March 09, 2009
Long-time, first-time
Posted by Andrew Lund

Thanks so much to Gordon and Christine for the invitation to join in the fun!  As a longtime devotee of sports radio, “Long-time reader, first-time blogger” doesn’t quite sound right, but it’s close enough.  Over the next two weeks I’ll subject everyone to a number of thoughts on the Delaware Supreme Court’s upcoming decision in Ryan v. Lyondell, good faith more generally and some other stuff, but I wanted to start off with an exec comp post.


Pursuant to a last minute insertion by Sen. Dodd, last month’s stimulus bill limits annual incentive compensation for certain executives at bailed-out firms to one-third of their total annual compensation.  Suffice it to say that this provision has not fared well among commentators.  The basic complaints center on fear that firms will shift to higher salaries, they'll avoid participating in the program, and/or the limitations will lead to a brain drain.


Without commenting on the merits of the provision itself, I’m wondering about its implications for executive compensation across all firms.  Specifically, has the federal government officially fallen out of love with performance-based compensation?  As many know, Section 162(m) of the Internal Revenue Code denies deductions for public companies’ compensation expenses for any of its top five officers to the extent they exceed $1 million.  As almost all of the people who have heard of 162(m) also know, there is a gigantic loophole for this limitation.  Firms keep the deduction if the compensation above $1 million is “performance-based”.  That is, the federal government prefers performance-based compensation.


Or, it did until last month.  Now that Congress has rejected performance-based pay as an effective tool for aligning executives’ interests with the federal-government-as-creditor, can the 162(m) performance-based pay exception be far behind?  Maybe the federal government’s concerns as a creditor differ from the shareholder-intensive focus of 162(m).  If performance-based pay, as usually practiced, favors shareholders vis-à-vis creditors (and if we can justify preferring shareholders to creditors outside of the bailout context), the two positions are not necessarily irreconcilable.  But I’m more than a little skeptical that Sen. Dodd was thinking about this shareholder/creditor distinction when he forced the provision through in the face of opposition from the Obama administration.  Rather, it seems like Congress (and Barney Frank, in particular) doesn’t trust performance-based compensation anymore as a corporate governance tool.  Accordingly, I suspect there’s a better than 50/50 chance that the 162(m) loophole will be gone in the near future for all public companies.  In fact, Treasury had already started taking steps towards imposing limitations.


What would it mean to take away the deduction?  It isn’t clear how much 162(m) has really driven decisions about total compensation and, to the extent it has, whether it’s been a net positive. (See Gregg Polsky’s nice paper on the subject)  It certainly has shifted the kind of pay towards performance bonuses and stock options.  And although the feds may not be into performance-based pay anymore, institutional shareholders still are.  So the end of the 162(m) exception would likely not signal a shift away from options to salary or lower total comp.  Instead, it would only further level the playing field between plain vanilla options and both restricted stock and indexed options, neither of which currently count as “performance-based” for 162(m) purposes unless vesting is conditioned on a performance hurdle.

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