also receive bonuses (also normally cash, but this could also be stock option), but don’t receive anywhere near their annual salary in bonuses like many executives do. [22] Important Terms S-U, The Strong Business Credit Mentors, http://www. strongbusinesscredit. com/glossary/business_glossary/important_terms_s-u. html (last visted Feb. 22, 2009). A list of important business terms. 23] This means that if an employee or executive does not do well in a given year, they will not normally receive a bonus based on their good-performance and will be left with their annual base-pay salary barring some kind of generous other type of bonus. [24] Joint Committee on Taxation at 2 [25] Id. at 6. [26] Id. [27] Id. If an executive is rewarded at the end of a fiscal year for reaching goals, one could say that their “performance” over the year was well. Whatever compensation received as a result of performance can be considered “performance-based” compensation. [28] Stock-Options, What Are They? , Share Market Basics, http://www. haremarketbasics. com/STOCK-OPTIONS. htm (last visited Feb. 22, 2009). [29] Joint Committee on Taxation at 6. Simply put, a stock option gives the executive the right to buy a certain amount of stock at a set price at some date in the future. Oftentimes this can be the most volatile form of compensation because if an executive is awarded a stock option when the stock was at a low price, and the company does really well after that point and the stock price skyrockets, the executive has the right to exercise the option and make a lot more money than originally expected at the time the option was granted.

The opposite holds true in that the option could have been granted when the stock price of the company was relatively high, and if the stock price plunges, or lowers at all, and the stock price never goes back above the price of the stock option, the executive might never exercise the stock option because it would not be valued at anything because he or she could simply buy the stock at the market price instead of using the option price, which would be higher, thus making the option worthless until the stock price eventually recovers, if it ever recovers at all. 30] Id. This is, in essence, the same as a regular commission at a regular job. When the executive reaches a higher level of sales, or the equivalent, the executive may receive higher compensation based on the commissions originally set by the company. [31] http://www. investorwords. com/2201/golden_parachute. html. [32] Del Jones & Edward Iwata, CEO Pay Take a Hit in Bailout, USA Today, Oct. 2, 2008, http://www. usatoday. com/money/companies/management/2008-09-28-executive-pay-ceo_N. htm.

This article goes on to talk about the current situation regarding golden parachutes and how many of the directors at these companies have been asleep over the last dozen years regarding these packages and how there needs to be much reform in this area. Id. [33] Id. See also http://www. irs. gov/publications/p15b/ar02. html#en_US_publink1000101739 (A fringe benefit is a form of pay for the performance of services. For example, you provide an employee with a fringe benefit when you allow the employee to use a business vehicle to commute to and from work”).

This can also include benefits such as a corporate jet, which is a business vehicle used for work purposes. [34] See infra notes 144-46. [35] Joint Committee on Taxation at 6. See supra note 11. [36] Performance Based Compensation, The Free Library by Farlex, http://www. thefreelibrary. com/Performance-based+compensation-a053462155 (last visited Feb. 22, 2009). This is a good summary of the history of section 162 and what requirements the compensation needs to meet in order to be included in the exception to allow for the tax deduction. 37] Joint Committee on Taxation, at 7. “One reason this may occur is that firms may substitute performance-based compensation for fixed salary. ” Id. However, by changing the type of compensation paid to executives, it is difficult to measure exactly how much an executive is being paid because we look at compensation in terms of present value, but the problem is that we cannot accurately measure what the future value of some stock options will be because we cannot accurately predict what the price of the stock will be at the time the option is exercised.

Similarly, we cannot measure unknown variables such as possible commission in terms of present value because we simply do not know how much of a commission the executive will receive. In addition, we cannot value a golden parachute in today’s dollars because we do not know when the executive might receive this benefit and even if we did know when, we do not know the discount rate to use in order to value it today. [38] Id. at 6.

If someone were to offer a much lower base salary, but included in that would be a chance to earn more money, but also the chance to not earn more money, that person would normally prefer the higher based salary unless there was an opportunity to earn much more money. Basically, the higher the bonus pay is, the more likely an employee is to accept that type of pay and try their best to earn it. The lower the incentive is, the less likely it is that an employee will try as hard. [39] Id.

When the government puts a cap on tax-deductibility of salary, it is likely that executives who were not making the cap amount would feel like they are being underpaid because the rest of the industry, or many of their counterparts, are making more than them, so they would likely ask for a raise to at least the cap level. This would of course raise the average amount of compensation paid across the industry. [40] http://www. latimes. com/classified/jobs/news/la-fi-execpay16apr16,0,7671465. story.

An article that goes on to say that “Four out of five executives said shareholders should have some say on pay, and 55% said their CEOs’ compensation did not reflect or only somewhat reflected the companies’ results. ” Id. [41] Mayson Manufacturing Co. v. Commissioner, 178 F. 2d 115, 119 (6th Cir. 1949) (citing Mayson Mfg. Co. v. Commissioner, 178 F. 2d 115, 119 (6th Cir. 1949). In this case, the petitioner company is challenging the tax court’s ruling that compensation paid to its executive was unreasonable, and therefore not tax-deductible. Id. t 116. The court goes on to list these factors in determining whether compensation paid to a particular employee is reasonable given the conditions of employment. Id. at 119. [42] Id. [43] Id. It is not expected that you can pick anybody off the street and pay them to do the work of an executive at a large company. It takes certain experience and skills to be able to be an executive and do the job well. Qualifications are normally higher for higher paying jobs, such as that of an executive at a large company. Such qualifications likely include a type f business or a law degree, experience in management, and a good sense of leadership. [44] Id. The nature and scope of an occupation can vary greatly. Some occupations require the employee to come in for a set amount of time, normally 40 hours a week. Other jobs, like that of surgeon might require round the clock duties and be on call at all times. For an executive, it can hardly be expected that one would only be expected to work 40 hours a week. It is likely that an executive might work 60-80 hours a week because they are needed in many aspects of the business.

Also required of an executive is a solid understanding of the nature of the industry the company is in. [45] Id. Complexity of a business requires management and executives who understand how the industry runs and knows what to do to keep the business running profitable. [46] Id. When a company excels in its industry, it can either continue to pay its employees the same amount, or it can increase its employees’ wages to attempt to hold onto the employees who helped the company excel in the first place.

For example, if an executive proves to be a great asset to a company, he or she might be lured away by a different company with higher wages. In order to prevent this, companies would need to reward their employees with raises to prevent them from leaving. [47] Id. If the economy is doing well, it is likely that business it also doing well and should be able to afford to pay its employees and executives higher wages. [48] Exxon CEO pay up nearly 18 Percent in 2007, boston. com, Apr. 10, 2008, http://www. boston. com/business/articles/2008/04/10/exxon_ceo_pay_up_nearly_18_percent_in_2007/.

The reverse is also true. If the economy and or the business is not doing well, the employee should not expect an average pay increase, and might even expect that a layoff is possible and that they might lose their job. [49] Mayson 178 F. 2d at 119. If wages at one company are higher than that of a close competitor, it is likely that employees will be tempted to switch companies, so each company needs to set its wages competitively, but especially not low enough to where its own employees will want to go elsewhere to be paid the higher wages.

This is also true for executives. If a similar executive at a rival company is getting paid $X, then the executive would likely feel like he or she should be paid somewhere close to $X. [50] Id. [51] Id. See also Susan M. Heathfield, The Scoop on Salary Increases: What Pay Raise Can You Expect From Your Employer? , About. com , http://humanresources. about. com/od/salaryandbenefits/a/salary_savvy. htm (last visited Feb. 23, 2009) . This site gives survey statistics that pay raises in 2006 were expected to be the same as in 2004, which was a national average raise of 3. %. Id. Also mentioned was that over 75% of employees nationwide received non-promotional bonuses the year before the survey was conducted. Id. This market research tends to show that most people can expect pay raises, even though they did not receive a promotion in a given year. Id. [52] Id. [53] Id. Although the list is 50 years old, there has not been a significant change in the way we do business, so the list given is still extremely helpful and a great starting place for determining what might be a reasonable salary for an executive in a given year. [54] John J.

Castellani, Executive Compensation: Principles and Commentary, Business Roundtable 1622 PLI/Corp 91 (2007) (Search in journals in Westlaw in natural language). This article was written by John J. Castellani, who was President of Business Roundtable, “an association of chief executive officers of leading U. S. corporations with a combined workforce of more than 10 million employees and $4. 5 trillion in annual revenues. Business Roundtable has been cited by the Financial Times as ‘the most influential chief executive lobbying group in the U. S. ’” Id. at 93. [55] Id. at 101. [56] Id.

If the goal of the company is to retain the best possible executive, then it would be wise to have a company policy to have a very large budget for its executives. If the company does not think that having an extremely experience and expensive executive fits within the company’s interest, then it would be wise to have a smaller budget for its executives. Many companies can probably afford more expensive executives who might be able to do a better job, but it might not be in every company’s best interest to spend more money on a position that it feels can be done just fine by someone with less experience. 57] Id. These directors are not to be employees of the company, therefore making them more objective in their decision-making, which should lead to better and more economic decision-making in the best interest of the company. In general, a board of directors is “empowered to (1) set the company’s policy, objectives, and overall direction, (2) adopt bylaws, (3) name members of the advisory, executive, finance, and other committees, (4) hire, monitor, evaluate, and fire the managing director and senior executives, (5) determine and pay the dividend, and (6) issue additional shares. ” BusinessDictionary. om, http://www. businessdictionary. com/definition/board-of-directors. html (last visited Feb. 23, 2009). [58] Id. By having the board of directors knowledgeable about the possible payouts, it lets the board determine what the maximum payout might be, given everything goes in favor of the executives, and also the other way around and it lets them see what the minimum amount is that an executive might earn if everything goes against them. This will allow the board to determine whether the executive might be paid too much or too little. [59] Executive Compensation, 1622 PLI/Corp at 91.

It is hard to imagine an investor in a company making decisions that would negatively affect his or her share in the company. The same holds true for executives who own stock in the company. If the executive owns part of the company, he or she is likely to do everything in their power to make sure that stock goes up in value. However, if an executive does not have ownership in the company, he or she may be more inclined to make more risky decisions that may put the company in danger. If the executive has no direct interest in the company, it is less of a loss if the company does poorly. [60] Id.

Having a third party observe the company, its policies, and its procedures is a good way to take a step back and see whether you really are doing what is best for the company. Sometimes a third party who bears no interest in the company whatsoever is able to make better decisions because they tend to be more neutral and less biased. When an executive is making decisions, it is difficult to step out of the executive role and view the company from different angles. The same goes with any job in any company. No matter where one is in the company, it is difficult to look at the company from any other perspective besides your own. 61] Id. [62] Id. The top employees’ salaries should not be secret to the owners of the company, the shareholders. If a board of directors elects to pay an executive an outrageous amount, the shareholders should at least know about it. [63] Id. [64] Executive Compensation, 1622 PLI/Corp at 91. [65] Id. It suggests that executive compensation of all companies should pay its executives to achieve results. Id. This simply means that there should be an element of risk within the company and the practices of the executives that will be able to propel the company’s profits and take a larger industry r market share. The other suggestion is that executive compensation should be established by an independent board of directors who would be more objective and who would also be able to oversee the executives to determine whether its goals were met. [66] Theodore F. di Stefano, Executive Compensation in an Obama Administration, E-Commerce Times, Nov. 21, 2008, http://www. linuxinsider. com/story/65205. html. Di Stefano assembled this list in an article relating to the Obama Administration and how it is likely to view executive compensation during the Obama Presidency.

Id. The author actually comes to the conclusion that the Obama Administration probably will not alter or limit executives’ compensation except in the situation when a company receives bailout money, then there will be caps and restrictions on what executives might be paid. Id. [67] Id. [68] Id. This is a simple game of finding the perfect balance in setting the compensation high enough to attract new executives but setting it low enough to where the executive does not feel too comfortable in his or her settings and strives to do a job well done. [69] Id. 70] Id. Seeing results is key in motivating an employee. If an employee is rewarded soon after hard work, it is likely that the employee will be motivated to repeat similar behavior. Oftentimes if a company has a short-term need, coming up with an incentive-package can help motivate the employees to complete the need in order to receive the package. Id. [71] di Stefano, http://www. linuxinsider. com/story/65205. html. [72] Id. [73] Id. The article explains that a long-term incentive can take anywhere from one to three years or even longer to complete. Id. It keeps the executive’s eye on the goal to be achieved in order to earn the incentive, and it increases the chance that the executive will stay around at least long enough for the incentive shares to become fully vested. ” Id. A good example of this might be a retirement plan that requires an employee to stay for a certain amount of years in order to fully recognize the maximum amount of retirement benefit as possible. If an employee is two years away from maximum benefits, it is highly likely that the employee will stay there instead of switching jobs where a decent retirement is less likely. 74] Id. [75] Anne Moore Odell, Shareholders One Step Closer to Having “Say on Pay,” Sustainability Investment News, May 3, 2007, http://www. socialfunds. com/news/article. cgi/2284. html. This is a great step in that it gives the shareholders a direct voice in how they would like the company to operate. Normally the shareholders elect a board of directors and the board makes many of the decisions as to who to hire, etc. , and the chief executives make many of the business decisions. Naturally it is a great step for shareholders to have a voice, even if their vote or voice is not binding.

It shows the management which direction the owners of the company want it to head and can show hesistance if they do not feel comfortable with the direction it is currently taking. [ows the different types of


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