The Truth about Executive Compensation - 14 June 2009

The Truth about Executive Compensation

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.  Well, 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

http://seekingalpha.com/author/dan-braem/instablog