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ANALYSIS
March 2, 2009
Sagging Index no longer reflects what’s going on in the market, some say, Replacements? Google it, to start.
March 2, 2009
Downward price spiral will actually boost the cost of capital for most companies. CFOS, take note.
March 2, 2009
The latest bailout at AIG could be a preview of how the president will deal with Wall Street.
March 2, 2009
No corporate defaults. Big debt offerings. Percolating CP issuance. Things may be looking up in the capital markets.
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December 7, 2008 12:01 AM ET
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. There are good reasons to expect that performance-based compensation will improve company performance by better aligning the interests of senior management and the company’s shareholders. For instance, economists argue that performance-based pay helps to align the risk preferences of managers and shareholders. If CEOs (and other senior management) were paid only salaries, they would have an incentive to run a steady ship and to take little risk, because if the company fails, they would lose their generous salaries and their high status. Thus, for example, CEOs would have an incentive to reject risky projects, even if those projects were likely to enhance shareholder value. Performance-based compensation can ameliorate this problem by giving CEOs a stake in the company’s upside performance. Stock options are the most prevalent form of performance-based pay used by public companies. Notably, holders of options have a greater preference for risk than stockholders. While stockholders suffer dollar for dollar from stock price decreases, option holders remain in the same position whether the stock stays flat or becomes absolutely worthless. Option holders are thus much more likely to have a “bet the house” mentality than stockholders. They also prefer leverage, which increases both risk and return, to a greater extent than stockholders. 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.
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