This article is reprinted with permission from the
March 27, 2007
edition of
New York Law Journal.
2007 NLP IP Company.

Executive Pay Continues to Rise Despite "Pay Reforms"

By Joseph E. Bachelder

Legal, tax and accounting changes have targeted "excessive" executive pay for many years. Nonetheless, executive pay and, most particularly, CEO pay, according to major surveys, continues to rise.[1]

The following includes comments on two decades of changes directed at reforming executive pay and what, if any, impact such changes have had on the levels of executive pay.[2]

Part A.  Rule Changes Over Two Decades

1984 - Parachute Tax.[3] In 1984, concerned with large executive payouts in connection with corporate takeovers, Congress imposed an excise tax of 20 percent on severance payments and other economic benefits provided to executives in connection with changes in control in excess of amounts permitted by the statute ("excess parachute payments"). (The same circumstances giving rise to the excise tax on the executive result, in most cases, in loss of deduction to the employer for the same amounts.)

Comment: By excepting "parachute payments" in situations in which the aggregate payments do not exceed 2.99 times a "base amount," Congress implicitly "gave its blessing" to severance payments and benefits up to that level (2.99 times the "base amount.")[4] The applicable sections of the Internal Revenue Code (code), §§280G and 4999, probably did, in some cases, keep a lid on parachute payments that might otherwise have been made. On the other hand, the establishment of the "2.99 multiple" as a standard, in general had a "lifting" effect on acceptable levels of severance (generally expressed as multiples of salaries and bonuses).[5]

• 1992 - Major Changes in Proxy Statement Disclosure Requirements.[6] In 1992 the Securities and Exchange Commission (SEC) substantially expanded the scope and detail of the disclosure of executive pay required by the rules governing proxy statements.

Comment: With greater disclosure and greater awareness of what executives were being paid, a "ratcheting effect" on executive pay occurred. According to many commentators on executive pay, executives, advised by expert consultants, became more aware of what their colleagues in other companies were being paid and pressed to be paid at, or above, the median of pay for those other executives. Boards of directors, wanting "above average" performance, felt they should pay above the average as shown by the data presented to them.

1993 - $1 Million Cap on Deductibility of Non-Performance Based Executive Pay.[7] In 1993 Congress enacted Code §162(m), which imposes on employers that are publicly traded corporations a cap of $1 million on deduction of certain types of pay to the CEO and four other top-paid officers (generally these represent the five most highly paid executive officers of the corporation) that is not "performance-based." "Performance-based pay," defined as pay based upon the achievement of performance goals, is excepted from the cap. Pursuant to regulations, stock options with an exercise price of no less than fair market value of the stock on the date of grant generally have been treated as "performance-based pay" and thus are eligible for the exception.

Many companies have chosen to pay over $1 million in non-performance-based pay (the most frequent form is salary) to their top executives and forgo the deduction. Other companies have designed their incentive compensation plans so as to comply with the performance-based exception from the $1 million cap.

Comment: Code §162(m) furnished executives with salaries less than $1 million a basis to push for an increase in their salaries. The ground: Congress had given its approval" of salaries up to $1 million. As noted above, many companies have elected to forgo deduction of salaries above $1 million rather than limit salaries paid to their CEOs and other senior executives to $1 million. Since 1993, salaries in many public corporations, especially the largest ones, have increased significantly and today many CEOs have salaries exceeding $1 million.[8]

2002 - Sarbanes-Oxley Act.[9] In July 2002 the Sarbanes-Oxley Act adopted a number of rules that directly or indirectly affect executive pay. Section 402 of the act prohibits loans to executive officers. Section 403 of the act requires that trades and other changes in beneficial ownership of employer securities by officers and directors (as well as 10 percent insiders) be filed with the SEC no later than two business days after the transactions occur. In addition, the 2002 Act established new rules for corporate governance including requirements as to independence of directors on audit committees. These rules, as applied by self-regulatory organizations like the New York Stock Exchange and NASDAQ, have been extended to require independence of directors involved in the executive compensation setting process.

2004 - Additional 20 percent Tax on Certain Deferred Compensation.[10] The American Jobs Creation Act of 2004 enacted Code §409A which imposes an additional 20 percent tax on nonqualified deferred compensation that fails to meet certain requirements imposed pursuant to that section.[11]

Comment: Section 409A and the proposed regulations under it are extremely complex.[12] (Final regulations are expected at about the time of the scheduled publication of this column.) It is doubtful that code §409A will reduce executive pay. It will cause executive pay to be redesigned to comply with §409A. Also contributing to this redesign will be the new SEC disclosure rules requiring greater disclosure of deferred compensation.

2004 - Accounting Change: Expensing of Stock Options.[13] Effective for most publicly traded companies for the first interim or annual reporting period commencing after June 15, 2005, FASB adopted an accounting change with major impact on executive pay by requiring a charge against earnings for stock option grants. The previous accounting advantage (no charge against earnings) for stock options has been eliminated.

Comment: Since the new rule, corporate employers have tended to cut back the number of stock options granted but also have tended to replace much of the value represented by stock option cutbacks with other forms of equity awards such as restricted stock and restricted stock units.[14]

2006 - Another Major Change in Proxy Statement Disclosure.[15] In November 2006, new proxy statement disclosure rules took effect. These significantly revised the 1992 disclosure rules, substantially expanding disclosure requirements.[16]

Comment: Certainly greater transparency of executive pay will be achieved.[17] Once again, however, as executives see greater detail about what their fellow executives are making there may be a ratcheting effect on executive pay. (This likely will be exacerbated by a single "total pay" number required for each named executive officer by a new column in the Summary Compensation Table). A similar ratcheting effect may impact on director compensation which now has its own separate table - resembling the Summary Compensation Table for named executive officers.

Other Developments. The legislative and regulatory changes noted above do not represent a full listing of significant legislative and regulatory changes affecting executive pay in recent years. Other changes include the expansion of coverage in the Form 8-K, which requires disclosure of material developments affecting senior-level executives. (Form 8-K is now required to be filed within four business days of the event being reported.) The fall-out from the stock option backdating scandals includes new SEC reporting requirements regarding related changes to financial statements.
A number of major U.S. corporations have adopted, or are considering adopting, new corporate governance rules relating to executive pay. These include (i) new rules relating to shareholder advisory votes on executive pay and (ii) new requirements that CEO pay be approved by at least three-quarters of the employer's independent directors.

Part B.  Why the Rule Changes Discussed Above Have Not Prevented Significant Increases in the Level of Executive Pay.

Most statutory and regulatory rules do not directly impact the setting of executive pay levels.

(a) Disclosure rules do shed more light on executive pay. But they do not prevent the setting of higher pay. In fact, as noted above, by causing the circulation of more data on executive pay they may have contributed to the rise in such pay.

(b) Tax rules directed at reducing executive pay (e.g., code §§280G and 162(m)) and regulating the form of it (e.g., code §409A) do generally require redesign of executive pay arrangements in order to comply with the new requirements. However, they do not generally result in reducing the level of pay and, again, as noted above, may have an opposite effect.

(c) As in the case of tax changes, accounting changes generally impact on the design but not the level of CEO pay. For example, as discussed in the first main section above - 2004: Accounting Change: Expensing of Stock Options - the imposition of a charge against earnings for stock options has led to increased awards of restricted stock (and restricted stock units) as a partial substitute for stock option grants. Ironically, a grant of equity in the form of stock or stock units, with only a time vesting requirement, will provide the executive with an economic reward notwithstanding that there is no gain, or even a loss, in shareholder value. In this sense, the accounting-driven shift to stock from stock options is a step backward from efforts to better align executives' interests with growth in shareholder value.

A market, whether real estate, publicly traded securities or executive pay has a force (up or down) that exists regardless of statutory and regulatory interventions of the sort noted above. To say that executive pay is not a perfect market may be a proper complaint but it is not an answer to the point made in the preceding sentence. For a corporation to let, or risk letting, a key executive leave because it is paying below-competitive levels may itself lead to criticisms of boards of directors who (a) may be viewed as pennywise and pound-foolish, especially if the successor executive performs poorly and (b) may incur as much cost (or more) in trying to secure a capable replacement.

The "Cost Pass-Through Syndrome." In many cases, when senior management makes a convincing argument for a pay increase, directors of public companies would rather pass through some additional cost to shareholders (see next paragraph) than be faced with an unhappy senior management. Most rule changes noted earlier in the column do not appear to impact significantly on this phenomenon. (Most significant in this respect may be the changes being made, or considered, by corporations in their governance rules affecting the approval of executive pay as discussed in the “Other Developments” section above.)
It is probably true that many directors would be more stringent if the costs involved were coming out of their own pockets. Since most directors of public corporations do not own a significant portion of the employer they are really making decisions with regard to other people's money (albeit with the burdens and responsibilities of being fiduciaries for the shareholders). This observation may run counter to the paradigm that Adolf Berle and Gardiner Means, authors of "The Modern Corporation and Private Property" (1932), would have hoped for. But it is a fact of life.

Per Share Cost of Executive Pay Increases. Twenty years of Jack Welch as CEO of GE cost shareholders of GE approximately $1 billion. Those 20 years also increased the total market value of GE shares by over $300 billion. (The compound annual growth rate in Total Shareholder Return for this period was approximately 21 percent.) The cost per share for Jack Welch's total compensation over that period: approximately 10 cents. Cost allocation among the outstanding shares of major U.S. corporations (in the case of GE, billions of shares) means a very small per share cost for most executive pay increases. The author's guess is that, consciously or not, many boards of directors would rather pass through pennies per share (in some cases, a fraction of a penny) of cost to shareholders than lose a key executive they want to keep.

Major public companies are competing with the compensation paid in the private equity market. Ironically, in contrast to the point made above in paragraph 2 of the section entitled "A market, whether real estate, publicly traded securities or executive pay has a force (up or down) that exists regardless of statutory and regulatory interventions of the sort noted above," owners of privately held companies are in certain respects more generous with executive pay than are directors of publicly owned companies. (In the 1990s this was true of the so-called "high tech" start-up companies and today it is true of many private equity ventures.) Equity is the component of CEO pay as to which private owners tend to be more generous than publicly held companies. If the venture works (generally from its sale or a public offering) then everybody, including senior executives, will stand to gain a great deal. Awards to CEOs and other top management in private ventures are frequently made not in terms of number of shares but in terms of a percentage of total equity. It is not uncommon for a new CEO of a major privately held enterprise to receive equity representing several percentage points (sometimes even more) of total outstanding equity. This, of course, reflects not only the opportunity side but also the risk side associated with such ventures. It does add to the pressure (including management's own view on whether its own compensation is competitive) on boards of directors to meet perceived needs to be competitive in what they are paying their executives.

Part C.  A Counterpoint

Notwithstanding the point of view expressed in this column, it must be acknowledged that scrutiny and frequency of rule changes affecting executive pay is greater currently than previously in the past two decades. A look at rule changes noted in the first part of the column shows increasing frequency in recent years in legislation and regulations affecting executive pay. The rate of executive pay increase in the 2000s has been less than in the 1990s. Thoughtful commentators such as Lucian Bebchuk of Harvard Law School are increasingly being listened to not only in the academic community, but also in Washington and in the boardroom. Finally, it is difficult to assess where executive pay would be currently if such legal, tax and accounting interventions noted in this column had not taken place. As high as executive pay seems to be today, it might have been even higher without at least some of the scrutiny and interventions noted above.


1. From 1992 through 2005 median CEO pay at S&P 500 companies as shown in ExecuComp grew at a cumulative annual rate of 9.9 percent. CEO pay continued to grow during the first five years of the 2000's but at a rate significantly lower than in the 1990s.

2. This column does not address what, if any, impact judicial developments may have had on executive pay levels. It would appear that judicial developments have had limited impact. Delaware, for example, avoids judicial examination of reasonable compensation unless the business judgment rule is rebutted by the plaintiff. Under that rule, unless directors have not complied with their fiduciary duties, executive pay decisions by directors generally are protected from judicial scrutiny. The directors of The Walt Disney Company jousted with shareholders for approximately a decade over the compensation and severance of Michael Ovitz. In 2006, the Delaware Supreme Court affirmed the 2005 decision by the Court of Chancery finding that there was no violation of fiduciary duty by any of the directors in connection with the determination of Ovitz's compensation and severance arrangements. Brehm v. Eisner (In re Walt Disney Co. Derivative Litig.), 906 A2d 27 (Del. 2006) aff'g In Re The Walt Disney Company Derivative Litigation, 908 A2d 693 (Del. Ch. 2005).

Currently, there is litigation in New York in which the New York Attorney General has sued Richard Grasso, Kenneth Langone and the New York Stock Exchange over approximately $140 million of pay to Mr. Grasso. Summons and Complaint dated May 24, 2004. People of the State of New York, by Eliot Spitzer, the Attorney General v. Richard A. Grasso, Kenneth G. Langone and the New York Stock Exchange, Inc., (Sup. Ct. N.Y. Co., May 24, 2004). Index No. 401620/2004 (, NYS law). (New York v. Grasso) For decisions with regard to motions made by both sides in the case, see New York v. Grasso, No. 401620/04, 816 N.Y.S.2d 863 (March 15, 2006) and New York v. Grasso, No. 401620/04, 2006 N.Y. Misc. LEXIS 3023, at *1 (Sup. Ct. N.Y. Co., Oct. 18, 2006). The trial has not yet taken place. Even if it holds against the defendants the fact that it is decided under the New York Not-For-Profit Corporation Law will limit the ultimate impact of the Grasso case in the setting of executive pay in for-profit corporations. (The New York Stock Exchange is now held by a profit-making publicly traded corporation. In the period at issue in the Grasso case, it was still subject to the New York Not-For-Profit Corporation Law.)

In the early 2000s, a number of high profile corporate scandals such as those at Enron, WorldCom and Tyco involved senior management with very high levels of compensation. The principal thrust of the initial litigations, involving criminal charges and convictions, addressed fundamental issues such as fraud. Being close to the center of these situations, compensation of the executives received substantial attention. In the long term, however, it is unclear whether such cases will have a significant effect on the setting of executive pay levels in major U.S. corporations.

3. 26 USC §§280G, 4999. The golden parachute provisions were added to the Internal Revenue Code of 1954 by the Deficit Reduction Act of 1984.

4. For this purpose, "base amount" generally means the average of the W-2 compensation over the five-year period (or lesser period that the executive has been employed at the employer in question) preceding the year in which the change in control occurs.

5. It is ironic that shareholders, who were intended to be protected by Code §§280G and 4999, are those ultimately disadvantaged by the loss of a tax deduction to the corporation. This disadvantage is increased in many cases in which gross-ups are made to executives that incur the excise tax (that is, additional payments made to the executives to keep them whole after the incurring of the excise tax).

6. 57 Fed. Reg. 48,125 (Oct. 21, 1992). The new rules were announced in SEC Release Nos. 33-6962, 34-31327 and IC-19032 (1992).

7. 26 USC §162(m). The Revenue Reconciliation Act of 1993 (RRA) is Title XIII of the Omnibus Budget Reconciliation Act, Pub. L. No. 103-66 (1993).

8. For 2005, out of 484 companies in the S&P 500 reported in the ExecuComp database, 178 (approximately 37 percent) paid salary in excess of $1 million.

9. Sarbanes-Oxley Act of 2002, Public Law No. 107-204 (2002).

10. 26 USC §409A. American Jobs Creation Act of 2004, Pub. L. No. 108-357, §885 (2004).

11. The Senate version of the Small Business and Work Opportunity Act of 2007 contained a provision that would have expanded the impact of Code §409A by subjecting all deferred compensation paid to an employee in one taxable year to the 20 percent additional tax if it exceeded the lesser of $1 million or the average annual compensation includible in gross income over the preceding five taxable years. The bill as passed by the House of Representatives did not include this provision.

12. The current proposed regulations were published at 70 Fed. Reg. 57,930 (Oct. 4, 2005). Application of Section 409A to Nonqualified Deferred Compensation Plans.

Earlier guidance including that issued Dec. 20, 2004 in Notice 2005-1 (2005-2 I.R.B. 274 (published as modified on Jan. 6, 2005)) remains applicable with respect to Code §409A, subject to whatever will be done with that Notice by the final regulations, the publication of which appears imminent.

13. Share-Based Payment. Statement of Financial Accounting Standards No. 123 (revised 2004) (FAS 123R). Financial Accounting Standards Board (FASB). Document available at

14. The value of stock options being granted to senior executives appears to have decreased as the time approached for most publicly traded corporations (mid-2005) to commence the charge against earnings for the grant of stock options. On the other hand, the increase in grants of other forms of equity (such as, in particular, restricted stock) appears to have taken up much of the "slack" attributable to the decrease in stock option grants. For the period 1997-1999, the S&P ExecuComp database indicates that the ratio of stock option awards to restricted stock awards was approximately 85/15 with an average total equity award of approximately $2.9 million. For the period 2003-2005, the ratio was approximately 68/32 with an average total equity award of approximately $2.8 million. (Notwithstanding the decrease in value of stock option grants over the last several years, the most substantial portion of equity value being granted to senior executives continues to be in the form of stock options.)

15. 71 Fed. Reg. 53,158 (Sept. 8, 2006). The new rules were announced in SEC Release No. 33-8732A (Aug. 29, 2006) entitled Executive Compensation and Related Person Disclosure.

16. The numerous changes introduced by the new rules have been the subject of prior columns (see this column on March 31, 2006, April 21, 2006 and Aug. 31, 2006). The many changes made include, among others, substantial revision of the Summary Compensation Table, the addition of new tables for disclosing compensation and benefits, a new table for disclosing director pay, substantial expansion of footnote disclosure and a new Compensation Discussion and Analysis section.

17. In connection with the 2007 proxy season, there have been numerous criticisms that the new rules are causing very confusing disclosure. Criticisms include, for example, that (i) the method of disclosing stock option grants in the Summary Compensation Table (based on accounting treatment for stock option grants) is very misleading, (ii) the setting forth of the annual bonus in the column for Non-Equity Incentive Plan Compensation (column (g)) by some employers and the setting forth of the annual bonus in the bonus column (column (d)) by others and (iii) the different treatment of seemingly similar types of compensation (e.g., restricted stock units that pay out in stock being treated in one way in the Summary Compensation Table and restricted stock units that pay out in cash being treated in another way.)