Congress Takes Aim at Executive Compensation

Several bills that Congress is expected to send to the White House in the near future will further regulate executive compensation arrangements, which shareholders, directors and politicians have called excessive as a result of high profile cases that have made headlines across the country.
According to some figures between 1970 and 2001, median pay among the top 100 executives rose from 35 times that of the average worker to more than 500 times as much. The issue of CEO pay exploded in the wake of Enron when top executives pulled their investments out of the company before it went belly up while employees’ 401K retirement plans evaporated. Since then Home Depot’s Bob Nardelli and Pfizer’s Hank McKinnell – both leaving with about $200 million each – have fanned the flames of shareholders’ ire. Attorneys who handle compensation matters for their executive clients identified four laws, two of which are pending in a Congressional conference committee, that will affect how executives are paid.
·         Rep. Barney Frank (D-Massachusetts) is proposing the “Protection Against Executive Compensation Abuse Act.” That will require public companies to issue annual reports that show the compensation plans for the company’s principal executive officers. Such information will reveal any type of compensation – whether present, deferred, or contingent – paid or to be paid to executives; an estimate of the present value of any accrued pension; the estimated market value of any other benefits received by executives; any agreements or understandings concerning any type of compensation. A shareholders vote will be required to approve compensation plans.
·         Senate Finance Committee Chairman Max Baucus, (D-Montana) is proposing to set a $1 million limit on the amount of tax-deferred compensation employees can receive each year. According to the bill’s language it would allow employees to defer the lesser of $1 million a year or the average of their taxable compensation over the previous five years. Any deferred compensation above those amounts would be immediately subject to taxes as high as 35 percent. Individuals would pay taxes they had been deferring and companies would be required to immediately claim compensation deductions.
·         The Securities and Exchange Commission has promulgated amendments to the disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters and security ownership of officers and directors. These amendments would apply to disclosure in proxy and information statements, periodic reports, current reports and other filings under the Securities and Exchange Act. The amendments would also apply to the current proxy season.
·         The Jobs Act adds new Internal Revenue Code Section 409A, which will govern the treatment of a range of nonqualified deferred compensation plans. The law was adopted in November 2004. However Michael Sirkin, a partner with Proskauer Rose and a senior member of its Employee Benefits and Executive Compensation Group, said the final regulations have not been completed because of “unanswered questions” and its broad language and complexity. The law would regulate excess benefit plans, supplemental executive retirement plans, severance plans, certain equity plans, and others. With regard to severance pay, the law stipulates that key employees of publicly-traded companies generally would be prevented from taking a distribution upon separation from service of deferred compensation, until six months after the separation date.
“Unfortunately they are trying to quickly react to specific problems,” Mr. Sirkin said about some of the new, or proposed, laws. “They are not taking all of the necessary time before adoption to sift through all the practical ramifications and figure out how it’s going to be implemented.” The new SEC proxy disclosure rules will result in going a long way to improve governance by requiring the disclosing in detail of compensation matters to the company’s shareholders. The real point after disclosure is that companies must have a compensation committee with “backbone” and an ability to determine what is reasonable compensation and what is too much, “they can best evaluate the situation and what’s best for the company,” said Mr. Sirkin, who represents executive, companies and compensation committees.
Shareholders and investors will probably be watching directors scrambling to gather various documents and contracts directly related to executive pay to comply with pending legislation and regulation. Outside consultants and lawyers figure to play a prominent role in interpreting these contracts to board directors. Directors will pay handsome fees, for such services due to the complexity associated with corresponding tax and regulatory issues.
“You have stock option plans, non-qualified plans, SERPs [Supplemental Executive Retirement Plans, which are non-qualified deferred compensation plans that are put in place to provide additional retirement income for executives], and deferred compensation” which go through different corporate hands, said Alton C. Ward, an attorney with Hill, Ward & Henderson and who is Co-Chairman of the firm’s Corporate and Tax Group and leads the firm’s Executive Compensation and Employee Benefits practice. “Now all the companies are being forced to look at all of this. All the benefits of the executives - it’s a hot issue.”
Some argue that since the CEO's pay is set by the board of directors, with the CEO determining the selection, tenure, and committee assignments of directors and most often selecting the compensation consultants as well, an unhealthy conflict of interest occurs and prevents effective price competition. However, Daniel P. Moynihan, Principal of Compensation Resources, Inc, disagrees with that popular observation. He is already seeing a change in board behavior because the audit and compensation committees are making the compensation consultants selection, deciding on the committee pieces, and deciding on the board compensation. “A lot of that power has been taken away from management,” he said.
As overall regulation and criticism mount, the media has reported on CEOs and other executives leaving public companies (or taking public companies private) for privately held organizations, and especially, private equity firms in the pursuit of making hefty sums of money without bearing public scrutiny. All of our sources who agreed to go on record said compensation and pay were of course a big factor in CEOs decisions for heading to private companies. However, the challenge, ego, power, opportunity, and dynamics were probably first, or at least second, considerations. “I think people seek dynamics all the time and that is leading business” for the private equity industry and the merger and acquisitions transactions that it is spurring, said Mitchell Feldman, president of A.E. Feldman Associates Inc., an executive search firm. Mr. Moynihan said the aggravation has risen with public companies where executives accept more risks complying with Sarbanes Oxley and other regulatory regimes. “And if you look at why companies go public it’s typically the access to capital. What we found is that in this new economy there is plenty of access to capital in the private equity space – so you can get access to capital without having to go public,” he said. Private equity firms spent about $370 billion in 2006 to take 1,010 companies private, up from a mere 324 companies in 2001.
Private equity firms have recruited CEOs and executives to target distressed companies, become the company’s temporary CEO, restructure failing organizations, take the company public again in a few years, and then install a permanent CEO once the new company is humming along on the public market. “They get to ride off into the sunset with their pockets lined with cash,” Mr. Moynihan said. CEOs and executives may also go onto become a private equity fund’s general partner investing in numerous companies and getting back exceptional returns once the companies are taken public or sold off in a M&A deal. PE investors are finding executives’ insight and respective expertise very valuable for specialty funds.
The PE industry has also become a stiff competitor with public companies in terms of dishing out the best executive compensation deal because deal volume and fundraising have surged deep into record territory and thus PE firms are scrambling to hire more people. Business Week pointed out that dealmakers two years out of their MBA program can earn $400,000-plus per year in base salary and bonus, plus a share of company profits that can be worth much more. Founders and CEOs of large hedge funds can earn hundreds of millions of dollars per year with private equity leaders earning similar amounts.

“Investors are pouring money into segments of the market that have the least amount of government regulation,” Mr. Feldman explained. Sources said they did not expect the private equity party to end any time soon with interest rates remaining low and the number of bankruptcies being low. When the PE bubble does burst, the CEOs and executives that did leave public life will more and likely return or migrate toward hedge funds. “When the bottom does fall out they will go back to what they know,” Mr. Moynihan remarked. “I would liken it to all the guys who left the big companies in the mid- to late-90s to go to Internet companies – but they all found jobs.”