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Executive Compensation and Its Legal Considerations Essay

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Updated: Sep 21st, 2020

Introduction

Executive compensation refers to the financial remuneration and other non-financial rewards that are given to company executives for their services to their organizations. In many cases, it is comprised of a mixture of salary, shares on the company stock, and benefits such as health insurance, housing, social security, and retirement benefits. Executive compensation is awarded based on factors such as government regulations, level of performance, tax laws, and the desires of the organization’s management team. In the past three decades, executive compensation has risen dramatically, and it has become incomparable to the average worker’s remuneration. Debates have ensued as to whether the rise has been a result of the scarcity of qualified executives or as a result of corporate greed. Examples of federal laws and regulations that affect executive compensation include the Dodd-Frank Act of 2011, the Sarbanes-Oxley Act, and the Tax Cuts and Jobs Act of 2017.

Effective Executive Compensation

The main aims of crafting an executive compensation plan are to attract and retain talent in an organization and ensure that the incentives awarded to executives are linked to the overall strategy and priorities of the organization (Carpenter and Yermack 32). Studies have shown that organizations that deploy sufficient resources toward the structuring and implementation of comprehensive executive compensation plans report higher revenue growth and profitability. In that regard, it is important for companies to prepare executive plans properly by putting into consideration the short-term and long-term organizational plans. This goal can be achieved by using metrics to prepare a compensation plan, communicating the plan to the entire organization, benchmarking compensation levels, valuing company equity regularly, and incorporating both short and long-term incentives.

Challenges

Executive compensation is a controversial topic in many organizations because of its numerous legal implications. One of the major mistakes made during the development of an executive compensation plan is to offer incentives that are not regulated by specific metrics (Carpenter and Yermack 35). It is necessary for organizations to use compensation metrics that are specific, measurable, attainable, and time-bound to offer incentives to executives. This approach enables executives to be aware of what they should focus on in order to achieve the goals of the organization. Some organizations use metrics such as profitability and revenue to determine executive compensation (Sheehan 32). However, the most effective metrics include a number of key performance indicators (KPIs) that give a more accurate measure of an organization’s performance.

A lack of communication between the organization and its executives I another challenges that are encountered. A communication gap with regard to the components of an executive compensation gap should be eliminated. Organizations should discuss the executive compensation packages of their executives regularly. It is also important for companies to offer competitive packages in order for them to attract and retain top talent. Proper compensation is one of the most effective strategies for attracting highly-qualified executives. Multiple reference points should be used to evaluate the compensation packages of other companies in order for an organization to offer its executives competitive remuneration (Carpenter and Yermack 39). In today’s business world, competition for top talent is very high. Therefore, companies must offer their executives highly competitive compensation. A competitive compensation package should include both short and long-term incentives (Sheehan 36). In that regard, the incentives should be tied to the short and long-term goals of the organization. In many organizations, short-term incentives are usually cash, while long-term incentives are determined based on the financial performance of the organization.

Legal Considerations

One of the most important responsibilities of a company’s board is to determine the most appropriate amount of compensation for its executives. In the United States, executive compensation takes many forms. For example, the compensation plans for executives working for-profit and nonprofit organizations are different. Traditionally, nonprofits paid their executives less than they would earn elsewhere because the work that they do is considered philanthropic (Sheehan 40). However, that is a poor strategy for attracting and retaining great leaders. As mentioned earlier, executive compensation has risen dramatically in the last few years, and the criticism leveled against it emanates from the unrealistic rise.

Current company sizes and performance are small compared to the amount of executive compensation. Many critics have argued that it is excessive and does not reflect certain parameters such as stock prices of companies and organizational growth (Carpenter and Yermack 43). Many organizations offer their executives reasonable compensation as a means to comply with tax and charitable trust laws. These laws impose penalties to nonprofits that give their executives excessive compensation. On the other hand, firms that give excessive compensation face the risk of the withdrawal of certain incentives such as tax exemption (Sheehan 44). The federal and state governments have put measures in place to regulate executive compensation especially in nonprofit organizations. The federal law on compensation states that the compensation awarded to any employee should not surpass the reasonable amount under all the circumstances.

The United States Securities and Exchange Commission (SEC) is one of the authorities that regulate executive compensation. It has several requirements that are aimed at ensuring that executive compensation is in accordance with the law. For example, the SEC requires all companies that are publicly traded to share information regarding the determination of their executive compensation with the public (Carpenter and Yermack 45). The SEC posts the compensation amounts of executives on its website for investors and shareholders of those companies to see. The information gives investors an opportunity to compare the compensation of their executive with those of other companies.

Nonprofit organizations are not affected by federal regulations as much as public corporations. In recent times, executive compensation has been discussed extensively because of its variance among different organizations. As it continues to command attention, various government agencies are creating new disclosure rules and regulations to guide HR professionals in making certain decisions. For instance, the SEC, IRS, and the US Congress have created various rules that guide how compensation committees approach pay practices in organizations. There are several laws and regulations influencing executive compensation that have been passed. They include the Dodd-Frank Consumer Protection Act and Sarbanes Oxley.

The Dodd-Frank Consumer Protection Act

The Dodd-Frank Act was signed into law in 2010 as a way of avoiding a recurrence of the 2010 financial crisis, and its main objective was financial reform. Its passage into law motivated boards of companies to engage with shareholders about the issue of executive compensation (Carpenter and Yermack 53). The Act includes several provisions that target executive compensation at publicly traded companies. For example, the “say on pay” provision mandates all public companies to involve their shareholders in the determination of the compensation of their executives. The law strengthens the independence requirements for compensation committee members, requires companies to disclose the ratio between the pay of the CEO and other employees, and requires companies to explain the relationship between compensation and performance (Sheehan 56).

In addition, the Act requires companies to disclose their hedging policies that affect employees and top executives. The Dodd-Frank Act requires shareholders to review executive compensation at least once in every three years. Many companies conduct annual reviews (Carpenter and Yermack 58). Since the enactment of the Act in 2011, shareholders have become very influential in the determination of executive compensation. Critics argue that say-on-pay by shareholders does not contribute toward the control of executive pay (Sheehan 61). However, surveys have shown that it improves the relationship between directors and shareholders, and it encourages the evaluation of executive compensation from different perspectives. The Act has brought several changes to organizations regarding compensation. For example, in 2014, activists launched more than 200 campaigns that were aimed at compelling organizations to revise their executive compensation plans.

One of the effects of the Dodd-Frank Act is the creation of executive compensation plans that are tied to specific company goals. According to the Act, public corporations should offer executive compensation that is commensurate with the attainment of certain performance metrics (Sheehan 61). In addition, any form of enhanced compensation should be disclosed to the SEC. These provisions have compelled HR leaders to compensate executives based on their performance. Many organizations are embracing performance-based pay plans in order to comply with the new laws. This has necessitated a re-writing of compensation and incentive plans that were previously used. These and other compensation laws have leveled the ground for appropriate competition among public and private organizations as they struggle to attract the best talent (Carpenter and Yermack 66).

As a result, corporations in both sectors are coming up with creative ways of restructuring compensation packages. The majority of companies attract employees by offering compensation plans that are performance-based and long-term. The legal requirement of aligning pay with performance is compelling many companies to grant their executives performance-vested long-term incentives (LTIs). LTIs require companies to evaluate various factors that include shareholder needs, company objectives, and the legal requirements of designing compensation plans (Carpenter and Yermack 74). Many public companies have begun adopting Performance Shares, which are actual company shares that are only awarded to executives after they attain specific organizational goals. Traditionally, such shares were issued after an executive served a company for a certain number of years.

The new rules and regulations are also necessitating a shift from stock options toward cash rewards that are hinged on performance. Cash payouts are dependent on the achievement of pre-established goals set by a company’s board or management team (Sheehan 64). Other companies are opting for performance-vested Restricted Stock Units (RSUs) that are awarded to executives upon attaining certain performance goals. Other organizational privileges such as the purchase of company stock at certain prices and the issuance of Stock Appreciation Rights (SARs) are gradually becoming dependent on performance and not years of service. Examples of measurements used to determine executive compensation include revenue growth, return on capital, income growth, total shareholder return, and EBITDA growth.

Fair disclosure of information is another legal aspect that should be considered when addressing executive compensation. The SEC’s Regulation Fair Disclosure (Reg FD) prevents the selective disclosure of material information to shareholders. In that regard, it requires all companies to disclose information to all shareholders at the same time. Prior to its passage, cases of selective disclosure of information were prevalent. Institutional investors got access to market-critical information before smaller investors. It is unlawful for companies to disclose information regarding executive compensation to some shareholders and hide it from others. All shareholders should get an opportunity to participate in the process determining executive compensation.

Sarbanes Oxley and Tax Code

The Sarbanes Oxley is a law that was passed in 2002 to curb the prevalence of corporate and accounting scandals. The Act gives the Securities and Exchange Commission the power to cut back the stock awards and pay awarded to executives annually. (Sheehan 67) The Act has stringent provisions because it requires public corporations to report to the SEC all incentives offered to executives. The Act has improved transparency and accountability in public firms because the SEC is aware of all the components of their executive pay structures. The law is supported by other regulations such as section 162(m) of the IRS Tax Code (Carpenter and Yermack 85). This provision limits the amount of deductible compensation that a company can pay an executive to $1 million dollars. Prior to the passage of the Tax Cuts and Jobs Act, two exceptions to the aforementioned law included performance-based and commission-based pay. However, the two laws repealed the exceptions. In that regard, it is important for companies to evaluate their equity plans so that they can create appropriate executive compensation plans. Prior to the passage of the Tax Cuts and Jobs Act, the rapid rise in executive compensation was blamed on the tax code.

State regulations

Companies must be aware of efforts by state governments to regulate executive compensation. In that regard, the federal and state governments have created various laws and regulations that corporations should obey when creating pay plans for their executives. States began regulating executive pay after the 2008 financial crisis. States such as New York and California have developed rules and regulations that govern companies that conduct business with the states. For example the state of New York limits the amount of pay that executives can receive from organizations that are funded by the state government (Sheehan 86). In addition, the regulations apply to companies that receive big state contracts. Many states are finding creative ways to increase revenue, and limiting executive compensation is one of them.

Conclusion

Executive compensation is one of the most discussed issues in today’s business world. Critics argue that the pay that is awarded to executives does not compare with the pay given to the average employee. In order to address the imbalance, the federal and state governments have created laws and rules to regulate executive compensation. Examples of federal laws that regulate executive compensation include the Dodd-Frank Act of 2010 and the Sarbanes-Oxley Act of 2002. The SEC requires all public companies to disclose information regarding their executive compensation plans and how the plans are created. Current federal and state laws have enhanced accountability, especially to shareholders who now have the power to evaluate and determine executive compensation. It is important for companies to develop pay plans based on the requirements of federal and state laws.

Works Cited

Carpenter, Jennifer, and David Yermack. Executive Compensation and Shareholder Value: Theory and Evidence. Springer Science & Business Media, 2013

Sheehan, Kym Maree. The Regulation of Executive Compensation. Edward Elgar Publishing, 2012.

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