Caution: New regs may not ultimately have the desired effect

The annual review and analysis of corporate filings for public companies is in full swing.  Almost invariably, this scrutiny brings with it an outcry concerning the exorbitant levels of executive compensation and the lack of a direct relationship between what some executives made and the financial performance of their companies.  In addition to articles that highlight some of the more , there are typically investigative reports that identify illegal, or at best, highly questionable activities.  Given the propensity of the public and investor in general to recoil at the issue of excessive executive compensation, it is no small wonder that they exert considerable pressure on regulators to control or reduce executive compensation.
 
Given that the desire is so strong to control executive compensation, it raises the question of what does the future hold.  In trying to answer this question, it is important to understand how compensation levels are set.  Assuming that the underlying purpose is to enable an organization to recruit and hire the best talent to meet its business needs, it naturally stands that the company will be very interested in what the competitive market levels are for the position to be filled.  This then places a lot of emphasis on availability of reliable information about the market to determine what an individual should be paid.  Recruitment of executive talent is typically not as aggressive as, say, real estate sales; at that level, multiple offers are limited, since fewer companies are competing for the same individual.  However, as opposed to home sales, the ideal candidate can typically raise the offer on his/her total compensation levels, since oftentimes the individual is still employed somewhere else.  The company then must try to lure him/her away with an enticing total compensation package, and typically requires buying out an existing package.  The “golden handcuffs” that a previous employer put in place to retain the executive probably will not stop him/her from leaving, but it will have the effect of raising the ante for the next employer.
 
If the marketplace is intended to dictate the amounts of compensation, of equal importance are the specific design considerations of compensation programs covering executives.  The basic principles of executive compensation programs, particularly equity-based plans, is to maximize the after-tax dollars to the individuals, while minimizing any negative tax and accounting considerations to the organization, such as those set forth by the IRS, FASB and IASB.  In addition, the executive compensation plans must adhere to all regulatory requirements, including the Sarbanes-Oxley Act (SOX) and those set forth by the Securities and Exchange Commission (SEC) and similar governing bodies.
 
With this as a backdrop, the question is: what does the future hold for executive compensation?  There are some experts that say that the latest requirements, including the proposed SEC regulations on enhanced disclosures, which spell out the use of tally sheets, identification of perquisites down to a lower level, and more transparency, will achieve the long sought-after effect of lowering compensation.  Unfortunately, there is a good chance that the recent and proposed requirements will have the opposite effect, namely, to show an increase in the level of reported total compensation, as the combined value of the diverse components of pay come to light and a total dollar value of the executive compensation package is shown.  If history repeats itself, there have been a number of incidents in the past where legislation and IRS changes have actually had the effect of raising compensation, which set new “floors” rather than “ceilings” as originally intended.  One example of this is the infamous “million dollar rule” - IRC 162(m) - which required base compensation above $1,000,000 to be performance-based in order for a public company to deduct the expense for tax purposes.  Instead of lowering pay, it actually increased the base salary and expanded the amount of performance-based pay.  IRC 162(m) was one of the main drivers in the increased issuance of stock options in the ‘90s; stock options are considered performance-based for IRS calculation purposes.  In addition, there has been a huge increase in the upside potential of annual incentives; typically performance-based, they provided the opportunity to raise the total compensation without negatively affecting the million-dollar rule.  Assuming that the performance measures are real, and actually drive the business, and they in turn help to increase shareholder value, additional performance-based pay is a little like “apple pie and motherhood”; a concept that few can argue with.  When above-average performance is achieved and increased compensation justified, this concept does work; however, it only takes one rotten apple to spoil the barrel and raise the red flags of what is perceived as "excessive" compensation.
 
Therefore, is history destined to repeat itself?  Will the new crop of regulations have the effect of lowering pay levels?  As in the past, this time around, we don’t think so.  They will hopefully make Boards and their Compensation Committees more cognizant of their responsibilities and better tie the compensation to defensible performance standards and achievements.  However, the market, although possibly leveling off, will still be a major determinant of what an organization needs to pay in order to attract top talent, retain proven individuals, and reward them through pay plans tied to the achievement of appropriately selected performance metrics.