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Comp Rx: Kill Employment Contracts?

Amid the tussle over what to do about executive compensation, a radical solution is floated.

October 2008
by David McCann/CFO Magazine

Employment contracts for CEOs and other senior executives were not very common until about 20 years ago. And according to a noted compensation expert, investors' interests would be served well by a return to the old way.

Excessive executive pay could be limited by a simple but radical change: the elimination of employment contracts, according to Bruce Ellig, a noted author, speaker, and advisor to corporate boards on compensation and human resources issues. To effectively accomplish that, he suggests, Congress could entirely disallow tax deductions for compensation made under a contract — for all companies, not just financial services firms that participate in a federal bailout program.

Companies that then signed executives to lucrative employment contracts anyway would expose themselves to possible shareholder lawsuits for misusing company assets, according to Ellig, a former longtime head of human resources at Pfizer Inc. He further suggests that Congress could impose an excise tax on contract recipients for income received under contracts.

Without employment contracts, companies would be able to compensate departing executives reasonably, rather than being tied to exorbitant payments contractually agreed to years earlier, Ellig tells CFO.com. "I talk to people on boards all the time who say, 'Oh, our hands are tied, the CEO has an employment contract.' Well, you shouldn't have given him a contract. You wouldn't have the problem, would you? Why don't you go talk to him and see if he'll agree to tear it up?"

Taking a stance against employment contracts is both the right thing and the fair thing to do, according to Ellig. "If you've got shareholders losing value and employees losing jobs and the company teetering on the brink of bankruptcy, why should an individual who was a main source of the problem be protected?" he says. "If the employment-at-will principle is fair game for everybody else in the organization, it should be fair game for executives as well."

Significantly diluting the CEO's risk of poor performance may be ill-advised, as he surely will take comfort that he'll be protected in case the company fails or he is terminated. "That's not a positive motivation," says Ellig, who has written seven books, including "The Complete Guide to Executive Compensation" and "The Evolution of Employee Pay and Benefits in the United States."

Certainly, the reason companies give employment contracts is to secure and retain top executive talent. But Ellig says executives will have enough incentive if a new employer agrees to pay for the value of anything the executive is leaving behind at his old job to take the new one, and awards stock that will vest over a period of years. Then, if the executive left within a specified time period, he would have to pay back the cash and wouldn't get the stock.

All of that can be agreed upon in the typical type of offer letter that many employees, both executives and non-executives, receive. It could even be agreed upon orally.

In both of those cases, the agreements may constitute legally binding contracts. But to support Ellig's view of disallowing the tax deductibility of payments made under contracts, Congress and the IRS could stipulate that an "employment contract" is one that, for example, is prepared by outside counsel, agreed to and signed by the board, and lays out all terms and conditions of employment in detail including length of employment and amounts to be paid upon severance.

Ellig acknowledges that he hasn't heard anyone else making such a suggestion, adding that "I've always been a maverick."

Indeed, some other observers view it as an extreme approach. "To disallow all deductions for executive compensation would go far beyond what is necessary," says Mark Poerio, an employment practice partner at Paul, Hastings, Janofsky & Walker. Beside, he notes, it wouldn't solve the problem of excessive compensation anyway; companies would still pay significant incentives in order to be competitive in the marketplace. "I don't see why the fact of whether it's stated in an employment agreement should make the difference in whether it's deductible," Poerio says.

Furthermore, in the past, limiting deductibility has not deflated executive pay, notes Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. In fact, it has had the opposite effect. In 1993, the IRS decreed that cash compensation over $1 million per executive annually would no longer be deductible, triggering the rise of stock options as the leading compensation tool.

A reduction in deductibility for compensation expense to $500,000 per executive was part of the financial services bailout bill that the House of Representatives voted down on Monday. "That was problematic," Elson says.

Elson adds that he thinks concerns over executive compensation should be handled separately from the bailout legislation, because it's making legislators take their eyes off the ball as to what's really important.

Poerio too is frustrated at the bright spotlight on executive compensation as part of the bailout discussion. "It is very disproportionate — we're talking about $700 billion, and what's at stake with regard to compensation is a drop in the bucket," he says. "It resonates with Main Street America, and executives are overpaid and we should cut them back. But if that ever becomes part of how somebody makes a decision on this, that is skewed and wrong."

David McCann is a reporter at CFO.

© CFO Publishing Corporation 2008. All rights reserved.