Compensation Objections

By Trishan Arul    April 8, 2009

This is a follow up post to my plan to deal with egregious executive compensation. The basics are simple:

1. Compensation above a reasonable limit (3X the President’s salary or ~$1.2M) is taxed at a special rate of 90%. Such compensation is not deductible to the company and incurs a penalty tax of 10X the amount paid.
2. Such compensation must also be approved by an absolute majority of voting shareholders with no proxy voting allowed, i.e. it must be actively approved by the people who actually own the company but up until now have zero control over compensation policies.
3. Long term compensation which is tied to the indexed value of the company and paid out over at least 5 years is subject to regular rates with no limit.

This rewards long term value creation and virtually eliminates the incentive to game the system for short term profits while taking risks with other people’s money. It truly aligns the interests of management with that of its owners instead of the “heads I win, tails you lose” structure that has dominated compensation for the past 10+ years. There are many objections to reforming compensation and I wanted to respond to some of those below.

• Hurts the US competitiveness since the best people will leave – The United States is the largest most vibrant economy in the world. The opportunity to work in a democratic capitalist country with a strong rule of law provides people with a greater chance of success than anywhere else. And US citizens are subject to income tax on their worldwide income. So if people really want to leave the country, renounce their citizenship, and work in another country, let them. Ask Russian Mikhail Khodorkovsky how the legal system works for billionaires in some other parts of the world.
• High tax rates will discourage work and reduce economic output – This is true at confiscatory tax rates which is clearly the case with a 90% rate or really anything above 50%. So this proposal might discourage some people from working. However, the people who truly create economic value do so over the long term, such as entrepreneurs building companies, and they wouldn’t be affected by this proposal at all. They will still be able to earn billions, they just won’t get it paid out in a single year. Anyone who truly believes that they are valuable shouldn’t be discouraged by such a prospect.
• Paying people based on what their successors do is unfair – Even when executives leave a company, they still will be paid out over five years. The notion that top management has an immediate impact on the results of a large enterprise is dubious. Changes in strategy and execution for companies that size take years to occur. Worst case scenario is that the first few years results are based on the executive’s work and the last couple years are the result of their successor. Maybe this would give imperial CEO’s a reason to do better succession planning. Would Sandy Weill at Citibank really have jetisoned Jamie Dimon and installed Chuck Prince if his pay was at stake? I doubt it and Citi shareholders & employees would have suffered less.
• Private companies don’t have a stock price – Any private company that is large enough to pay an employee over $1M/year can afford to obtain a professional valuation each year. In fact IRS Section 409A requires that any company granting stock options must set a FMV for its stock using a formal valuation. So this is already a requirement for large companies.
• Government should not interfere with the free market – I agree completely, if it is a properly functioning, fair, and free market. Executive compensation is hardly set in an open market by the owners of the company. While it may not be practical for widely held, public corporations to give all shareholders a say on compensation, the current system is clearly broken and needs to be fixed.

Another long post, but I think the topic deserves more national discussion. Reforming the incentive pay system would go a long way towards avoiding the reckless behavior that has imperiled the world economy. And rewarding only those who really create economic value is the right thing to do.