Bill Clinton had what he thought was a great idea to curb the soaring paychecks of the nation's executives. It was 1991, shortly after the launch of his Presidential campaign, and he had just read a best seller on corporate greed by compensation guru Graef Crystal.
Clinton's brainstorm: Use the tax code to curb excessive pay. Companies at the time were allowed to deduct all compensation to top executives. Clinton wanted to permit companies to write off amounts over $1 million only if executives hit specified performance goals. He called Crystal for his thoughts. "Utterly stupid," the consultant says he told the future President.
THE SHAME GAME
Now, 13 years after Clinton's plan became law, the results are clear: It didn't work. Over the law's first decade, average compensation for chief executives at companies in Standard & Poor's 500-stock index soared from $3.7 million to $9.1 million, according to a 2005 Harvard Law School study. The law contains so many obvious loopholes, says Crystal, that "in 10 minutes even Forrest Gump could think up five ways around it."
From the Internal Revenue Service to corporate boardrooms, Clinton's remedy has become the biggest inside joke in the long history of efforts to rein in executive pay. It has allowed companies to take deductions for executive pay tied to goals as vague as "individual achievement of personal commitments" (BellSouth Corp.(BLS) or improving "customer satisfaction" (Dell Inc. (DELL)). Energy giant AES Corp. (AES) for a time demanded that its top people maintain a workplace that was "fun."
"We were trying to shame companies into changing their behavior," says former Clinton senior adviser Bruce Reed. "And companies have been shameless in ignoring what we did." Or perhaps just astute in exploiting the flimsiness of Section 162(m) of the IRS code, as the measure is formally known. Reed acknowledges that the Clinton team deliberately watered down the proposal to make it more palatable by, for example, not applying the performance requirement to the award of stock options. Clinton did not return calls for comment.
As the Democrats prepare to take control of Congress, 162(m) is likely to come under intense scrutiny. The Securities & Exchange Commission has already announced it will require greater disclosure of executive pay beginning in 2007. On Oct. 23 a coalition of 25 pension funds with $850 billion in assets formally demanded more information about the sort of advice compensation consultants provide to Exxon-Mobil Corp. (XOM) and 24 other corporate giants. Meredith Miller, assistant treasurer for policy of Connecticut's state employee pension plan, says 162(m) is one of the investor coalition's main concerns. "We've become more sensitive to the gaming" of pay rules, she says.
Soon after the Clinton idea was enacted in 1993, compensation and tax advisers announced that they'd found ways to get around it. "It is unlikely that 162(m) will cause corporations to lower executive compensation levels," lawyer George A. Villasana wrote in the February, 1995, issue of CPA Journal. Currently the senior corporate counsel at AutoNation Inc. (AN), the country's biggest car dealer, Villasana observes that "companies have done exactly what I predicted."
Michael S. Melbinger helped turn Villasana's prognostications into reality. Melbinger heads the executive compensation practice at the Chicago-based law firm Winston & Strawn. His clients include Boeing (BA), Discover Financial Services (MS), and the New York Stock Exchange (NYX). "I don't want to give away my secrets," Melbinger says, "but I can figure out a completely legal way to structure most all compensation to fit within the `performance-based compensation' exception of Section 162(m)." As a practical matter, the law's requirement of performance criteria for deduction of pay above $1 million quickly established $1 million as the minimum base pay any self- respecting CEO expected from a major corporation.
Members of compensation committees of the boards of four of the nation's largest corporations told BusinessWeek that 162(m) is merely a nuisance that hasn't stopped them from paying executives whatever they consider fair. All of these directors requested anonymity for fear of losing their positions. Companies are under no legal obligation to disclose how they comply with 162(m), and as a result, a shroud of secrecy surrounds the topic.
BENDING THE RULE
"Look, this thing does not work," one irs official says about the rule. In 2004 the tax agency audited compliance at 24 companies and found that 23 had failed to comply with at least one requirement of 162(m). Among the failures: not getting shareholder approval for performance goals. The agency says it is continuing to monitor how companies in general comply with the rule. But the official confirms that a corporation that carefully navigates the provision's loopholes has little to fear.
One perfectly legal way to follow the letter of 162(m), if not necessarily its spirit, involves listing dozens of performance categories, keeping many hopelessly vague. A board's compensation committee can choose any one or a combination of the goals to measure an executive's performance. This laundry list often sounds responsive to shareholder concerns and seems to establish direct links with financial performance. The list may suggest, for instance, that an executive will be judged on "earnings per share" or "operational revenue." But how much in earnings or revenue? Such details are worked out in private by the compensation committee. BellSouth declined to comment on its board's application of the goal "individual achievement of personal commitments." Dell similarly didn't want to explain how it calibrated "customer satisfaction."
During Dennis Bakke's tenure from 1994 through 2002 as CEO of Arlington (Va.)-based AES, which operates power plants, his performance goals included maintaining a "fun" workplace. One way the board measured the fun quotient was with an annual employee survey. (Sample question: "How well do you believe AES people company-wide are doing in relation to the four principles listed below: fun, fairness, integrity, and social responsibility?")
"To some, it's soft," Bakke says of the focus on fun. "To me, it's a vision of the world." Targets set by other corporations are no more rigorous, he argues. "They all pretend to go through these metrics," he says. But "pay is determined by competition, by the market, by what the board wishes to pay, plain and simple."
Bakke, who was paid stock options valued at more than $9 million in his final year with AES, also was evaluated based on goals such as the successful financing of subsidiaries and ensuring that employees demonstrated "social responsibility." Today Bakke, 61, heads a nonprofit that runs charter schools.
Another way companies can reward executives in a tax-friendly manner, even when performance falters, is to set aside an inflated pool of money for such compensation. To qualify for a deduction, companies must set a maximum sum for compensating their top five officers. Many companies set aside more than they are likely to pay. If executives fail to meet certain performance goals, the company can still award lucrative (and deductible) bonuses by reducing compensation below the make-believe maximum.
Liz Claiborne Inc. (LIZ) in 2003 decided to cap total compensation of then-CEO Paul R. Charron at 200% more than his $1.3 million salary. Because Charron failed to meet some performance targets, the apparel company's compensation committee awarded him a bonus of $1.7 million on top of his salary--not the maximum amount, but a lot of it. Raul Fernandez, the CEO of ObjectVideo Inc. and chairman of the Claiborne committee, says: "You have to create frameworks that create the maximum amount of flexibility, deductibility, and getting the right amount to the person."
When all else fails, some companies simply ignore 162(m), forgo the tax deduction, and pay executives whatever the board wants. Scott McNealy, former CEO of Sun Microsystems Inc. (SUNW), has benefited from this approach. In addition to his base salary of $121,789, he was paid a $1.1 million bonus in 2005, even though the company was forced that year to restate earnings from earlier periods. McNealy failed to meet 162(m) performance goals such as achieving strong operating income and earnings per share, according to Sun's 2005 proxy statement. Presumably that meant Sun couldn't deduct the bonus, though the company won't comment on that. But Sun had other reasons for paying McNealy the extra money, says company spokeswoman Jennifer Farris: "employee retention," or keeping McNealy from leaving. Replaced as CEO in April and now serving solely as chairman, McNealy didn't return phone calls.
By Keith Epstein and Eamon Javers