Upper Saddle River, N.J. - September 12, 2006 - The government’s investigation into the excesses of executive compensation has now expanded into the practice of granting backdated stock options, with at least 100 companies now under the microscope. This seemingly widespread and highly questionable practice has triggered the government’s consideration of ways in which to put a lid on what many consider to be an abuse of executive compensation.
IRS Section 162m, in force since 1993, allows companies to deduct compensation above $1 million, for certain executives, only when it is performance-based. The rules interpreted stock options as being performance-based, whereas restricted stock grants are not, if the restriction is tied to time vesting. Because of the variable accounting treatment for performance-based stock options and restricted stock, most companies have not attached specific requirements to these grants. According to a recent article in the Wall Street Journal, Congress is open to considering the elimination of the performance exclusion. Although they expect stiff opposition to this change from publicly-traded companies, the recent introduction of Sarbanes-Oxley and expensing of stock options under FASB regulations appear to indicate that mass public and media outcry are more successful currently at driving reform than any actions from the business community.
It is interesting to note that some individuals within the government recognize that changes in the regulations can have huge and totally unexpected consequences. The exponential increase in the use of stock options that began in the second half of the 1990’s was a clear result from the enactment of Section 162m. The total elimination of the performance exemption would have a tremendous impact on the financials of many companies; any change in the regulations may therefore be tempered by only eliminating the exemption currently tied to nonperformance- based stock options.
What should a company do? Other than giving input to your representatives in Washington, the most important thing to do is to take a hard look at your current executive pay programs and determine if they will pass the “sniff test”. Are they performance-based, and are the underlying performance criteria tied to increasing owner/shareholder value? Is the amount paid out commensurate with the competitive market, and is it appropriate, given the level of performance achieved? Does the overall program address the four major objectives of compensation:
1) focus attention on desired results
2) attract qualified talent
3) retain valued and productive employees
4) motivate them to achieve improved results.
If these questions can be answered positively, there is a good chance that the programs reflect a balance between executive needs and those of the company and its stakeholders. If some of these questions are answered negatively, the programs should be further examined and revised so that they will pass increased scrutiny.
Compensation Resources, Inc provides consulting in Executive & Sales Compensation, Salary Administration, Stock Option & Performance Management Plans.
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