Wealth Creation as a Sin
January 1, 1996
by Jonathan R. Macey
Table of Contents
It is not yet clear how favorably history will treat the economic and social developments of the 1980s. That decade saw the longest peacetime expansion in U.S. history with the nations GNP nearly doubling from $2.7 trillion to $5.3 trillion.1 During that time, nearly 100,000 Americans became millionaires every year, and the top 20 percent of American families saw their average income increase more than $9,000 up to $85,000 per year.2 Over 20,000,000 new jobs were created, and full employment was maintained for much of the decade.3 It is certainly true that, for many, the 1980s were a remarkable period of economic prosperity.
However, 1980s are not so fondly remembered. In fact, much criticism and scorn has been directed at the economic developments of the 1980s and the greed is good attitude that supposedly characterized the period. Some label the 1980s as the decade of greed, and suggest that conspicuous consumption, cold careerism and self-centered spirit4 were pervasive. Indeed, the media has devoted much effort to destroying any positive memories that some might have of the 1980s.5
Critics are quick to point out that although the GNP nearly doubled, the national debt tripled.6 Also, the gains in income made by the top 20 percent of families were accompanied by a $576 decrease in the average income of the lowest 20 percent of families.7 Nearly 1.4 percent of the population, amounting to about 2 million people, joined the ranks of the impoverished.8 Critics seem to match every positive aspect of the decade to a concomitant negative aspect that served to make the rich richer and the poor poorer.
Particular attention has been paid to the heavy merger and acquisition (M&A) activity of the decade. The M&A activity during the 1980s was indeed unprecedented in volume: Between hostile and friendly takeovers, over one-third of the companies in the Fortune 500 were engulfed by other firms (or went private).9 Buyers paid out over $1.5 trillion in order to consummate their acquisitions, and firms spent billions in order to defend against hostile takeovers.10 It is estimated that $60 billion in fees were paid to dealmakers, attorneys, and commercial banks.11
Those who view the M&A activity of the 1980s favorably point out that the threat of a hostile takeover can force the management of companies to work harder and smarter in order to keep share value high and thereby protect their jobs. Also, the activity has been credited with undoing some of the early conglomerate silliness, stripping corporations back to products and markets they knew.12
The consensus of the media, however, seems to be that the M&A activity was a bad thing. The media has characterized the participants in the transactions of the deal decade as greedy corporate raiders and financiers obsessed with the accumulation of wealth and power.13 Michael Milken, the junk-bond king at Drexel Burnham Lambert,14 is often held up as representing the 1980s mentality that money should be made at any cost, skirting the laws if necessary to make a profit. Critics frequently assert that the shady and greed-driven deals of the 1980s caused or contributed to the economic woes that the country experienced in the early 1990s.15
It is in light of these conflicting views of the 1980s that this report will analyze four groups of Internal Revenue Code (I.R.C.) provisions enacted by Congress over the period 1984-1992. The first two provisions are I.R.C. sections 4999 and 280G, imposing a 20 percent excise tax on excess golden parachute payments received by individuals, and disallowing corporate deductions of the excess golden parachute payments as a business expense.16 The second provision is I.R.C. section 5881. This code provision imposes a 50 percent excise tax on greenmail payments received by those attempting to acquire a corporation through a hostile takeover. The third and most recent provision is I.R.C. 162(m), which provides that compensation paid to certain executives in excess of $1 million yearly cannot be deducted as a business expense by the corporation.
This report will argue that Congress, in enacting the above-mentioned tax code provisions, has clearly embraced the more critical and politically popular view of the economic and social developments of the 1980s. Congress, during and after the 1980s, sought to curb the perceived greed and excesses of the corporate world by creating tax disincentives to discourage certain arguably legitimate and rational corporate compensation policies. Particularly, Congress targeted compensation paid to corporate executives (through enactment of I.R.C. 162(m), 280G , and 4999) and greenmail payments made in defense of a hostile takeover bid (I.R.C. 5881). These taxes, this report argues, are, in effect, sin taxes that impose a sanction on highly compensated individuals who have legally and legitimately earned income in the form of very high salaries or greenmail.
This report is broken down into three parts dealing with golden-parachute payments, greenmail, and excessive executive compensation. The first section of each part will describe the nature of these forms of compensation and detail their merits. The second section will discuss the legislative history of each tax provision and will present the statements put forth by Congress concerning its rationale for each provision.
The third section will analyze critically Congresss purported justifications for each tax provision to determine if they are rational and credible. Each section will conclude that despite Congresss vague and fundamentally weak justifications, the legislation mainly serves to impose Congresss (and concededly much of societys) moral judgment that it is wrong for executives and corporate takeover specialists to make too much money. The report will conclude that I.R.C. sections 280G, 4999, 5881, and 162(m) are indeed types of sin taxes imposed by Congress as a gesture to punish highly paid individuals who are able to suc-cessfully take advantage of the offerings of the corporate world.
What Are Golden Parachutes and What Are Their Merits?
Section 280G of the Internal Revenue Code defines a golden-parachute payment as a payment that is contingent on a change (I) in the ownership or effective control of the corporation, or (II) in the ownership of a substantial portion of the assets of the corporation.17 Generally, corporations offer golden parachutes to executives as part of their pay packages in order to provide them with a certain degree of financial security in the event of a takeover of the corporation. If another firm takes over the corporation and the executive is displaced from her job, the golden parachute provides the executive with a large sum of money to cushion her fall from the ranks of the highly compensated corporate elite. The golden parachute is, in essence, a form of lay-off insurance for the executive, meant to protect her from an abrupt loss of employment resulting from a merger or acquisition of her firm.
In addition to their primary purpose of compensating executives for the loss of their jobs (and the power and prestige that accompany them), there are several additional justifications for golden-parachute payments. The first justification is that golden parachutes are needed in order to remove some of the agency costs associated with takeovers. The existence of the golden parachute allows an executive to evaluate a potential takeover more objectively, because she need not fear substantial pecuniary loss resulting from a loss of employment. The argument is that executives often selfishly deploy defensive tactics in efforts to thwart takeover attempts that may be in the best interests of the shareholders. The golden parachute may effectively create a counterbalancing incentive to executives that will make the prospect of losing their job less repugnant.
A second argument in favor of golden parachutes is that they are necessary to attract and retain top management talent. The insurance-like character of golden parachutes makes them very attractive to an executive, especially during periods of heavy merger and acquisition activity such as the decade of the 1980s.18 Moreover, as golden parachutes become more and more popular among Fortune 500 corporations,19 firms not offering such insurance will be less attractive to an experienced, proven executive. Golden parachutes, therefore, make it more likely that a corporation will be able to lure a quality executive and keep her in the face of a takeover threat or an attempt by another firm to draw her away. For these reasons, golden parachutes can benefit a corporation and its shareholders by promoting stability within the corporations leadership.
A third, rather questionable argument made in support of golden-parachute payments is that they actually discourage attempts to take over a firm. The idea is that the large cost of assuming the golden-parachute obligations of an acquired firm creates a disincentive for a potential acquirer to target that firm.20 This notion that golden parachutes somehow raise the cost of a takeover will arise later in this report in relation to Congresss justifications for measures against golden parachutes. At that point this report will discuss how this argument does not square with the facts concerning hostile takeover bids. In any event, the argument is that a firm can insulate itself from undesirable hostile takeover bids by providing executives with golden-parachute payments.21
Congressional Taxation of Golden Parachutes
In the Deficit Reduction Act of 1984, Congress included two new provisions that impose punitive taxes on corporations making excess golden parachute payments to their executives and on the executives receiving the payments. Section 280G denies a corporate income tax deduction for golden parachute payments that have a present value in excess of three times an executives base amount of pay.22 Further, section 4999 imposes a 20 percent excise tax on the recipient of such excess parachute payments.23 These harsh measures, in effect, treat golden-parachute payments that are in excess of three times an executives base pay as per se unreasonable under the tax code.24 In addition, the 20 percent excise tax is particularly harsh in that it is applied in addition to the normal amount withheld through the income tax.25
Congress adopted these measures near the beginning of the 1980s when M&A activity was high26 and golden parachutes were becoming commonplace. The provisions were most likely a response to the harsh criticisms in the media concerning golden parachutes.27
A typical criticism of golden-parachute arrangements is that the payments are ridiculously high, far above what would be adequate compensation for losing ones job. Moreover, it is asserted that nearly all employment involves the risk of job loss, and that executives were already paid more than enough money to compensate for such a risk.28
Congress, in justifying sections 280G and 4999, avoided relying on the general arguments that the payments were too high and unfair. Rather, in its explanation of the provisions, Congress put forth several more theoretical arguments concerning the effects of the payments on shareholders and the market for corporate control in general. However, even assuming that the tax code is an appropriate tool for regulating corporate activity (a proposition with which this author disagrees), nearly all of Congresss justifications for discouraging golden parachutes are based upon questionable arguments.
The House and Senate Joint Committee on Taxation provided three reasons for imposing the taxes: (1) golden parachutes hindered acquisition activity in the marketplace and, as a matter of policy, should be strongly discouraged; (2) Congress was concerned that the existence of such arrangements tended to encourage the executives and other key personnel involved to favor proposed takeovers that might not be in the best interests of the shareholders and others; and (3) Congress decided to discourage transactions that tended to reduce the amounts which might otherwise be paid to target corporation shareholders.29
The Senate committee issued a separate report detailing its rationale for approving sections 280G and 4999. The committee in its report explained that there was concern that in many instances golden parachute contracts do little but assist an entrenched management team to remain in control. They also provide corporate funds to subsidize officers or other highly compensated individuals.30 These justifications put forth by the joint committee and the Senate committee will be analyzed in depth in the following section.
The second rationale mentioned by the Senate committee, that excessive parachute payments subsidize executives at shareholder expense, is the only tax policy rationale put forth by Congress for sections 4999 and 280G.31 Although the report is vague as to how executives are subsidized, Congress is probably implying that in many cases parachute payments are too high and not supported by adequate consideration; thus they are like gifts. However, section 162(a) of the I.R.C. has always provided that only ordinary and necessary expenses are deductible in calculating taxable income.32 The code goes on to clarify that this includes only allowances for reasonable salaries and compensation to employees for services actually rendered.33
Thus, if Congress was really concerned about the reasonableness of golden-parachute payments, it is not clear why it did not leave it to the IRS to do its job of enforcing section 162(a) on a case-by-case basis, looking at the particular payments in question.34 There is ample authority for the IRS to challenge the reasonableness and deductibility of executive compensation.35 There are many cases in which the IRS has argued that certain executive compensation is unreasonably high and constitutes a disguised dividend payment.36 Thus, it is more plausible that Congress was concerned more with remedying a perceived corporate governance problem than with refining the definition of an ordinary and necessary business expense.37 However, with regard to its obvious objective of regulating corporate behavior, Congress did not put forth any factually or theoretically solid explanations of why golden-parachute payments that exceed base pay by a certain amount constitute a corporate governance problem with which they should be concerned.
The joint committee stated that it was concerned that golden parachutes hindered acquisition activity in the marketplace, and the Senate committee made essentially the same point speaking in terms of management entrenchment. These arguments presume that golden-parachute payment obligations are generally high enough to make a firm a less desirable target for a takeover. The joint committee also stated that it was concerned about shareholders receiving less for their shares. Their rationale presumably was that the golden-parachute payment obligations that come along with a target firm are so high as to affect the maximum amount an acquirer is able to tender for shares of stock. Therefore, the House and Senate relied on the weak position that golden parachutes raise the costs of acquisitions enough to significantly affect the takeover decision of a potential acquirer or the takeover price he is able to pay.
The weakness of this argument lies in the fact that the many millions of dollars required to pay off ousted managers usually amount to a very small percentage (usually less than 1 percent ) of a typical offer.38 For example, in Allieds takeover of Bendix, the $4 million golden-parachute obligations that Allied acquired amounted to only two-tenths of 1 percent (.002 percent) of the $1.4 billion takeover price.39 Further, the takeover market of the 1980s involved over $1.5 trillion in purchases and highly leveraged deals where firms arguably overpaid for companies anyway.40 Investment bankers and lawyers made over $60 billion just for putting the deals together.41 In such a market, it is unlikely that deals turned on the presence or absence of several millions of dollars in golden-parachute obligations. Thus, the justifications that rely on the assumption that golden-parachute payments significantly affect takeover decisions and takeover prices are questionable at best.
The second justification mentioned in the joint committees report is that golden-parachute agreements may actually encourage an executive to acquiesce in a hostile takeover that is not in the best interests of the shareholders. This proposition relies on the assumption that an executive making hundreds of thousands of dollars (possibly millions) per year would be eager to relinquish his job completely for a payoff of three years base salary.42 This is questionable at best. It may be more likely for older executives approaching retirement, but the existence of stock options and hefty pensions makes this not so clear. Such arguments fail to take account of the value to executives of the power and prestige of their positions in the ranks of the corporate elite. It seems more plausible that the payments would be a factor that allows an executive to evaluate a takeover more objectively.
Thus, Congress fails in its attempt to justify sections 280G and 4999 in terms of necessary tax policy and in terms of regulating corporate behavior to protect shareholders or the economy. Moreover, if Congress was actually concerned about protecting shareholders, denying the corporation a tax deduction for golden-parachute payments and taxing the recipient is a poor means of protecting them. Indeed it has tended to harm them more than help them. Since provisions 280G and 4999 were passed, corporations desiring to make parachute payments falling within the tax codes definition of excess parachute payments have merely taken the tax penalty imposed by 280G and grossed up the payments in order to compensate the executive for the 20 percent excise tax imposed by 4999.43 These actions taken by corporations in response to the golden-parachute tax provisions have served to increase costs to shareholders rather than benefit them.44 This situation additionally serves to illustrate how Congresss use of tax policy to regulate corporate behavior can backfire or be ineffective.
Notwithstanding Congresss purported justifications, the best explanation for sections 280G and 4999 is that Congress intended to levy a punitive tax on a corporate compensation practice that it considered to be excessive. Congress could not have liked the fact that executives were benefiting so greatly from the hostile takeovers of their companies and the loss of their jobs; and the vast amount of negative publicity concerning golden-parachute payments45 no doubt put pressure on Congress to act.
However, Congress could not come up with any strong arguments for why it needed to act on this perceived problem. The parachute arrangements were the result of legitimately bargained contracts and involved no breach of duties to shareholders, and the tax code already disallowed tax deductions for unreasonable compensation packages. Therefore, Congress was forced to put forth the five rather transparent arguments mentioned above in order to justify what was essentially a sin tax on the parachute arrangements. This sin tax was intended to punish the corporation and the recipient for legitimately but unfairly making too much money.
What Are Greenmail Payments and What Are Their Merits?
Greenmail payments are defined by the Internal Revenue Code as consideration transferred by a corporation to directly or indirectly acquire stock of such corporation from any shareholder if such shareholder held such stock for less than 2 years before entering into the agreement to make the transfer, [and] at some time during the 2-year period ending on the date of such acquisition such shareholder [or any person related to or acting in concert with such shareholder] made or threatened to make a public tender offer for stock of such corporation, and such acquisition is pursuant to an offer for stock not made on the same terms to all shareholders.46 More simply, greenmail is payment from a corporation to a person or persons intended to induce them to abandon an attempt at a takeover of that corporation. Typically, the managers of the target pay a premium above market price for the shares of the potential acquirer, yielding him a large profit on his investment in the firms shares.
Assuming that the directors of the corporation are not acting solely to entrench themselves (an issue that will be addressed below), greenmail can serve a legitimate corporate purpose. Greenmail, by giving a corporation some power to control its destiny, may allow a corporation to stave off a takeover attempt that is not in the best interests of the corporation or its shareholders. This theory, called the shareholder-welfare hypothesis, holds that greenmail can benefit shareholders and society by facilitating an auction for the shares of a corporation, thus allowing corporations to be controlled by the highest-valued user.47
For example, suppose a potential acquirer, M, conducts extensive research and determines that a corporation, B, is undervalued. M then initiates a two-tiered takeover of B. This action signals other potential acquirers that B is undervalued and that a profit can be made from a takeover. Suppose that another potential acquirer, T, then enters the picture and expresses an interest in B, but needs time to put together an offer. If B calculates that its value would be less under the control of M than it would be under the control of T, B should pay greenmail to M48 to prevent his taking control. As a consequence, B will eventually be acquired by T or an even higher-valued user that subsequently enters the picture. In any case, the corporation, the shareholders of B,49 and society benefit because Bs resources will end up under the control of a user more highly valued than M.
In addition to allowing firms to create an auction for their shares, greenmail also rewards a potential acquirer for discovering an undervalued firm and providing such information to the market.50 Rewarding those who produce important information will encourage the production of such information and lead to a more efficient market for corporate control.51 A more efficient market for corporate control works as an important check on managers and directors and, as mentioned above, leads to the most efficient use of a firms resources. Thus greenmail, if utilized wisely and in good faith, can clearly be a desirable.
Congressional Taxation of Greenmail
The Omnibus Budget Reconciliation Act of 1987 contained section 5881, which imposed a 50 percent excise tax on greenmail payments received.52 This tax is levied regardless of whether the greenmail is taxable under normal income tax rules.53 Moreover, when the greenmail is taxable as income, section 5881 can result in nearly a 90 percent cumulative tax rate on the payments.54 This tax, similar to the one imposed on recipients of golden-parachute payments, is quite onerous and was clearly a part of Congresss efforts in the 1980s to curb per-ceived excesses in the hostile takeover market and within corporations.
These provisions were enacted during a time when greenmail payments were frequent and highly criticized.55 In a one-year period in the mid-1980s, corporations paid out over $4 billion to repurchase blocks of stock from individual shareholders.56 Several well-publicized cases, such as Warner Communications repurchase of 5.6 million shares of its stock from Rupert Murdoch for 33 percent above market price, drew much attention to and criticism of the practice of greenmail.57 Critics of greenmail usually characterize the payments as a tool for management to entrench itself at shareholders expense. It is also asserted that the payments to raiders are unfair because similar repurchase terms are not offered to all shareholders.58
Oddly, Congress justified section 5881 primarily as a tactic to discourage takeovers in general. The section was passed during a period when anti-takeover sentiment in Congress was strong.59 For example, Representative Byron Dorgan, a vocal critic of greenmail and hostile takeovers in general, is quoted in the Congressional Record:
[Legislation is needed] in response to the spate of hostile takeovers and the devastation that they bring. Obviously legislation will not stop hostile takeovers, but it will discourage these manipulative raids. Its time that Congress acted to protect American workers, American competitiveness, and the American economy from the greed and crimes of these raiders.60, 61
In any event, Congress purportedly enacted section 5881 to discourage the practice of greenmail, which in turn might discourage raiders from the initial attack on a corporation.62 To the extent that these taxes can deter attacks by raiders, they might accomplish Congresss stated purpose of avoiding devastation associated with hostile takeover activity.
In addition, Congress stated that it had a problem with raiders making a profit off of greenmail, though it did not state specifically why. The legislative history contains the following explanation: [T]he committee believes that taxpayers should be discouraged from realizing short-term profits by acquiring stock in a public tender offer and later being redeemed by the corporation in an effort by the corporation to avert a hostile takeover.63 Presumably, Congress was persuaded that greenmail represented some evil to shareholders or society and that it needed to be regulated. The next section will analyze critically Congresss purported justifications for section 5881.
From the legislative history of section 5881, it is relatively clear that Congress had no true tax policy justifications for the 50 percent tax on greenmail. Section 5881 does not serve to define the tax base, to raise revenues, or to meet any of the other traditional justifications for a tax.64 Therefore, it can only be concluded that section 5881 was a naked measure to regulate the behavior of corporations and corporate raiders.
Indeed, as mentioned above, Congress made no secret of its general disapproval of hostile takeovers and the payment of greenmail. So what is wrong with Congress protecting shareholders and society from the effects of such practices it deems harmful? The answer is that section 5881 is too broad to actually protect anyone; it deters all hostile takeovers and greenmail payments regardless of whether they cause any harm. Clearly Congress could not have rationally believed that all hostile takeovers and greenmail payments were bad and needed to be discouraged in order to protect shareholders and the public from harm.65
The theory that a robust market for corporate control has positive effects in terms of disciplining managers is well established. The basis of this theory is that a high market price for a corporations shares is the best deterrent to a hostile takeover. A low share price relative to a firms potential going-concern value or actual liquidation value is precisely what a corporate raider is looking for. It follows that managers who are interested in keeping their jobs will strive to keep the value of the firms shares high, and the best way to do so is through responsible and effective management. Thus the self-interest of managers will lead to more healthy and efficient corporations, which are beneficial to the general economy, society, and, of course, shareholders.
This is a well-known and widely-accepted principle of corporate law. Despite the fact that some hostile takeovers may not be in the best interests of shareholders, employees, or society, Congress must have been cognizant of the above theory and could not have rationally believed that it needed to deter all hostile takeovers.66
In the same vein, the payment of greenmail is clearly not in all cases a bad thing. The shareholder-welfare hypothesis, discussed above, posits a situation where the payment of greenmail results in an increase in the value of a firm due to the reallocation of the corporations resources to a higher-valued user.67 A more efficient allocation of resources and a stronger, more valuable firm is clearly in the best interests of society and shareholders.
As further support for the proposition that Congress could not have rationally believed that discouraging greenmail would benefit society by discouraging takeover activity, it should be noted that one of the main criticisms of greenmail payments has always been that it helps entrench existing management. Critics contend that corporate executives who fear losing their jobs in a hostile takeover will pay out corporate assets to finance purely self-interested defensive tactics.68 However, by discouraging the acceptance of greenmail through a hefty tax on such payments, hostile takeovers may indeed be facilitated. As discussed above, greenmail is an effective means for a corporation to protect itself from the kind of attack, acquisition, and liquidation that Representative Dorgan alludes to.69 If a raider is discouraged from accepting the payoff because of the large tax, then managements ability to avert a hostile takeover by buying off the raider is impaired. Thus, in this situation a harmful hostile takeover may be unavoidable, a result Congress purportedly intended to discourage.
This report is not asserting that a better outcome will always be produced by a robust market for corporate control and the ability of managers to pay greenmail. Rather, the argument is that Congress could not have rationally justified a blind punitive tax on all greenmail payments by asserting that greenmail generally leads to harmful results in the form of increased hostile takeovers and injury to shareholders.70
Thus, this report concludes that Congress did not intend to discourage all greenmail payments in an honest attempt to minimize harm to society and to shareholders. It is likely that Congress did perceive that greenmail in some instances encouraged harmful takeover activity, but there is a much more plausible explanation for section 5881. Considering the bad press aimed at corporate raiders such as Carl Icahn and T. Boone Pickens, it is most likely that Congress was disturbed by the large premiums that raiders were making in the greenmail deals. Although Congress must have recognized that greenmail in some instances could be beneficial to a corporation and to society, it must have seen the payments to greenmailers as too high. Greenmailing a firm is not an illegal or illegitimate activity,71 so Congress resorted to the tax code to implement anti-greenmailer policies because of a taxs ability to cut away benefits deemed ill-gotten. The 50 percent excise tax, therefore, is most plausibly explained mainly as a sin tax designed to strip raiders of legally obtained profits associated with locating undervalued firms and initiating takeovers.
TAXATION OF EXECUTIVE COMPENSATION OVER $1 MILLION
Excessive Executive Compensation: The Controversy
It is undeniable that corporate executives, CEOs in particular, are very well compensated these days. For example, in 1990, John Sculley of Apple, Paul Fireman of Reebok, and Michael Eisner of Walt Disney each made over $10 million in salary, bonuses, and long-term compensation.72 In addition, at least seven other CEOs made over $10 million and at least 25 made over $5 million in salary, bonuses, and long-term compensation.73 Indeed it is not unusual for a CEO to make over 35 times the salary of a manufacturing employee, and in some cases the figure has been as high as 1,000 times.74
However, it should be noted, and it infrequently is, that many of these huge figures that are quoted include millions of dollars in benefits from stock option redemptions. These options are accumulated over many years and, if redeemed all at once in one year, can increase the CEOs compensation that year manyfold. For example, John A. Shirley, president of Microsoft, had reported earnings of $26.008 million in 1990. Of that amount, only $414,000 was in salary and bonuses, with $25.594 million coming from stock option redemptions. Also, of Stephen M. Wolfs $18.301 million earned in 1990, $17.151 million of it was in long-term compensation.75 In fact, of the 20 highest-paid CEOs of 1990 (all receiving over $5 million for the year), only two actually earned more than $5 million in salary and bonuses.76 A strong argument can be made that it was more the staggering market performance of the 1980s than irresponsible pay practices that has led to the very high levels of total yearly compensation reported today.77 Despite the large profits many CEOs reap from stock option redemptions, few would deny that stock options are an important tool for reducing agency costs within the modern publicly held corporation.78
Those who would be so bold as to defend current executive pay levels make several arguments. First, it is pointed out that the executive compensation is generally set by the directors of a corporation. In the absence of any conflicts of interest, these directors are able to exercise their sound business judgment in setting the compensation of the executives in the corporation. It can be persuasively argued that directors generally have no personal stake in setting salaries and that the market for executive talent determines what a corporation must offer an executive to lure him to the firm or to prevent him from leaving.79
Second, it is pointed out that top executives are burdened with a tremendous amount of responsibility. The CEO of a major corporation must manage thousands of employees and millions or billions of dollars in assets and debt. In order to induce one to take on such a stressful, high-profile, and high-accountability position, the pay need be very high.
Third, it is argued that the skill and knowledge that it takes to responsibly manage a multibillion-dollar corporation are as rare and as valuable as the ability to bat over .300 for an entire season in baseball, or to put on an impressive performance in a major motion picture. However, few are outraged to hear that a top baseball player is going to earn $6 million a year or that a major film actor has earned over $10 million for barely a year of work.
Critics respond to such arguments by asserting that the market for executive talent is severely flawed and that executive pay is simply not correlated with how an executive performs. Although there is conflicting empirical evidence concerning the correlation between executive pay and performance, it seems that those critics, such as Graef Crystal, claiming little or no correlation have louder voices.80
Also, critics argue that executives are merely managers of an enterprise and are unlike professional athletes or entertainers, who are products that directly generate revenue. Further, critics cite salaries of CEOs in Japan and Germany and assert that U.S. CEOs are paid much more for lesser or equal performance.81 A final point made is that the United States lack of competitiveness internationally is due in part to the large gap between the salaries of low-level workers and executives. Critics assert that the widening gap between executive compensation and the earnings of workers at the lower end is sapping morale and reducing commitment.82
In the 1992 Budget Reconciliation Act, Congress responded to the controversy surrounding executive compensation by adding section 162(m) to the Internal Revenue Code. Basically, this provision denies corporations the right to include certain excessive employee remuneration83 as a business expense in calculating their taxable income. The section provides that no deduction shall be allowed under this chapter for applicable employee remuneration to the extent that the amount of such employee remuneration for the taxable year with respect to such employee exceeds $1,000,000.84 There are many stipulations and exceptions to the general rule, but the basic premise is that for publicly held corporations, the CEO and the four other highest-paid employees (deemed covered employees) may not receive nonperformance-related compensation above $1,000,000.
Undoubtedly, section 162(m) was a response by Congress to the vast amount of criticism aimed at executive compensation in the early 1990s. Evidence of this can be found in the report issued by Congress justifying the new tax provision. The committee stated that [r]ecently, the amount of compensation received by executives has been the subject of scrutiny and criticism.85 Moreover, this is the only comment the committee makes with regard to its rationale in the Reasons For Change section of the report. Interestingly, Congress made no attempt to justify the provision in terms of tax policy or of protecting shareholders, the economy, or society.
For reasons similar to those put forth above concerning the tax on golden parachutes, it would be difficult for Congress to assert that section 162(m) was necessary to clarify the concept of net income in the tax code. As noted, section 162(a)(1) of the I.R.C. already disallowed deductions for unreasonable salaries or compensation, and the IRS had ample precedents with which to attack compensation that it believed patently unreasonable or equivalent to a disguised dividend.86 In any event, Congress apparently thought it appropriate to set a bright-line limit on what can be considered reasonable compensation for corporate executives.
However, similar to the consequences of the tax on golden parachutes, section 162(m) is likely to result in increased costs to shareholders in terms of executive salaries. Just as the golden-parachute tax did not deter corporations from providing executives with golden-parachute payments above a certain level, section 162(m) is not likely to affect what a corporation is going to offer its most valuable executives in order to secure their services. The denial of a tax deduction will lead to a higher tax liability for the corporation, which will lead to lower profits for shareholders.87 Thus, as a bright-line rule intended to protect shareholders from the excesses of corporate officers, the measure is likely to prove rather ineffective.
Despite the fact that Congress was not very explicit concerning its justifications for I.R.C. section 162(m), some insight into the motivations and general attitude of Congress concerning section 162(m) can be gained from the words of Senator Levin on the Senate floor in the 102nd Congress:
[T]here appears to be an unusual consensus [in the Senate] on the issue of CEO pay. Most of us are in agreement that there has been unacceptable excess and that the brakes should be applied. Measured against corporate profits, cost of living, worker salaries, and the salaries of CEOs in other countries, the pay of American CEOs is exorbitant. Not only has CEO pay become an issue in and of itself, but it has become a symbol of the deepening discomfort that we are feeling about the values of our society, the fear that many of us have that the social disruption that we are experiencing is due in part because the rich are indeed getting richer and the rest of us are getting nowhere.88
Senator Levins words seem to indicate that Congress was won over by the arguments that executive pay is out of proportion to corporate performance and out of line with the compensation of executives in other countries. However, the Senator neglects to mention who is harmed and why Congress should be concerned.
Most telling are his words blaming exorbitant executive salaries for creating social disruption and a discomfort with the values of our society. These phrases seem to indicate a general feeling that executive salaries represent some kind of serious social defect. It seems he believes that by curbing the salaries of executives, a more acceptable and morally correct result can be achieved.
Considering the lack of other significant societal interests, this kind of thinking, correct or not, was most likely the true motivation of Congress in enacting section 162(m). Coincidentally, the measure was passed in the early 1990s when there was much criticism in the media concerning the excesses of the 1980s and the widening gap between the rich and the poor.89 This report argues that critics of section 162(m) have been correct in describing the policy behind it as misguided populism, and in questioning the significance of the societal interest concerning executive salaries.90 It does not take much presumptuousness to conclude that section 162(m) was basically a gesture by Congress in response to pressure from the public and the media.91 Congress showed its concern for the average worker by punishing corporations in order to discourage them from paying too much to their executives. Of course, too much was defined in terms of what is morally or ethically correct rather than with concern for what the law allows or the market dictates.
After careful analysis of the four Internal Revenue Code provisions, their legislative history, and the political and social environment in which they were enacted, it seems rather clear that Congress did not enact these provisions chiefly to further legitimate tax policy goals or to protect some group or groups of citizens that could not fend for themselves. Rather, a much more plausible explanation for provisions 280G, 4999, 5881, and 162(m) is that Congress felt obligated to take action as a gesture to show its concern for the unfairness of some legal and legitimate corporate compensation policies. It was logical for Congress to choose the tax code, primarily because of its ability to discourage and punish without directly prohibiting an activity.
This approach parallels very closely the approaches taken by Congress in imposing sin taxes on cigarettes, alcohol, and other perceived evils in society. Those taxes punish users of certain substances by making them pay extra for their consumption choice. This involves the government making judgments as to how citizens should conduct themselves and discouraging activities it finds unwise or morally incorrect.
The golden-parachute, greenmail and excess-executive-compensation provisions similarly work to impose the governments view as to how much certain highly-compensated individuals should be able to make without it being too unfair. The government, in effect, punishes individuals and corporations in order to discourage them from engaging in certain legal and legitimate practices that involve the payment of large sums of money.92 In many cases, individuals are merely taking advantage of their skills and intelligence (in full compliance with the laws), and corporations directors are exercising their business judgment in good-faith efforts to adequately reward employees or protect the corporations against undesirable takeovers. Such interference by the government with the lives of citizens and the operation of the free market is of questionable wisdom and arguably has no place in a free society.
1. Otto, Freed from Greed, Time, Jan. 1, 1990, p. 76.
4. Henkoff, Is Greed Dead?, Fortune, Aug. 14, 1989, p. 40.
5. See Otto, note 1 above; Henkoff, note 6 above; Faltermeyer, The Deal Decade, Fortune, Aug. 26, 1991, p. 58.
6. See Otto, note 3 above.
9. See Faltermeyer, note 7 above.
13. See, for example, Otto, note 3 above.
15. See Ibid.
16. I.R.C. S162(a) (West, 1988).
17. I.R.C. SS 280G(b)(2)(A) (West, 1988).
18. During the period 1981-1984, over 4,000 mergers and acquisitions took place. Morrison, Those Executive Bailout Deals, Fortune, Dec. 13, 1983, p. 82.
19. By 1983, 15 to 30 percent of the largest U.S. firms provided golden parachutes to key executives. (Survey by Howard International found 15 percent, and survey by Pearl Meyer found 30 percent .) Ibid.
20. David V. Maurer, Golden Parachutes Executive Compensation or Executive Overreaching?, J. Corp. Law 9, no. 346 (1984): 354-55.
21. One problem with this argument is that it is not clear that a corporation insulating itself from hostile takeovers in general is a good thing. Some takeovers, though hostile, may be in the best interests of the shareholders and should not be deterred. Additional problems will be discussed below.
22. I.R.C. SS 280G(a),(b)(1),(b)(2)(A)(ii) (West ,1988). The base amount of pay is defined as the average annual income in the nature of compensationwith respect to the acquired corporation in the disqualified individuals gross income over the 5 taxable years [previous to the takeover year]. Staff of the Joint Committee on Taxation, 98th Cong., 2d. Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, p. 200 (Comm. Print, 1984) [hereinafter Joint Comm. on Taxation].
23. I.R.C. S 4999(a) (West, 1988).
24. The tax code denies tax deductions for salaries that are in excess of a reasonable allowance for salaries or other compensation for personal services actually rendered. I.R.C. S 162(a)(1) (West, 1988).
25. I.R.C. S 4999(c)(1) (West ,1988).
26. See note 20.
27. See, for example, Morrison, note 20; Moore, Golden Parachute Arrangements Shelter Displaced Executives, Legal Times of Washington., Oct. 25, 1982, p. 1, col. 1; and Klein, A Golden Parachute Protects Executives, But Does It Hinder or Foster Takeovers?, Wall Street Journal, Dec. 8, 1982, p. 56, col. 1.
28. Maurer, note 22 above, p. 353.
29. Joint Comm. on Taxation, note 24 above, p. 199.
30. Committee on Finance, United States Senate, 98th Cong., 2d. Sess., Deficit Reduction Act of 1984, vol. 1, p. 195.
31. It should be noted that the most basic rationale for a tax, that of raising revenues, is inapplicable here because Congress acknowledged when it passed sections 280G and 4999 that the revenue effect of such provisions was less than $5 million per year. Ibid., p. 196.
32. I.R.C. S 162(a) (West, 1988).
33. I.R.C. S 162(a)(1) (West, 1988).
34. According to one commentator, [t]here are no unusual difficulties applying the Codes general rulesabout unreasonable compensation to parachute payments. In the case of the normal golden parachute payment, it is easy to find the normal indicia of nondeductible compensation under section 162. This is a classic situation in which the regular rules under section 162 adequately identify unreasonable compensation. It is not clear why these rules would require augmentation in the form of section 280G. Edward Zelinsky, Greenmail, Golden Parachutes and the Internal Revenue Code: A Tax Policy Critique of Sections 280G, 4999 and 5881, Villanova Law Review 35, no. 131 (1990): 163.
35. Memorandum from TEI President Reginald W. Kowalchuk to Members of the Congressional Tax-writing Committees, The Tax Executive, July-August 1992, p. 296 [hereinafter Kowalchuk Memo]; Lee A. Sheppard, The Misguided Populism of the Executive Compensation Limit, Tax Notes, April 26, 1993, p. 454.
36. Kowalchuk Memo, note 37 above.
37. Rather than refining the notion of income, [sections 4999 and 280G] evidently constitute penalties for engaging in corporate behavior Congress sought to restrict. Zelinsky, note 36 above, p. 164.
38. The amounts involved [in golden-parachute arrangements], while often large, are not large enough compared to the size of tender offers to effect decisions made by those making tender offers. Maurer, note 22 above, p. 354; See also Comment, Golden Parachutes: Ripcords or Rip Offs?, J. Marshall Law Review 20, no. 237: 254-56; and Herzel, Golden Parachute Contracts: Analysis, National Law J., (February 1982): 22.
39. See Maurer, note 22 above, p. 354.
40. Ready-to-go money drove takeover prices beyond what [could] be justified by a companys earnings. In the Eightiesfunny paper pushed pries too high. Faltermeyer, note 7 above.
42. As mentioned in the text accompanying note 24, parachute payments above three times an executives base salary trigger the taxes.
43. [The golden parachute taxes have] failed in practice. Corporations [have] simply added a gross up to their pay packages for executives that is, companies paid an additional tax on behalf of the individual receiving the golden parachute. Andrew R. Brownstein and Morris J. Planner, Who Should Set CEO Pay? The Press? Congress? Shareholders?, Harvard Business Review, (May/June 1992): 28.
44. Rather than eliminate golden parachutes or reduce their size, the excise tax just made them more expensive for the company and ultimately the shareholder. Ibid.
45. See note 29 above and accompanying text.
46. I.R.C. S 5881(b) (West, 1988).
47. For a more detailed discussion of the shareholder-welfare hypothesis, described above, see Jonathan R. Macey and Fred S. McChesney, A Theoretical Analysis of Corporate Greenmail, Yale Law Journal 95, no. 13 (1985): 16-27.
48. Of course, the greenmail price need be less than the expected increased value of the firm in the hands of the third party. See ibid., p. 27.
49. Specifically, if T ultimately acquires B, the shareholders of B will receive a higher share price than they would if M had acquired the firm. This is because T expects to make B more valuable than M did, and therefore is willing to pay a higher price than M to acquire it.
50. Macey and McChesney, note 49 above, p. 15.
51. Ibid. p. 61.
52. Eric A. Lustig, The Emerging Role of the Federal Tax Law in Regulating Hostile Takeover Defenses: The New Section 5881 Excise Tax on Greenmail, University of Florida Law Review, 40 (1988): 789, 791.
53. I.R.C. S 5881(d) (West, 1989). The [50 percent ] tax imposed by [section 5881] shall apply whether or not the gain or other income referred to in subsection (a) is recognized. Ibid.
54. Zelinsky, note 36 above, p. 154.
55. Macey and McChesney, note 49 above, p. 13
56. Ibid., p. 13-14.
57. Kirkland, When Paying Off a Raider Benefits Shareholders, Fortune, April 30, 1984, p. 152.
58. Lustig, note 54 above, p. 791.
59. The House Ways and Means Committee stated in its report: The Committee believes that corporate acquisitions that lack the consent of the acquired corporation are detrimental to the general economy as well as to the welfare of the acquired corporations employees and community. H.R. Rep. No. 391, 100th Cong., 1st Sess. 1086, reprinted in 1987, U.S. Code Congressional and Administrative News, 2313-1, 2313-701.
60. H.R. 2995, 100th Cong., 1st Sess., 133 Congressional Record E3043 (1987).
Interestingly, this type of rhetoric contrasts with the language used to justify the provisions taxing golden-parachute payments. In justifying the tax discouraging golden-parachute payments, one of Congresss statements was that golden parachutes hindered acquisition activity in the marketplace, and should be strongly discouraged. Thus, it appears that within a few years, Congress shifted its stance on the desirability of a robust market for corporate control and began to look for ways to discourage corporate raiders from taking over unwilling corporations.
61. See text accompanying note 31.
62. The Committeebelieves that it is appropriate not only to remove tax incentives for corporate acquisitions, but to create tax disincentives for such acquisitions. Legislative History-P.L. 100-203, 1987 U. S. Code Congressional and Administrative News, 2313-701, p. 1086.
64. See Zelinsky, note 36 above, p. 160-87.
65. In addition, even if Congress did believe that hostile takeovers were generally bad for the economy, why did it not enact legislation to directly address the problem? A 50 percent excise tax on the recipient of greenmail is surely a roundabout approach. Of the four bills that were introduced in Congress in 1984 to outlaw greenmail, all failed. Note, Greenmail: Targeted Stock Repurchases and the Management Entrenchment Hypothesis, Harvard Law Review, 98 (1985): 1045.
66. As noted above, the legislative history of the golden-parachute provisions mentions Congresss concern about measures that hindered acquisition activity in the marketplace. See note 31 above and accompanying text.
67. Indeed, the message of Professors Macey and McChesneys article is that greenmail should not be outlawed based on the assumption that it is always a bad thing. They assert, rather, that any regulation of the activity should be aimed at ensuring that the shareholders are benefited regardless of managements motivations for the greenmail payment. See Macey and McChesney, note 49 above, p. 60-61.
68. See Macey and McChesney, note 49 above, p. 14-15.
69. See notes 49-53 above and accompanying text. Of course, it is possible that management will raise funds for greenmail by doing the same sorts of things that a raider would do if the takeover is successful, such as sell off high-cost operating divisions, close outmoded production facilities, and lay off workers. To the extent that these actions actually make the firm more efficient and profitable, they are economically desirable, and thus not deserving of per se discouragement. However, it should be noted that management does not have the same incentives as a raider to liquidate the firm in a haphazard, destructive fashion. A raider is going to be a residual claimant of the firms assets and stands to benefit directly from any liquidation that generates large amounts of cash. Moreover, the raider is typically going to be in need of a lot of cash in order to deal with the tremendous amount of leverage that is usually necessary for a hostile takeover. Therefore, the raider is more likely to use its power after the takeover to liquidate parts of the firm in order to effect large payments to itself as a shareholder with less concern for long-run efficiency and profitability. Management, on the other hand, is typically not going to represent a very large shareholder interest standing to benefit directly from large-scale liquidation. Also, management is more risk-averse due to its status as a fixed claimant on the corporations assets, and is less likely to act to hurt its firms overall strength. Thus, management is much more likely to have the long-term interests of the corporation in mind if it chooses to raise money for greenmail by selling off parts of the corporation.
70. Harmful in terms of encouraging takeover activity that is detrimental to the general economy as well as to the welfare of the acquired corporations employees and community. See note 61 above, p. 432.
71. It actually may reward a speculator for locating an undervalued firm. See Macey and McChesney, note 49 above, p. 15.
72. Sculley at $16.73 million, Fireman at $14.822 million, and Eisner at $11.233 million. The Flap Over Executive Pay, Business Week, May 6, 1991, p. 91.
74. Joani Nelson-Horchler, Whats Your Boss Worth?; 35 Times Your Salary? 1,000 Times? The Workforce Gets Angry, Washington Post, August 5, 1990, p. D3.
75. See note 74 above, p. 91.
77. Brownstein and Planner, note 45 above.
78. [I]f managers are to be persuaded to act in the interests of those they represent, said Prof. Kevin Murphy of the Harvard Business School, its crucial to use executive compensation to mimic the incentives of ownership. Peter Passell, Those Big Executive Salaries May Mask a Bigger Problem, New York Times, Apr. 20, 1992, p. A1.
79. However, critics of current levels of executive compensation argue that corporate boards are often loaded with other high-paid CEOs. Its a cozy you-scratch-my-back-Ill-scratch-yours arrangement. Thomas McCarroll, Executive Pay; The Shareholders Strike Back, Time, May 4, 1992, p. 46 (quoting Graef S. Crystal).
80. See Graef S. Crystal, Perspectives on Executive Pay, Los Angeles Times, February 25, 1992, p. 7; and Graef S. Crystal, Does Money Matter? Not For Americas Vastly Overpaid Executives, Washington Post, August 9, 1992, p. C1. But see Michael S. Kesner, Are Executives Paid Too Much? Prentice Hall Law & Business Corporations, LXIV, no. 3 (1993): sec. 2 .
81. The average Japanese CEO, for example, earns about $400,000 a year, whereas the average U.S. CEO earns around $1,000,000 in base salary alone. Nelson-Horchler, note 76 above. This difference, however, may not be as significant as the statistics suggest. When perks and other cultural features are taken into account, U.S. executives do not appear to be paid more than their Japanese counterparts.Japanese executives benefit from extensive perquisites, lifetime job security, and lifetime pay. AlsoJapanese companies typically use a team-management approach that places less emphasis on a CEOs individual abilities and importance than U.S. companies do. Brownstein and Planner, note 45 above. In addition, American executives do not benefit from cross-ownership with suppliers, customers and lenders that ensures the availability of capital, sales, and product in good and bad times.[And] one has to consider cost-of-living, tax structures and currency exchange rates, among other things. Kesner, note 82 above.
82. Robert B. Reich, Executive Salaries: From the Absurd to the Grotesque, San Francisco Chronicle, May 17, 1992, p. 16/Z1. However, even Reich notes that [t]he problem is not that American businessmen are draining the company treasuries. Even absurdly high salaries rarely make up a major percentage of corporate revenues. Ibid.
83. I.R.C. S 162(m) (West, 1994 Supp.).
84. I.R.C. S 162(m)(1) (West, 1994 Supp.).
85. Budget Reconciliation Act, Legislative History, P.L. 103-66, H.R. No. 103-111, p.646.
86. See notes 34-39 above and accompanying text.
87. In addition, the denial of a deduction gives rise to an unfair double taxation of officers salaries once at the individual leveland once at the corporate level (as the result of the denial of the deduction). Kowalchuk Memo, note 37 above.
88. 138 Congressional Record S214 (Jan. 23, 1992, daily ed; statement of Sen. Levin).
89. See notes 8-10 above and accompanying text.
90. See Brownstein and Planner, note 45 above; Sheppard, note 37 above; Marc Levinson, Lay Off the Pricey CEO, Newsweek, Feb. 10, 1992, p. 44.
91. In a different speech, Senator Levin implied that he felt such pressure. He said that hardly a week has gone by without another article detailing another example of sky-high executive pay.The public and many members of the business community want executive pay related to corporate performance. 138 Congressional Record S2907 (Jan. 30, 1992, daily ed.; statement of Sen. Levin).
92. Large relative to the average income of a U.S. employee or businessperson.
Jonathan R. Macey is J. DuPratt White Professor of Law at the Cornell University School of Law and a Research Fellow for The Independent Institute.