The AIG Bonuses:
The economics of rewarding performance -- and circumventing regulatory limits
19 Mar 2009 in Regulatory Economics, Regulatory Policy
Is there anything new -- and objective rather that opinionated -- that can be said about the AIG bonuses story?
Provisions for these bonuses were written into the recipients' employment contracts. It appears some bonus payments were for contemporaneous performance, some were to keep an employee from leaving to work for a competitor (i.e., "retention"), and some were deferred compensation for previous years' performance. In addition, it appears that some bonus payments were structured to reduce income taxes because Congress had previously attempted to set arbitrary limits on executive salaries. By calling pay a "performance bonus" it would be exempt from previously enacted legislation capping at $1 million the annual salary that could be treated as a business expense.
These distinctions are important, but they seem to have been missed or glossed over in the deluge of press coverage. To make them clearer -- and, it is hoped, less emotionally charged -- an analogy will be made with professional athletes, entertainers, and soldiers. How athletes and movie stars are compensated often elicits wonder at the magnitudes involved, but except among a sports' team's fans, rarely the kind of opprobrium that has been directed at AIG and other corporate executives. Of course, highly compensated corporate executives have long attracted much more critical attention than athletes and entertainers; the previously enacted cap on deductibility did not apply to athletes, entertainers, or other highly [aid professionals such as doctors and lawyers. (Few begrudge solders for receiving large re-enlistment bonuses that can double their income.)
Contemporaneous Performance
It has been widely suggested that AIG employees could not have earned bonuses for contemporaneous performance when the company as a whole lost tens of billions of dollars. There is at least two fatal flaws with this line of reasoning.
First, very few executives' job involves managing the entire firm. Every other employee deals with a subset of the company, and AIG has been profitable except for iots financial products division. If an employee is able to influence the profitability of a subsidiary or unit, and the company wants to pay for performance, then it makes sense to link the employee's bonus payments to the profitability of the subsidiary and not the firm as a whole.
Second, Even when a firm loses money it is not necessarily the case that a senior executive failed to achieve performance targets. Suppose that a firm is headed for a $1 billion loss. If an executive is able to reduce that loss to $500 million, then he has provided a significant benefit to the shareholders. (This is true whether the shareholders are owners of common stock or taxpayers holding warrants or preferred stock.)
In baseball, a player's contract may include several opportunities to earn a bonus. Typically, they will be based on his personal performance -- home runs, batting average, RBI, etc. It is possible that a manager's contract will include a bonus provision if the team makes the playoffs or wins a league pennant. But it would be unusual (and possibly counterproductive) to reward a player for team performance or give a manager a financial stake in the performance of a specific player.
In the movies, big-name directors and actors often are compensated with a fixed payment plus a percentage of gross sales. The fixed payment is like a salary; the percentage of gross sales is like a bonus. Obviously, an actor who gets a percentage of gross sales can make an enormous amount of money if the movie does well at the box office or when released on DVD. However, a contract calling for a percentage of net proft often results in no payment at all. Accounting in Hollywood is complex and controversial, so much so that many famous movies that were highly profitable as generally understood lost money according to Hollywood accounting conventions. The late humorist Art Buchwald fought and won a famous lawsuit that had, as its central legal question, how profits were counted. Even if the idiosyncrasies of "Hollywood accounting" are set aside, an actor can make a lot of money if his pay is guaranteed and the film is a financial bust.
This is analogous to the situation with AIG; some individuals' bonuses may have been guaranteed irrespective of the firm's overall performance, and there is nothing financially or economically unusual about it. Much of the problem may be semantic -- the word "bonus" invites making a cognitive linkage between the payment and phenomena that might be contractually irrelevant.
Retention
It has been widely suggested that the AIG employees who earned retention bonuses have nowhere to go, and thus should not be paid bonuses for staying with the company. Some have said these employees should have been fired, not retained. There are at least two fatal flaws with this line of reasoning.
First, what matters are market conditions that were present when the contracts were signed, not market conditions today. Every long-term contract is a gamble for both sides. At the time, AIG appears to have had good reason to worry that if certain employees were not paid retention bonuses they would be hired away by a competitor, in which case AIG and its stockholders would have been much worse off.
Second, some employees may be even more essential now for AIG's survival than they were before to wind down its derivative positions. Retaining them could be extremely important. AIG could yet lose more money, and if it does, future federal taxpayers will be worse off.
Sometimes, retention bonuses are paid to eligible candidates as a class, not as individuals. Each of the military services pays significant bonuses for re-enlistment and re-commissioning. For example, the Army pays a range of bonuses as large as $40,000, plus more than $70,000 in educational benefits under the GI Bill. These benefits are dwarfed by the million-dollar bonuses paid to AIG executives, but the principle is the same: Each organization strives to pay retention bonuses as large as needed to keep classes of valuable employees.
Retention bonuses have nothing to do with a firm's performance. Indeed, they cannot be linked, for if they were they would not incentive payments, not retention bonuses.
In sports, players often are paid bonuses for making long-term commitments. Sports teams typically require a high level of stability to win, and stability can only be achieved by retaining core personnel. The same is true in entertainment, where a hit movie leads to one or more sequels that require the services of the same lead actor.
Deferred Compensation
Contracts may call for deferred compensation to finesse the income tax laws, and if they cross the line the Internal Revenue Service is well-equipped to deal with it. It also may be beneficial to the employee to spread out income over an extended period, for example to avoid the temptation of overspending. If you win the lottery you can decide whether to take a lump-sum payment or an annual amount over (say) 20 years.
MSNBC senior producer John Schoen writes that executive contracts often include deferred compensation. Some deferrred payments apparently have come due in 2008 and 2009.
Adaptive Response to Congressional Restrictions on "Legitimate" Salaries
Schoen also says that contracts have been structured to get around the $1 million cap on salary deductibility that Congress enacted in 1993:
Congress limited the tax deduction companies could take for cash payments to $1 million. The result was a cottage industry of lawyers, consultants and advisors who structure even bigger pay packages with creative legal strategies that now make the AIG bonuses difficult to rescind.
This would be a predictable consequence of legislating limits on executive pay. Congressionally enacted limits notwithstanding, some executives deliver value to shareholders well in excess of $1 million. Market forces compel firms to seek out ways to compensate such employees for this performance. The size of this cottage industry would only have grown in the past 16 years, with the IRS given the job of distinguishing -- based on arbitrary distinctions having no economic content -- which performance-based contracts qualify for the enumerated exemptions and which do not.
A quick look at the actual statutory language is sufficient to appreciate how complex the task is to legally avoid the $1 million cap. In economic terms, the legal and accounting resources spent to comply with 26 USC 162(m) are pure waste. They produce nothing of value, but are made necessary by Congress' collective belief that firms ought not be able to treat salaries over $1 million as a business expense regardless of the market value certain executives actually provide. To the extent that AIG bonuses were written to adhere this language, the current controversy would not have occurred if Congress had not enacted the restriction in 1993.
It is hard to think of a parallel in entertainment, but there is an analogous phenomenon in sports leagues that have salary caps. For example, the National Football League has a complex salary cap arrangement with its Players Union. The invaluable Wikipedia describes how it handles "incentive bonuses" as follows:
Incentive bonuses require a team to pay a player additional money if he achieves a certain goal. For the purposes of the salary cap, bonuses are classified as either "likely to be earned", which requires the amount of the bonus to count against the team's salary cap, or "not likely to be earned", which is not counted. A team's salary cap is adjusted downward for NLTBE bonuses that were earned in the previous year but not counted against that year's cap. It is adjusted upward for LTBE bonuses that were not earned in the previous year but were counted against that year's cap.
In short, a lot of effort went into crafting the salary cap agreement and a lot more effort continuously goes into devising ever more creative ways to get around it. The NFL salary cap differs from 26 USC 162(m) in an important way, however. Team owners and the Players' Union have agreed to the cap as an anti-competitive restraint against free trade because they both benefit. Neither management nor labor wants to harm the League's profitability.
That's not the case for 26 USC 162(m). Congress enacted it because a majority believed that executives of publicly traded companies should not be paid more than $1 million per year. Lacking the authority to prevent them from firms from paying more, they altered the tax code to punish them if they did. The NFL and Players' Union can cooperatively monitor player contracts to optimize compliance with its own rules, but Congress can't. The law creates an inherently adversarial relationship with publicly traded firms.
On March 19, the House of Representatives passed a bill that would levy a 90% income surtax on bonus recipients. In our next post, we'll analyze this bill.
Omnibus Budget Reconciliation Act of 1993
26 U.S.C. 162(m)
Certain excessive employee remuneration
(1) In general
In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000.
(2) Publicly held corporation
For purposes of this subsection, the term “publicly held corporation” means any corporation issuing any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934.
(3) Covered employee
For purposes of this subsection, the term “covered employee” means any employee of the taxpayer if—(A) as of the close of the taxable year, such employee is the chief executive officer of the taxpayer or is an individual acting in such a capacity, or
(B) the total compensation of such employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the 4 highest compensated officers for the taxable year (other than the chief executive officer).
(4) Applicable employee remuneration
For purposes of this subsection—(A) In general
Except as otherwise provided in this paragraph, the term “applicable employee remuneration” means, with respect to any covered employee for any taxable year, the aggregate amount allowable as a deduction under this chapter for such taxable year (determined without regard to this subsection) for remuneration for services performed by such employee (whether or not during the taxable year).
(B) Exception for remuneration payable on commission basis
The term “applicable employee remuneration” shall not include any remuneration payable on a commission basis solely on account of income generated directly by the individual performance of the individual to whom such remuneration is payable.
(C) Other performance-based compensation
The term “applicable employee remuneration” shall not include any remuneration payable solely on account of the attainment of one or more performance goals, but only if—
(i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of 2 or more outside directors,
(ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such remuneration, and
(iii) before any payment of such remuneration, the compensation committee referred to in clause (i) certifies that the performance goals and any other material terms were in fact satisfied.
(D) Exception for existing binding contracts
The term “applicable employee remuneration” shall not include any remuneration payable under a written binding contract which was in effect on February 17, 1993, and which was not modified thereafter in any material respect before such remuneration is paid.
(E) Remuneration
For purposes of this paragraph, the term “remuneration” includes any remuneration (including benefits) in any medium other than cash, but shall not include—
(i) any payment referred to in so much of section 3121 (a)(5) as precedes subparagraph (E) thereof, and
(ii) any benefit provided to or on behalf of an employee if at the time such benefit is provided it is reasonable to believe that the employee will be able to exclude such benefit from gross income under this chapter.
For purposes of clause (i), section 3121 (a)(5) shall be applied without regard to section 3121 (v)(1).
(F) Coordination with disallowed golden parachute payments
The dollar limitation contained in paragraph (1) shall be reduced (but not below zero) by the amount (if any) which would have been included in the applicable employee remuneration of the covered employee for the taxable year but for being disallowed under section 280G.
(G) Coordination with excise tax on specified stock compensation
The dollar limitation contained in paragraph (1) with respect to any covered employee shall be reduced (but not below zero) by the amount of any payment (with respect to such employee) of the tax imposed by section 4985 directly or indirectly by the expatriated corporation (as defined in such section) or by any member of the expanded affiliated group (as defined in such section) which includes such corporation.
