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.
Dorf himself does not, noting that when counseling boards on executive pay packages, he approaches the issue “holistically” and, he insists, objectively, free of potential conflicts of interest that have been of concern to regulators in prior years.
A 2007 report issued by the U.S. House Committee on Government Reform and Taxation found that conflicts of interest among compensation consultants in 2006 were widespread. The report noted that more than 100 large publicly-held firms recruited compensation consultants. The latter received pay both for their advice on executive comp and — the cause of the conflicts — other services they provided to the firms.
These services, the report noted, “often far exceed[ed] those earned for advising on executive compensation.” One Fortune 250 company paid a compensation consultant more than $11 million for “other services,” over 70 times more than the company paid the advisor for executive comp services.
Compensation consultants interviewed by NU say such conflicts have been mitigated since the report’s release, in part through regulation. A new SEC rule (Item 407(e)(3)(iv) of Regulation S-K) requires companies to conduct a conflicts of interest assessment arising from the hiring of compensation specialist.
However, disclosure of the absence of conflicts (so-called “negative disclosure”) is voluntary in the proxy statements released to shareholders. In a 2013 survey conducted by TheCorporateCounsel.net, two-thirds of the companies polled indicated they planned to disclose.
Compensation consultants have also implemented guidelines to guard against conflicts of interest. Dorf says his firm’s ethics policy forbids staffers from providing more than $125,000 in “ancillary services” when advising companies on executive pay.
All well and good. But this leaves open the question as to whether compensation paid for advising on the executive comp is itself a conflict of itself. The charge is analogous to the perceived conflict leveled against the credit ratings agencies, which many alleged artificially inflated ratings of financial institutions in exchange for hefty fees in the run-up to the 2008 mortgage debacle.
Compensation consultants insist that current safeguards, in particular those resulting from passage of the 2010 Dodd-Frank Act, adequately address investor concerns. Under the law, boards and compensation committees now have to consider several factors when evaluating the independence of compensation consultants.
In addition to (1) determining whether the advisor does other work for the company, these include: (2) how much of the advisor’s revenue is derived from the corporate relationship; (3) what conflict of interest policies the advisor has set up; (4) whether the advisor has pre-existing relationships with board members; (5) whether the advisor has relationships with the executive officers; and (6) whether the advisor owns stock in the company.
“All compensation committees now go through this independence check with their advisors,” says Marc Baransky, a managing director at Semler Brossy Consulting Group. “If there are factors that might call into question the independence of an advisor, that’s something a comp committee needs to consider when choosing an advisor.
“So I think the perception that advice may arise from conflicts of interest has been addressed, both over the last 10 to 15 years and made explicit with the Dodd-Frank legislation,” he adds.