Response to legislation limiting the deductibility of executive compensation

Abstract

Three questions regarding the effectiveness of Section 162(m) are addressed by this dissertation: (1) did Section 162(m) target the firms who were paying their executives excessive compensation that was not related to performance? (2) did Section 162(m) achieve its desired result of reducing compensation levels and increasing pay-performance sensitivities? and (3) did stockholders benefit from Section 162(m)? The empirical results indicate that firms subject to Section 162(m) had higher levels of compensation, even after controlling for firm size, performance, industry, growth opportunities and CEO ownership. However, the cash compensation in these firms was more sensitive to firm performance. Therefore, it is questionable whether Section 162(m) affected the intended target. Firms with compensation in excess of 1 million were required to disclose their response to Section 162(m) in their 1994 proxy statements. They had three alternatives: (1) "qualify" compensation in excess of the 1 million by making it contingent on a performance measure, (2) defer excess compensation to a period when it would be deductible, and (3) forego the deduction. Firms were grouped by their response and their compensation levels, pay-performance sensitivities and pay mix were analyzed. Compensation levels increased for all three groups, primarily from the use of more stock options. This also increased the proportion of stock-based compensation (pay mix). Pay-performance sensitivities decreased for qualifying firms which runs counter to the intent of Section 162(m). On the other hand, firms who chose to forego the deduction demonstrate an increase in pay-performance sensitivities. Finally, the evidence indicates a positive market reaction to the announcement that a firm would qualify their compensation or forego the deduction. A negative reaction is documented for deferring firms. This seems to indicate that, overall, stockholders did benefit from Section 162(m).