Senate Finance Committee Looks at Executive Compensation Excesses

by Amanda Adams*, 9/12/2006

A Sept. 8 Senate Finance Committee hearing demonstrated that a 1993 tax code reform has failed to curb the growth of extravagant CEO compensation packages. In fact, the reform created loopholes that have opened the door for outrageous salaries and bonuses, and unscrupulous behavior by company executives and boards of directors.Senate Finance Committee Chairman Chuck Grassley (R-IA) vehemently denounced the loopholes in the tax code created by the 1993 reforms.
Prior to the hearing, Grassley told the Wall Street Journal that the original purpose of the 1993 law was to "make sure that there wasn't a great deviation between what executives got paid and what people further down the ladder" got paid.
"It really hasn't worked at all," Grassley said, explaining why he had called for the hearing. "I want to know what went wrong and how we can fix it."
Echoing Grassley's remarks, Christopher Cox, Chairman of the Securities and Exchange Commission, testified at the hearing that "as a Member of Congress at the time, I well remember that the stated purpose was to control the rate of growth in CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved. Indeed, this tax law change deserves pride of place in the Museum of Unintended Consequences."

The 1993 reforms applied to Section 162(m) of the tax code. Under 162(m), publicly traded corporations can deduct no more than $1 million in base pay for each of their five highest paid executives. More compensation of top executives can be deducted only if it is tied to job performance.
Despite the 1993 reform, executive pay continues to grow much faster than average worker's earnings, with much of it being deducted as "performance-based" pay. According to a recent report from United for a Fair Economy, the average executive made 40 times as much as a worker in 1980, but by 2005 made more than 400 times as much as a worker.
Part of this increase was fueled by section 162(m). Under the provisions of the reform, the nature of compensation for executives changes. Base salaries now take up only a minor portion of CEO compensation packages, while alternative types of compensation that qualify as "performance-based" pay, such as stock options, are increasingly common.
Not only did 162(m) fail to achieve its intended purpose, but it also made executive compensation more difficult to monitor. Harvard Law School Professor Lucien Bebchuk, who testified at the hearing, estimates that abuse of the performance-based provisions of 162(m) has cost the Treasury at least $20 billion. The IRS has launched a "Corporate Executive Compliance" initiative in response, hoping to improve the accuracy of reporting of executive compensation.
Witnesses at the hearing also discussed how 162(m) contributed to an up tick in stock options fraud. Stock options are automatically considered "performance-based" and have become a popular way of providing deductible executive compensation. Companies can "backdate," or choose the date from which the options would be issued, to change the value of the stock option. Stock backdating is not necessarily illegal, but it can make it easier for companies to hide the true extent of an executive's pay. Many companies that used backdating are now being investigated by the SEC for issuing fraudulent disclosures of executive pay, as well as possibly violating accounting rules.
Cox told the hearing that the SEC is ready to make new rules that would cut down on fraudulent disclosures, and Grassley expressed his intention to move forward on additional reform proposals, though he did not explicitly say what actions he would take.