Excessive CEO Pay: Key Regulatory and Legislative Development - 21 June 2009

Sunday, June 21, 2009

Excessive CEO Pay: Key Regulatory and Legislative Development

There have been two general approaches to executive pay reform. First,
changes to securities laws and regulations have attempted to strengthen
the bargaining position of shareholders by (1) requiring more complete
and comprehensible disclosure of CEO pay, (2) making boards more
responsive to shareholder interests, or (3) requiring a shareholder
vote on executive pay packages. Second, Congress has tried to restrain
the growth of executive pay by eliminating the tax deduction for
compensation paid in excess of specified caps.

Disclosure-Based Approaches

The
requirement that publicly traded companies disclose how much they pay
top executives dates from the 1930s. The SEC has modified the
disclosure format several times, as the forms of CEO pay have become
more various and complex. In 1992, the SEC required that proxy
statements include tables setting out several categories of pay for the
top five executives. These included base salaries, bonuses, deferred,
and incentive-based compensation, including stocks and stock options.

SEC 2006 Disclosure Rules

By
2006, the SEC had concluded that the 1992 disclosure rules were, in the
words of SEC Chairman Christopher Cox, “out of date.... [They] haven’t
kept pace with changes in the marketplace, and in some cases disclosure
obfuscates rather than illuminates the true picture of compensation....
We want investors to have better information, including one number—a
single bottom line figure—for total annual compensation.” In addition,
the SEC called for changes that would require firms to use “plain
English” in all their proxy statements, information statements, and
annual reports.5

To this end, the SEC amended its disclosure
rules in 2006 to combine what it called a “broader based tabular
presentation with improved narrative disclosure supplementing the
tables” in order to give shareholders and board members a “fuller and
more useful picture of executive compensation.”6 Announced on July 22,
2006, further amended on December 22, 2006, and currently under
consideration, the revisions would apply to disclosure in proxy and
information statements, periodic reports, current reports and other
filings under the Securities Exchange Act of 1934, and registration
statements under the Exchange Act and the Securities Act of 1933.7

The new and revised tables in the 2006 rules include a

•
Revised Summary Compensation Table, which was changed to include a
“Total” column aggregating the total dollar value of each form of
compensation quantified in the other columns;

• New Director
Compensation Table, which resembles the new Summary Compensation Table,
but differs in that it requires companies to present information only
with respect to the last completed fiscal year; and

• New Grants
of Plan-Based Awards Table, which requires companies to disclose
information on the fair value of the awards on the grant day.

For
stock awards and option awards reported in the Summary Compensation
Table and Director Compensation Table, the SEC initially required in
its July 2006 rules that companies report the total value of an award
made in a given year. The December amendments revised that requirement,
specifying that companies had to report in the tables only the portions
of the awards that vest in the year to which the proxy applies.8 In
addition, the December 2006 amendments require companies to include
footnotes in its Director Compensation Table corresponding to the
Grants of Plan-Based Awards Table fair value disclosures.

In
addition to the new and revised tables, the SEC introduced new rules
for narrative disclosure. The narrative disclosure is intended to aid
in the understanding of the tabular information. For example, with the
Summary Compensation Table, companies must provide information on the
material terms of each grant, “including but not limited to the date of
exercisability, any conditions to exercisability, any tandem feature,
any reload feature, any tax-reimbursement feature, and any provision
that could cause the exercise price to be lowered.”9

The SEC's 2007 Proxy Access Proposals

In
July 2007, the SEC proposed two quite divergent policy proposals. One
would essentially codify longstanding SEC practices of denying
shareholder-proposed candidates for board director positions to be
included in company proxy statements (briefly known as proxy access).10
The proposal, which the agency eventually adopted in late November,
appears to have been a response to the uncertainty that prevailed in
the agency after a 2006 Second Circuit Court of Appeals decision
(AFSCME v. AIG) that charged that SEC policy on shareholder proxy
access had been historically inconsistent. The second proposal, which
the agency did not adopt, would have allowed shareholders or
shareholder coalitions with greater than 5% of outstanding shares to
propose binding bylaw provisions that could permit specified
shareholders to nominate directors and require the company to include
the nominees in the company’s proxy statement. Generally, business
interests applauded the decision, while shareholder interests derided
it. Commissioner Cox, however, has indicated that the agency will
probably revisit the subject in 2008 when the commission is back to
full size.

Shareholder Approval

Under
H.R. 1257 (Representative Frank) and S. 1181 (Senator Obama), which are
both entitled the Shareholder Vote on Executive Compensation Act, proxy
statements shall permit a separate shareholder vote to approve
executive compensation as disclosed in the proxy. The shareholder vote
would not be binding on the board of directors; the board could choose
to ignore an unfavorable vote, though it is unlikely that they would do
so. The bill also would require proxy statements related to a corporate
merger or acquisition to include clear and simple disclosure of any new
“golden parachute” plans, or severance pay arrangements whereby top
executives receive extra compensation when the corporation is merged or
acquired by another firm. A separate, non-binding shareholder vote on
golden parachutes would be required. On April 19, 2007, H.R. 1257 was
approved by the full House.

The following legislative and regulatory developments have also affected CEO pay, although that was not their primary focus.

The Sarbanes-Oxley Act of 2002 (P.L. 107-204)

Enacted
in the wake of widespread accounting scandals at firms such as Enron
and WorldCom, P.L. 107-204 contains a broad range of corporate
governance and accounting reforms, some of which are relevant to
executive pay. Section 403 of the act requires insiders (defined as
officers, directors, and 10% shareholders) to file with the SEC reports
of their trades of the issuer’s stock before the end of the second
business day on which the trade occurred. This provision applies to
grants of stock options, a major form of executive compensation.
Previously, option grants did not have to be disclosed until 45 days
after the end of the fiscal year. Section 402 of the law makes it
unlawful for a public company to make loans, directly or indirectly, to
any director or executive officer.

Changes in NYSE and Nasdaq Listing Standards

In
2003, the SEC approved changes to the listing standards of the New York
Stock Exchange (NYSE) and the Nasdaq Stock Market that require
shareholder approval of almost all equity-based compensation plans.
Firms must disclose the material terms of their stock option plans
prior to the shareholder vote. The required disclosures include the
terms on which stock options will be granted and whether the plan
permits options to be granted with an exercise price that is below the
market value of the company’s stock on the grant day.

FASB's Options Accounting Rule

In
2004, the Financial Accounting Standards Board (FASB), a private sector
entity that writes accounting standards under the authority of the SEC,
released accounting directive FAS 123R, which requires companies to
recognize the value of employee stock option grants in their income
statements. (Previously, most companies had simply noted the value of
options grants in the footnotes to the financial statements.)
Recognition of the cost of options has the effect of reducing reported
earnings. Companies may reduce this impact by granting fewer stock
options to their officers and employees. Thus, FAS 123R may have
constrained executive pay even though that was not its primary intent.

Approaches Involving Caps on Tax Deductibility

The
second approach to CEO pay reform is to discourage excessive
compensation through the tax code, by limiting the deductions available
to either the firm or the employee when certain caps are exceeded.
While companies may generally deduct all employee compensation from
taxable income, various legislative proposals and enacted legislation
place limits on the tax deductibility of certain forms and amounts of
pay. Some examples are provided below.

The Omnibus Budget Reconciliation Act of 1993 (OBRA)

P.L.
103-66 established code section 162 (m), “Certain Excessive Employee
Remuneration,” which imposes a $1 million cap that applies to the CEO
and the four next-highest-paid officers. No tax deduction for
compensation above the $1 million limit is permitted, except for
“performance-based” pay, such as commissions or stock options, where
the ultimate compensation received by the executive depends on the
stock price, reported sales or profits, or some other financial
indicator. The OBRA provision is widely believed to have contributed to
the increased use of stock options in CEO compensation in the mid- and
late 1990s.11 To the extent that this is true, OBRA may have had the
unintended consequence of increasing CEO pay.12

Income Equity Act

Former
Representative Martin Olav Sabo introduced legislation in several
Congresses (e.g., H.R. 3260, 109th Congress) to deny a corporate tax
deduction for compensation paid to any individual that was in excess of
25 times the compensation received by the lowest-paid full-time
employee of the company.

H.R. 2 (Senate Version)

The
version of H.R. 2 (the minimum wage bill) passed by the Senate on
February 1, 2007, by a vote of 94-3, included several tax provisions,
one of which applies to executive pay. Current tax rules permit
individuals to defer taxes on income that is held in non-qualified
deferred compensation plans. Under the Senate version of H.R. 2, an
individual could defer no more than$1 million annually from taxable
income by contributing to such a plan.13 The version passed by the
House on January 10, 2007, had no similar provision.

Endnotes

5 Christopher Cox, “Speech by SEC Chairman: Chairman’s Opening Statement; Proposed Revisions to the Executive
Compensation and Related Party Disclosure Rules,” January 17, 2006, http://www.sec.gov/news/speech/
spch011706cc.htm.
6 “Executive Compensation and Related Person Disclosure,” Federal Register, vol. 71, no. 174 (September 8, 2006),p.
53160; “Executive Compensation Disclosure,” Federal Register, vol. 71, no. 250 (Dec. 29, 2006), p. 78346.
7 “Executive Compensation and Related Person Disclosure,” Federal Register, vol. 71, no. 174 (Sept. 8, 2006), p.
53158.
8 The SEC explained its December 2006 revisions thus: “Disclosing the compensation cost of stock and option awards
over the requisite service period will give investors a better idea of the compensation earned by an executive or
required disclosure of the sum of the number of securities underlying stock options granted (including options that
subsequently have been transferred), with or without tandem stock appreciation rights (SARs), and the number of
freestanding SARs.” “Executive Compensation Disclosure,” Federal Register, vol. 71, no. 250 (Dec. 29, 2006), p.
78338.
9 Ibid., p. 78343. For more on the SEC rules, see CRS Report RS22583, Executive Compensation: SEC Regulations
and Congressional Proposals, by Michael V. Seitzinger.
10 A proxy statement has SEC-approved information that is to be voted on at an annual meeting.
11 Other factors, such as the wave of public offerings by cash-poor technology firms and the bull market itself, also
increased the popularity of options during the 1990s.
12 For example, see the “Testimony Concerning Options Backdating,” by Christopher Cox, Chairman, SEC, before the
U.S. Senate Committee on Banking, Housing and Urban Affairs, Sept. 6, 2006.
13 Joint Committee on Taxation, Description of the Chairman’s Modification of the Provisions of the “Small Business
and Work Opportunity Act of 2007” (JCX-5-07), Jan. 17, 2007, p. 25.

For more information on Key Exec Pay Regulatory DevelopmentE.