Law Office of David S. Howard
David S. Howard, CPA

Politically Correct Compensation Plans for Top Corporate Executives

Executive compensation “quakes” have created a tsunami of another kind flooding the board rooms and executive suites of public corporations. Shareholders and the general public have become outraged with what has been termed excessive compensation of top executives.

A warning shake came during George Bush, Sr.’s presidential trip to Japan in January 1992. While the trip is might be mostly remembered for embarrassing incident when President Bush upchucked into the lap of the Japanese Prime Minister. Others of us remember the scolding Japanese business executives gave President Bush about the excessively high compensation of America’s corporate executives.

This criticism lead to the addition of section 162(m) to the Internal Revenue Code in the Omnibus Budget Reconciliation Act of 1993 (P.L. 108-357). Effective January 1, 1994, executive compensation in excess of $1 million would have to be incentive compensation approved by a compensation committee of the board made up of independent board members or it would not be allowed as a tax deduction.

Another jolt came with the Enron scandal in 2001. A major part of the scandal was the fact that top executives escaped the collapsing company by accelerating their deferred compensation and got cash while the employees left behind were stuck with their 401(k) plans funded with Enron stock. This and other scandals let to section 409A being added to the Internal Revenue Code in 2004 greatly restricting deferred compensation plans.

The financial meltdown of 2008 provided a jolt off the chart that has now added both momentum and volume to the wave of attack on excessive executive compensation. The general public, politicians and shareholders are outraged with large bonuses paid to executives of failed and bailed out companies.

There are daily stories in the business news of companies refusing to give their top executives raises or bonuses. There are angry shareholder groups who want “say on pay.” There are at least 28 bills before the House and Senate with proposals that will affect executive compensation. On December 17, 2009, the SEC approved new regulations for enhanced proxy disclosure of compensation arrangements. These new rules went into effect February 28, 2010; the day Canada’s hockey team defeated the US in the Olympics.

Special focus is not only on the CEO and the next four most highly paid officers (NEOs) but the scope is now larger and includes directors, other highly paid officers. Greater disclosure is now required for all employee compensation.

Nimble companies see the tsunami coming and have jumped up on their surfboards and are riding the wave. The companies that don’t catch on will be inundated.

Here is a quick FAQ for the CEO of a public company. This discussion is hardly comprehensive but it is directional.

Question 1 – I understand the term base pay but where has my annual bonus gone? Answer 1 – Don’t even say bonus. It is a bad word that is no longer PC. Look for something now called annual incentive compensation or annual at-risk compensation. There is also a whole new concept called maximum annual at-risk or annual incentive compensation. For example, the CEO of American Express had his 2009 annual non-equity incentive compensation capped at just under $23 million. American Express shareholders must feel relieved to know their CEO has his non-equity annual incentive compensation capped – it was so much easier when this was called a bonus.

Question 2 – What happened to my stock options why have they been cut back? Answer 2 – Stock options are not PC. They allow the executive to participate in the upswing in stock value with no investment in the stock itself. The new trend is for the executive to actually own shares of stock. Some companies require their top executives to own shares that have value equal to some multiple of their base compensation. Where does this stock come from? It is a gift from the company in the form of Restricted Stock Awards (RSA) or Restricted Stock Units (RSU).

RSA is actual stock given to the executive with a vesting over some period of time or upon the occurrence of certain incentivized events at the company. As the shares vest a portion can be sold off to pay the taxes triggered by the vesting. Ironically, stock ownership is generally better than stock options. Stock will hold value unless the company goes bankrupt. The sale can be taxed at capital gains rates. Options are worthless once the stock is below strike price and exercise is usually taxed as ordinary income.

For example shares given to an executive worth $10 each at the time of vesting will still have value if the stock goes to $3 a share or $30 a share. A stock option granted at $10 a share gives the executive the right to busy at $10 but is worthless when the stock goes to $3.

RSUs are deferred compensation plans measured by the value of the company’s stock and may be paid out in actual shares or cash upon termination of employment or some other event.

Question 3 – What happened to my golden parachute payment in the case of change in control or my being fired? Answer 3 – Golden parachutes are not PC. However, you will see that your retirement and pension plans have been beefed up. You will see an acceleration of vesting upon change in control, your being terminated or your actual retirement. You will see they have a SERP (Supplemental Executive Retirement Plan) to get you comparable benefits allowed your company employees under qualified plans which would otherwise limit your benefits or participation.

Question 4 – Where are all my old buddies on the compensation committee of the board. Answer 4 - Buddies on the compensation committee are not PC. The members of the compensation committee need to be independent trustees not otherwise employees of the company. These committees now hire compensation consulting firms to aid in the design of your compensation plan and to provide benchmarking data. The compensation committee would be foolish in this era to go it alone. You might want to invest in a compensation consulting firm if you get a chance.

Question 5 – What are the compensation tables I see in the proxy materials? What am I now a spreadsheet? Answer 5- The SEC is now requiring the disclosure of all forms of compensation for top executives in table form. The tables must show all forms of compensation including cash, equity, deferred, retirement, stock options, and fringe benefits. If there are elements which will depend on future events the company is now required to make reasonable estimate of what the payments will be worth. You now live in a fish bowl!

Question 6 – Can I still choose to travel on the corporate jet and be driven around in a corporate limo? Answer 6 – You may no longer have a choice. They company may require you to travel on a corporate jet or limo for security purposes. (This provision is borrowed from the Boeing executive compensation plan.) Not so bad. When you go to Washington DC to testify and the senator asks if you came in a corporate jet you can say I had to. It is in my compensation agreement and for security purposes.

Question 7 – What is this “say on pay” stuff? Answer 7 – Not only is every element of your compensation going to be on display so is all the background and compensation of the board members who set your pay. Soon shareholders may have the right to vote on executive compensation. Wells Fargo just made the news recently when they said they would subject their executive compensation plan to a shareholders’ “advisory” only vote on corporate compensation.

A friend of mine thinks the CEOs of the big bailed-out banks should have their “bonuses” paid from a pool of toxic assets. While this idea has still not been proposed it is clear that the tsunami is arriving at corporate shores.

Copyright © 2023 David S. Howard. All Rights Reserved. | Design: Kurt Elster