The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISpractices as attention focused on the “huge pay disparities between top executives in the twocountries.” 14Consistent with Time magazine’s labeling of CEO pay in 1992 as the “populist issuethat no politician can resist,” 15 CEO pay emerged as a bipartisan campaign issue among theleading candidates in the 1992 presidential election. 16 Legislation was introduced in theHouse of Representatives disallowing deductions for compensation exceeding 25 times thelowest-paid worker, and the “Corporate Pay Responsibility Act” was introduced in theSenate to give shareholders’ more rights to propose compensation-related policies. The SECpreempted the pending Senate bill in February 1992 by requiring companies to include nonbindingshareholder resolutions about CEO pay in company proxy statements, 17 andannounced sweeping new rules in October 1992 affecting the disclosure of top executivecompensation in the annual proxy statement. In 1994, the Clinton tax act (IRS Section162(m), passed as part of the Omnibus Budget Reconciliation Act of 1993) declared nonperformance-relatedcompensation in excess of $1 million as “unreasonable” and thereforenot deductible as an ordinary business expense for corporate income tax purposes. 18Executive pay came into the spotlight again in the 2000s after the “burst” in the Internetbubble and the accounting scandals at companies such as Enron, Adelphia, WorldCom, Tyco,Computer Associates, and scores of other companies. While executives at these companieswere awaiting trial or sentencing, another scandal emerged as academic researchers, the SEC,and the Wall Street Journal uncovered the practice of option-grant “backdating”. 19 Thispractice involves falsifying company records so that options granted on one date are reportedas granted on an earlier date when stock prices were unusually low. In particular, options thatwere reported as being granted with an exercise price equal to the grant-date market pricewere, in reality, granted at an exercise price below the market price on the actual grant date.14 “SEC to Push for Data on Pay of Executives,” Wall Street Journal (January 21, 1992).15 McCarroll, “The Shareholders Strike Back: Executive Pay,” Time, (May 5, 1992).16 “Politics and Policy—Campaign ’92: From Quayle to Clinton, Politicians are Pouncing on the Hot Issue ofTop Executive’s Hefty Salaries,” Wall Street Journal (January 15, 1992).17 “Shareholder Groups Cheer SEC’s Moves on Disclosure of Executive Compensation,” Wall Street Journal(February 14, 1992).18 The $1 million cap was not indexed to inflation, and converts to approximately €700,000 by 2009).19 Heron and Lie (2006a); Heron and Lie (2006b); Lie (2005); Maremont, “Authorities probe improperbackdating of options: Practice allows executives to bolster their stock gains; a highly beneficial pattern,” WallStreet Journal (Nov. 11, 2005).-7-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISThe backlash over CEO pay associated with the accounting and backdating scandalstriggered additional rounds of pay-related legislation and regulation. Enacted in 2002, theSarbanes-Oxley bill banned company loans to top executives and also required CEOs andCFOs to return ill-gotten bonuses and option gains following accounting restatements. 20 In2004, as a direct response to Enron (where a small number of executives were allowed towithdraw millions of dollars from their deferred compensation accounts just prior to thecompany’s bankruptcy), Congress added Section 409(A) to the Internal Revenue Code tolimit the flexibility in the timing of elections to defer compensation. In 2006, the FinancialAccounting Standards Board (FASB) began requiring firms to take an accounting charge forgranting options, and the SEC adopted significant new disclosure rules for executivecompensation affecting how (and what) compensation is disclosed and how companies mustdescribe their compensation policies and practices.The CEO pay controversies in 1933, 1982, 1992, 2006 and 2009 – and resulting callsfor government action – share several common themes. First, all occurred in economicrecessions or downturns that followed years of relative prosperity associated with largeincreases in executive compensation (and increases in USA income inequality moregenerally). Second, the controversies led to government action that was almost uniformlyeither ineffective or counterproductive, typically increasing (rather than reducing) CEO payand leading to inefficiencies in pay practices. Finally, while the controversies have touchedon legitimate issues concerning executive compensation, the most vocal critics of CEO pay(such as members of labor unions, disgruntled workers and politicians) have been uninvitedguests to the table who have had no real stake in the companies being managed and no realinterest in creating wealth for company shareholders.In this Section, we will explore the evolution of CEO pay in the USA: if pay structuresin the USA are indeed being imported into Europe, it is important to understand theirgenealogies. We begin with a challenging (and not completely satisfactory) discussion ofhow to measure CEO pay, a necessary component of any time-series. cross-sectional, orcross-country analysis. We then discuss the rise and fall of stock options in the USA, untilrecently the most important and distinctive component of executive compensation. Finally,we discuss the distinction between the “cost” of an executive compensation package from thestandpoint of the employer (i.e., the shareholders), and the value of that same package fromthe standpoint of the risk-averse and undiversified executive. This distinction is critical in20 The Sarbanes-Oxley Act also essentially halted option backdating by requiring that option grants bereported within two days following the grant. This desirable outcome was an unintended (albeit positive)consequence of the Act, since the backdating scandal was not unearthed until after the Act was enacted.-8-
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