August 10, 2005
The Tax and Financial Engineering Angle
Posted by Victor Fleischer

I will leave the Delaware fiduciary duty stuff to the experts, but I thought I would talk a bit about the role that the tax law and financial engineering played in the story.  The comp committee wanted to give Ovitz "downside protection," by which they apparently meant a guaranteed salary.  To preserve the appearance of pay-for-performance, they offered some of this guaranteed salary in the form of options, but if the options failed to appreciate to at least $50 million, Disney would make up the difference. 

This guarantee ran into a 162(m) problem: 

To that end, Santaniello concluded that the $50 million guarantee presented negative tax implications for the Company, as it might not have been deductible.  Concluding  that the provision must be eliminated, Russell initiated discussions on how to  compensate Ovitz for this change—from this, an amalgamation of amendments to certain terms of the OEA arose in order to replace the back-end guarantee. 

(Opinion pp. 26-27.)

Section 162(m) of the Code provides that corporations may not deduct compensation in excess of $1 million unless it is qualified performance-based compensation.  A guarantee means that the compensation is no longer performance-based.  I find it telling (but not at all unusual) that Disney's response was not to renegotiate for stronger performance-based incentives, but instead to seek a financial engineering solution that allows as little economic downside risk as possible without running afoul of 162(m).  Disney accomplished this by, among other things, lowering the strike price of some of Ovitz's options to at-the-money and increasing the severance package.  Long-dated at-the-money options are almost as good as receiving cash or stock, but produce better tax consequences for the executive.  I have written extensively about how the tax code distorts financial incentives in the private equity context.   The public company context is, sadly, even more distorted.  When it comes to corporate governance, tax only hurts.  It never helps.

Among other problems, the Code encourages the sort of financial engineering that makes meaningful review by a board of directors more difficult.  If Ovitz were simply offered $150 million in straight cash, guaranteed, the board might have asked more questions.  Instead, to ensure that the compensation was deductible, Ovitz received a package that was economically similar to cash, but more complicated and confusing.  The desire to camouflage the compensation is not primarily tax-related, but the tax Code's bias against cash salaries doesn't help.

The end result was a nonsensical compensation design that, as Professor Murphy testified, provided perverse incentives for Ovitz to perform badly and get fired.  The Board gets a free pass on this silly compensation design, apparently, because of the "type of person" Ovitz is.  The Chancellor, seemingly dismissing the relevance of incentives, explains: 

First, based upon my personal observations of Ovitz, he possesses such an ego, and enjoyed such a towering reputation before his employment at the Company, that he is not the type of person that would intentionally perform poorly. Ovitz did not build Hollywood’s premier talent agency by performing poorly. Second, nothing in the trial record indicates to me that Ovitz intended to bring anything less than his best efforts to the Company.

(Opinion p. 132.)  It should not be enough to point to an executive's reputation as a stand-up guy.  Incentives matter, and contracts should be designed with financial incentives in mind.  (Otherwise we should just drop the pay-for-performance charade and give cash.)  I don't think it's unreasonable to expect compensation committee members to understand a bit about incentives and conduct some meaningful review of the contracts. 

Whether meaningful review of the compensation design is a matter for Delaware law or "best practices" I do not have the expertise to say.  But I will suggest that if Delaware doesn't get its act together with respect to executive comp, we may soon see federal intervention, for better or for worse, perhaps through the tax Code.  And that's not likely to help anyone.

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