Say On Pay

Government bailouts are going towards corporate bonuses, and the public is livid. It’s time to give shareholders more say in the process.

In February, the Royal Bank of Scotland (RBS) was set to award its staff £1 billion (GBP) in bonuses, after the British government – which now owns 70 per cent of the bank – had spent £20 billion in bailout money to keep the bank afloat. The British Finance Minister, Alistair Darling, announced a hasty review on bonuses: “I expect the review to make recommendations about the effectiveness of risk management by banks’ boards, including how pay affects risk-taking.”

In these dark days of economic recession, executive compensation has become a hot topic. Some corporations are shoveling bonuses out the back door just as quickly as government bailouts came in through the front. Shareholders and government regulators – particularly in the United States – are rethinking corporate management doctrines that were developed two centuries ago.

The principles of modern corporate governance evolved from 19th-century concepts. Shareholders buy shares and become the owners of the corporation; directors manage the corporation in the best interests of the company – not necessarily the interests of shareholders. Thus, shareholders have no direct legal input on executive compensation policies.

Giving shareholders that input – say on pay – has the potential to radically shift the principles of corporate governance in North America.

Canadian banks have already set a good example. The Canadian Imperial Bank of Commerce, the Royal Bank of Canada, and others have passed resolutions that shareholders should be permitted non-binding votes on executive compensation. The banks took this step in light of impending shareholder revolts over corporate compensation. We should expect similar demands on governmental and regulatory bodies.

A “non-binding vote” may appear to be an oxymoron to some. It is, however, the first step toward shareholder participation in corporate decisions. In public corporations, the issue is whether shareholders have any input into management and board decisions. In regulated industries, the issue is whether the shareholders have a “right to know” before they have a “right to say.”

Corporations generally award bonuses for superior performance. In the absence of such performance, there has been mounting pressure to “claw back” past bonuses.

Some corporate boards, however, have introduced innovative ways of conceding executive bonuses. They channel what would have been the executive’s bonus to a charity of the executives’ choosing. Although these contributions do not restore shareholder wealth, they do benefit the charity in times of dwindling contributions. Presumably, the charity issues a charitable donation receipt, and the corporation – not the CEO – gets a tax deduction.

Charitable donations to divert executive compensation can be a minefield though. If the donation diverts the executive’s compensation at the executive’s direction, it may be an indirect payment to him or her that should be taxed. There are no easy answers to these structures and they should be carefully reviewed.

Another aspect of executive compensation that warrants scrutiny is the practice of “grossing-up” corporate perks and benefits. The “gross-up” payment covers the tax bite of perquisites – club memberships, use of corporate cars and jets, etc. In some cases, gross-up payments even extend to differentials in tax rates between countries.

The most expensive type of gross-up is payment on golden parachutes payable upon voluntary or involuntary severance. The amount of the gross-up for taxes payable is itself taxable as a perquisite. Hence, the gross-up requires a further gross-up and the cycle continues.

For example, assume that an individual receives a $100 benefit that is taxable at 35 per cent. That leaves $65 net. In order to restore the individual to $100 net of tax benefit, the corporation must gross-up the amount of the perk to $154, which will leave an after-tax benefit of $100.

As the recession grinds on, corporate boards and shareholders are taking a closer look at gross-ups. At least 43 companies in the Standard & Poor’s 500 stock index had already decided by April 2009 to stop paying gross-ups for taxes on executive perquisites and benefits.

It is too early to predict whether shareholder activism is merely transient and will abate when we climb out of the recession and equity values improve. At the very least, CEOs of responsible companies will begin disclosing more information to their members. After all, in corporate governance, sunlight is the best disinfectant.