The Truth About Executive Compensation

by: Dan Braem

The government has tried to regulate executive compensation before. Unfortunately, the regulation backfired in a BIG way. Let me explain.

There is a little rule in the Internal Revenue Code under section 162(m) that limits the deductibility of compensation for executives of public companies. In general, the deductibility of compensation is limited to $1 million for the top 5 paid officers in a corporation.

There is a big exception to this rule. If the compensation is structured properly, bonuses and stock options may be excluded from limitation under 162(m). In other words, a publicly traded corporation can deduct the top 5 paid officers if certain conditions are met.

Now, we get to the fun part. Do some research on your favorite companies, and find out how the big boys are getting paid. My bet is that most of them have base salaries under $1 million, with potential for big bonuses and stock options.

Hopefully, it isn't that hard to see the connection with the relatively low base salary (under $1 million) and the big incentives - companies want to maintain as much deductibility as possible.

But it gets better. Because the government has encouraged this type of salary structure, many companies will throw out huge amounts of stock options to their executives. Remember, these are generally excluded from 162(m).

In general, what is the incentive for these executives? To raise the stock price, of course. Sounds noble. But there is a catch. Executives have been given an incentive to pump the value of the share price. We have seen over and over that executives try to accomplish this through share buybacks, hoping the higher EPS (remember, there will be less shares with buybacks) leads to higher share prices.

Again, this doesn't sound that bad. But it is. Under the rules of 162(m), management teams actually have a disincentive to reward their shareholders with dividends. In general, a dividend will decrease the share price, since there is less cash and fewer assets. Conversely, managements have an incentive to forgo dividends and pump the share price with buybacks. Unfortunately, this scenario has gotten so out of hand that the obsession has lead to the destruction of many companies' balance sheets.

If you think I am crazy, maybe the words of Warren Buffett will convince you. If interested, please read the 2005 annual letter to shareholders where Buffett talks about the hypothetical CEO "Fred Futile".

There are too many Fred Futiles in corporate America. We need to get rid of 162(m). We need to take other steps to empower shareholders. We DO NOT need government to manage our companies.

When it comes to regulating pay, we have seen this movie before. Unfortunately, the movie looks like a horror film.