The Delaware Supreme Court upheld a Chancery Court determination that a board did not commit waste by consciously deciding to pay bonuses that were non-deductible under Section 162(m) of the Internal Revenue Code (Freedman v. Adams, Del. Supr., __ A.2d __, No. 230, 2012, Berger J. (Jan 14, 2013)). Unlike claims of gross negligence, claims of waste are not subject to exculpation or indemnification by the company and therefore have the potential for personal liability of directors.

The original suit was brought in 2008 by a shareholder of XTO Energy (later acquired by ExxonMobil) as a derivative claim. The suit alleged that XTO’s board committed waste by failing to adopt a plan that could have made $130 million in bonus payments to senior executives tax deductible. The board was aware that, under a plan that qualifies for the “performance based compensation” exception of Section 162(m), the company could have deducted its bonus payments, but, as the company disclosed in its annual proxy statement, the board did not believe that its compensation decisions should be constrained by such a plan. The Chancery Court held that the shareholder failed to state a claim. The Supreme Court agreed, holding that the decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment.

…continue reading: Delaware Supreme Court Upholds Board Compensation Decision

Most of the empirical work on executive compensation investigates the role of contemporaneous performance measures in setting cash compensation, ignoring the relevance of past performance measures and the structure of cash compensation. In our paper, The Relation between CEO Compensation and Past Performance, forthcoming in The Accounting Review, we focus on the relation between cash compensation components (salary and bonus) and past performance measures as signals of a CEO’s ability.

We first develop a simple two-period principal-agent model with moral hazard and adverse selection. Our model suggests that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection problems by separating agents into contracts with different levels of risk. Agents are screened and receive different bonus arrangements according to their types. The higher an agent’s type, the more sensitive his bonus is to contemporaneous performance. A higher ability agent receives a larger portion of his compensation in the form of bonus and less as salary. For a given agent, salary increases with his past performance and higher current salary predicts higher future performance. Current bonus, however, is negatively correlated with both past and future performance.

…continue reading: The Relation between CEO Compensation and Past Performance

It is common knowledge that people are not driven solely by the prospect of financial rewards. Yet, in business, motivational tools for top executives—particularly the CEO—almost singularly comprise financial incentives. In 1980, only 10 percent of the UK’s largest FTSE100 companies utilized incentive arrangements (in the form of cash and stock-based variable pay). Today, they are universally employed as a matter of best practice and variable pay accounts for approximately two-thirds of total compensation.

Widespread adoption of financial incentives has contributed to substantial pay increases, in absolute and relative terms. In the United Kingdom, the average compensation of FTSE100 CEOs climbed from £1 million in 1998 to £4 million a decade later, with the ratio of CEO pay to average employee pay nearly tripling. (The figures are, of course, higher for American executives.) The rise in top executive pay has far outstripped growth in share price and other indicators of company performance, with certain incentive arrangements proving counterproductive by encouraging excessive risk-taking and accounting manipulation.

Amid growing sensitivity to widening income inequality in many countries, it is no wonder that executive pay has remained a visible target.

…continue reading: Dim the Spotlight: De-emphasizing Pay for Performance

Though the global financial crisis of 2008 prompted a seismic shift in attitudes toward executive pay on the part of lawmakers, the public, investors, and other stakeholders, average compensation levels continue to rise or have returned to where they were before the crisis.

Mindful of the outcry over particular elements of pay packages, companies began scaling back bonus awards as well as payments related to “golden parachutes” and other forms of exit pay following the crisis.

Indeed, such components of executives’ total annual compensation declined in fiscal 2009 with some elements, including those dealing with exit pay, continuing to decline modestly into fiscal 2010.

But that has been more than offset through increases in other pay elements, most notably awards tied to company stock. The result is a 37 percent surge in total annual compensation paid to C-suite officers from fiscal 2008 to 2010 with stock awards now constituting more than half of the total pay pie.

As such, this post explores how the executive pay package mix and overall total annual compensation levels have changed since fiscal 2008 and the role played by stock-based awards in fueling the spike in total executive pay.

…continue reading: Post-Crisis Trends in U.S. Executive Pay

In the paper, Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior, we analyze the effect of a bonus tax on the risk-taking behavior of corporate executives in a principal-agent model. In our paper, the firm value (output) depends on the manager’s behavior in two dimensions. First, the manager can increase the firm value by exerting more effort. Second, the manager can choose a project with specific exposure. A project choice with a higher expected return simultaneously implies a higher risk. Therefore, the project choice influences the expected value as well as the variance in the output. For instance, bank managers dealing with credits face this kind of trade-off.

Credit at low interest rates can be assigned to firms with high ratings. Therefore, the bank has low expected profits but also low risks. Otherwise, credit at higher interest rates can be assigned to a start-up firm operating in a promising area but with high uncertainty. Thus, a higher expected return can be achieved by being exposed to higher risks. We assume that the principal offers a salary package consisting of a fixed salary and an incentive-based component (bonus rate). The bonus rate increases with the manager’s output. As the manager can only influence the output by his effort choice and the degree of exposure, the realization or failure of the project is stochastic.

…continue reading: Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior

In the paper, Excess-Pay Clawbacks, which was recently made publicly available on SSRN, Nitzan Shilon and I identify substantial deficiencies in the clawback arrangements of public companies. We also explain why the Dodd-Frank Act’s clawback requirement is likely to improve these arrangements, but does not go far enough.

The paper begins by highlighting the problem of “excess pay” – excessively high payouts to executives arising from errors in earnings and other compensation-related metrics. Such excess pay, we explain, can impose substantial costs on shareholders even if there is no manipulation or other misconduct. Unfortunately, directors frequently use their discretion to let current and departed executives keep excess pay. Thus, an optimal clawback policy would require directors to recover excess pay from either current or departed executives.

…continue reading: Excess-Pay Clawbacks

On 17 December 2010, the UK’s Financial Services Authority (“FSA”) issued the final form of the revised Remuneration Code (the “Code”). [1] The Code introduces significant restrictions on the way in which remuneration policies and structures are operated within financial institutions in the UK and beyond. The Code builds upon international standards set by the Financial Stability Board at a European level and goes beyond those standards in a number of key respects.

In this briefing, we have set out an overview of the background to the Code, a summary of the key provisions of the final form of the Code, as well as our commentary on some relevant provisions of the final-form guidance issued by the Committee of European Bank Supervisors (“CEBS”) on 10 December 2010. Finally, at the end of this briefing, we have focused in depth on some specific issues which may be of particular interest to our clients.

…continue reading: UK Financial Services Authority Issues the Final-Form Remuneration Code

As part of today’s UK Pre-Budget Report, the Chancellor of the Exchequer, Alistair Darling, announced two important measures targeting the banking sector. The first is the introduction of the much-heralded bank bonus tax, which will apply with immediate effect until April 5, 2010, to bonuses over £25,000. The second is the introduction of the Code of Practice on Taxation for Banks, which was originally published in draft form in June of this year.

This memorandum summarizes some of the key elements of these measures.

1. Bank Payroll Tax

Summary

Legislation in the Finance Bill 2010 will introduce a new “bank payroll tax” set at a rate of 50%. It will be payable by a bank, on the amount of a bonus to which an employee engaged in banking business is entitled, to the extent that the bonus exceeds £25,000. The tax will apply to bonuses awarded to the employee after the time of today’s announcement up to April 5, 2010. It is intended that in the longer term the remuneration practices of banking businesses will be changed as a result of corporate governance and regulatory reforms.

…continue reading: UK Pre-Budget Report Targets Banking Sector

(Editor’s Note: This post comes is based on an article that first appeared in the New York Law Journal.)

On Jan. 1, 2009, Merrill Lynch & Co. Inc. (“Merrill”) merged with Bank of America Corporation (“BofA”). [1] At the end of 2008, prior to the close of the merger, Merrill awarded approximately $3.6 billion in bonuses to its employees. The payment of these bonuses has been the subject of numerous investigations and lawsuits. This column discusses (i) the background to the payment of these bonuses and (ii) a pending lawsuit charging BofA with not furnishing adequate information to its shareholders in connection with their vote on Dec. 5, 2008, in which they approved the merger. [2]

Background

In the one-week period beginning Sept. 13 and ending Sept. 19, 2008, crises erupted at a number of major financial firms. The investment firm of Lehman Brothers filed for bankruptcy. The insurance conglomerate AIG received a pre-TARP bailout of $85 billion (giving the Federal Reserve a 79.9 percent stockholder position; additional amounts subsequently were provided with the total bailout amounting to approximately $170 billion). A third firm facing a financial crisis was Merrill. [3]

On Saturday, Sept. 13, 2008, Kenneth Lewis, the chief executive officer of BofA, met with John Thain, the chief executive officer of Merrill. They discussed the possible acquisition by BofA of Merrill. Merrill’s losses were turning out to be significantly greater than anticipated earlier in the year. Merrill’s losses, the deepening crisis on Wall Street and the precipitous drop in Merrill’s stock price threatened its survival.

…continue reading: Merrill Bonuses Raised Issues in Merger with Bank of America

(Editor’s Note: This post comes to us from Tracy A. Thomas of the University of Akron, and is based on a comment in the Washington University Law Review.)

In March 2009, ailing insurance giant American International Group (AIG) triggered a national outcry when it paid out $165 million in government bailout funds for employee bonus incentives. [1] President Obama called the bonus payments an “outrage” and promised that his administration would “pursue every single legal avenue to block these bonuses and make the taxpayers whole.” [2] He chastised the firm for its audacity of using borrowed taxpayer monies to reward financial recklessness and greed. This was the same company, of course, who within days of receiving its first infusion of government cash in September 2008, sent its executives on a half-million dollar boondoggle retreat at a fancy desert spa. [3] And just several months after the initial fiasco, AIG tried to award $265 million in further bonuses, [4] adding to performance bonuses of $454 million paid to employees and executives in 2008. [5] It was just over a year ago when AIG turned to the government for its survival. The government stepped in to assist AIG when the company faced imminent death from its risky financial derivative products that were backed by precarious mortgages. [6] Fearful that the toppling giant would trigger a cataclysmic domino effect, the government authorized the bailout funds to keep AIG, and the entire U.S. financial sector, afloat. [7] The government agreed to loan AIG the money, now totaling over $173 billion, collateralized with AIG’s assets and an 80% equity ownership of the company. [8] The first infusion of cash to AIG was authorized by the Federal Reserve in September 2008, supplemented with funds authorized in October by Congress in the $700 billion bailout bill, the Emergency Economic Stabilization Act (EESA), which established the Troubled Assets Relief Program (TARP).

As a result of the AIG bonus debacle, the President and Congress took several steps to try and avoid these problems in the future. In the EESA, Congress gave the Treasury Secretary the power to require these troubled financial institutions to meet appropriate standards for executive compensation, but did not directly prohibit the type of employee bonuses at AIG. [9] The subsequent American Recovery and Reinvestment Act (Recovery Act), passed in February 2009 after the transition to the Obama administration, added significant new restrictions for highly-paid executives of financial institutions that receive TARP assistance, including prohibitions against paying bonuses, retention awards, or incentive compensation, except as payments of long-term restricted stock. [10] President Obama also installed Kenneth Feinberg, former special master of the 9/11 Fund, as the pay czar to oversee all employee bonuses and payments for companies receiving large amounts of bailout funds, including AIG. [11]

…continue reading: Bailouts, Bonuses, And The Return Of Unjust Gains