Gargantuan pay packages for CEOs and other NEOs (named executive officers) have not gone unnoticed in the nation’s capital. Members of Congress have focused ever more of their attention—and skepticism — in recent years on executive pay.
The national spotlight has yielded a growing body of rules and regulations concerning executive comp, much of it the result of legislation. Topping the list: The Sarbanes-Oxley Act of 2002, which prohibits personal loans to executive officers and directors, including sign-on loans, salary advances, loans to purchase restricted stock, personal use of a corporate credit card and split-dollar life insurance policies — a once significant financial benefit for executives and their heirs.
The Sarbanes-Oxley also includes a clawback provision that requires executives to return income that would not have been earned absent the unethical or illegal manipulation of financial operations. One problem with this provision: By the time it’s invoked, says Dorf, the executive in question will likely have spent the money received.
The possibility of malfeasance is one reason why Dorf recommends imposing a “circuit-breaker” to prevent payouts that might have resulted from wrongdoing or actions that left a company in a perilously weakened position.
“The circuit-breaker is a very important consideration in compensation plan design,” says Dorf. “Before you pay out the money, make sure you have the funds and be certain that everything passes the smell test. If something doesn’t smell right, then you better hold off until such time as the compensation has been thoroughly vetted and approved.”
As well as cross-checked against federal requirements. In 2005, the IRS promulgated Section Internal Revenue Code Section 409 (an outgrowth of the American Jobs Creation Act of 2004), which requires that non-qualified deferred compensation plans established for executives, among them arrangements funded with permanent life insurance, adhere to rules regarding the timing of deferrals and distributions. The penalty for non-compliance: a steep 20 percent penalty tax slapped on plans for the current year and for all prior years.
Despite the restrictions, the plans continue to be popular, particularly among younger CEOs for whom the deferred comp can provide not only tax-advantaged post-retirement income, but also income replacement in the event of their untimely death.
“For a 40-year-old CEO, putting money into a life insurance-funded deferred comp plan is a very smart idea, both because of the death benefit and because it’s a great tax play,” says Paul Dorf, managing director of Compensation Resources.
While adhering rigorously to 409A’s requirements, companies are less mindful of tax consequences connected with another IRC section, 162m. The code prohibits companies from deducting compensation in excess of $1 million if the payout is not tied to performance. Yet, says Dorf, over 90 percent of Fortune 500 companies defy the rule, justifying their actions, oddly, by noting that shareholders benefit.
“If, say, half of a $15 million payout is not performance-related and therefore not tax-deductible, then the company’s profitably, stock price and, I assume, investor perceptions of the business will be negatively impacted,” says Dorf. “So how can a company assert, as it so often does in proxy statements, that ignoring the regulation is in the best interest of shareholders?”
To be sure, shareholders frequently get to vote on CEO remuneration, thanks to “say-on-pay” rules enshrined in corporate law. But in few instances— just three percent of cases in 2012 — have shareholders rejected a board-proposed CEO pay package. And whether voting up or down, they tend to ignore board actions respecting Section 162m.