Opinion: The problem with performance-based compensation - 7 Dec 2008

A major cause of the current economic crisis was the simple failure of
financial institutions to adequately price risk. Former Federal Reserve
chairman Alan Greenspan recently testified that he was “in a state of
shocked disbelief” that the “self-interest of lending institutions”
failed so markedly to protect shareholders. One question is whether a
provision of the tax code that encourages companies to use significant
amounts of performance-based compensation may have contributed to the
current dire situation.

Fifteen
years ago, in response to populist outrage over outsize executive pay
packages, Congress decided to limit the amount that public companies
could deduct for compensation paid to senior executives. Under the new
law, while companies could claim tax deductions for an unlimited amount
of performance-based compensation paid to senior executives, they could
deduct no more than $1,000,000 of other types of compensation, such as
salary. Partly as a result of this change to the tax code, companies
have increasingly turned to performance-based pay, particularly stock
options, as the primary form of compensation for senior executive
officers...

entire article -http://www.financialweek.com/apps/pbcs.dll/article?AID=/20081207/REG/812049954/1023/OTHERVIEWS

...The issue then is whether the tax push for
performance-based pay has gone too far with respect to the risk
preferences of senior management. With solely cash compensation,
managers could be expected to take too little risk. With solely stock
option compensation, managers could be expected to take too much risk.
The recent behavior of financial institutions and their apparently
voracious appetite for risk may suggest that the pendulum has swung too
far.

Another conclusion may be that the heavy use of stock
options as the preferred form of performance-based compensation should
be reconsidered. If senior management were granted restricted stock
(stock that vests over time) as opposed to options, the incentive to
take too much risk would be removed. Managers would then own stock,
just like shareholders. One significant practical problem with this
approach is that the current tax law does not treat restricted stock as
performance-based compensation; accordingly, restricted stock grants
are subject to the $1,000,000 limitation on deductibility.

Recent
events should cause Congress to reconsider whether the tax code’s
intervention in executive compensation design is warranted. At a
minimum, the current tax law’s preference for stock options over
restricted stock ought to be removed.

Gregg D. Polsky is a professor of law at the Florida State University College of Law.