Abstract
Congress should allow a unique class of preferred shares whose dividends are tax-deductible as long as a significant majority of senior management compensation is in the form of these shares. Tax-deductible interest should be further limited to compel firms to issue these shares because a lower tax liability will increase firm value. Managers will be discouraged from making high-variance and often losing bets with other peoples’ money because they will have skin in the game. Their compensation will be directly tied to corporate performance rather than the volatility of the stock market, which is the case with common stock and options awards.
Keywords
The severe recession triggered by the 2007 financial crisis was the result of a bubble in real estate prices caused by lax (and fraudulent) mortgage lending standards exacerbated by the use of derivatives such as collateralized mortgage obligations (CMO) and credit default swaps. 1 In response to the crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which has since been partially repealed, 2 was enacted in 2010 to prevent future financial crises.
Events that lead to crises are rarely duplicated. According to Lowy, 3 the real estate bubble of the 1980s was triggered by poor regulatory oversight, rising interest rates and the savings and loans industry’s lax lending standards, especially for commercial properties. Prior to 2008, there was little discussion in any publication about questionable CMO bond ratings and their potential for creating an asset bubble. Chances are that the source of future financial meltdowns will not be anticipated, and the existing set of regulations will be inadequate to address deficiencies in the regulatory framework. The Economist 4 speculated that excessive levels of corporate debt could be the source of the next financial crisis. Adding to extant risks, managers might be devising new ways to circumvent the existing set of regulations to maximize their compensation.
Having Skin in the Game
So is it possible to adopt a set of regulations that are impervious to a dynamic and evolving economy and which would work for financial and nonfinancial companies? Taleb, 5 a former hedge fund manager and trader, states that senior management should not enjoy the rewards of their actions but transfer the downside risks to taxpayers. That is, you cannot get rich without owning your own risk and paying for your own losses, which he refers to as having skin in the game. 6 Forcing skin in the game balances this asymmetry better than the onerous and complex regulations imposed by government agencies to prevent the heads-I-win, tails-you-lose hustle that managers have devised.
A proposal enacted by some firms is to clawback senior manager compensation in the event of manager malfeasance. 7 After the financial crisis Congress tasked the SEC (Securities and Exchange Commission) with developing rules that would require companies to institute clawback policies. According to Morgenson, 8 clawback rules that have been implemented are inadequate because they cover only a portion of manager compensation and are generally restricted to cases in which accounting irregularities force a company to restate its results. In some cases, companies require clawbacks only if compensation earned was based on inaccurate financial disclosures.
Even if clawback rules are reformulated to meet a higher level of fiduciary stewardship, will managers willingly accept such reforms? They could find ways to conceal their assets to make it difficult, time consuming and expensive to execute a clawback. One could circumvent this problem by deferring a majority of their compensation, which could be clawed back in the event of manager malfeasance. But who would determine the amount that should be clawed back? Managers would resent the heavy hand of government confiscating their hard-earned compensation. Leaving it up to management is not a good idea either because of the conflict of interest; remember managers back-dating their own stock options. 9 So are there alternatives to induce managers to have skin in the game?
Preferred Stock to the Rescue
An avenue worth exploring would be for Congress to consider allowing corporations to issue a unique class of noncumulative preferred stock for which dividends would be a tax-deductible expense as long as a significant majority of senior manager (directors, CEO and the CEO’s direct reports, referred to as managers henceforth) compensation would be paid in the form of this stock with the remainder to be paid in cash. 10 Only the shares awarded to managers would be restricted (referred to as restricted preferred henceforth) in that they would vest gradually after a number of years to ensure managers’ long-term skin is in the game. Dividends for other classes of preferred stocks would not be tax-deductible.
Table 1 presents an example of the deferred compensation for a manager whose total compensation is $15 million each year, of which $5 million is paid in cash in the year that it was earned and the remaining $10 million is in restricted preferred stock which will vest at the rate of $2 million per year from the 6th to the 10th year in the future. So, assuming that the hire date is year 1 (Y1), the manager will receive $5 million in cash that year, but the restricted stock will be paid out in $2 million installments, each year, in Y6 through Y10. In Y2, the manager will receive $5 million in cash and the restricted stock will be paid out in $2 million installments in Y7 through Y11. In Y6, the manager will receive $5 million cash plus the $2 million in preferred stock that vests from Y1’s compensation plus the deferred $10 million that will be paid in Y11 through Y16. In Y7, the immediate compensation is $5 million cash plus the $4 million in preferred stock that vests from Y1 and Y2’s compensation plus the deferred $10 million that will be paid in installments in Y12 throughY17.
Restricted Preferred Stock Vesting Schedule.
Note. Y = year. $10 million annual compensation deferred. $2 million received annually, 6th to 10th year.
The last column shows the nonvested accumulation of restricted stock each year, which increases at a decreasing rate after the first 5 years and reaches a steady state of $70 million in year 9. So, by Y9 the manager is owed $70 million in the future, which could decline significantly if the value of the preferred stock deteriorates. That is, the manager has a lot to lose if earnings collapse and dividends are not paid.
As is the case with interest expense, the total amount of dividends on these shares that are tax-deductible should be limited to prevent an excessive amount of shares being issued such that it would jeopardize the interest of common stockholders. Limits on the amount of interest expense that is tax-deductible, to prevent excessive risk taking with what Blinder 11 refers to as other peoples’ money (OPM), should also be reduced further. Currently, a company can deduct interest expense of up to 30% of its earnings before interest, taxes, depreciation, and amortization (EBITDA) for computing taxable income. Any amount in interest expense beyond that cannot be deducted. 12
The tax code could be modified to reduce the limit on interest deductions to 10% and preferred dividends to 20% of EBITDA. Another option would be to increase the limit above 30% for both payouts combined and increasing the corporate taxes rate to keep the changes revenue neutral. These are arbitrary numbers that are put forth to explain the concept. The Treasury Department and the IRS with input from academics and compensation consultants would draft a proposal that would determine the ceilings and the percentage of total compensation to be deferred.
Firms would be incentivized to issue these shares because the tax-deductibility of dividends increases after-tax earnings and hence the value of the firm. Modifying the Miller and Modigliani theorem, 13 the value of the firm would be
where VL is the value of a levered firm; Vu is the value of an unlevered firm; Tc is the marginal corporate tax rate; D is the market value of tax-deductible debt outstanding; and P is the market value of tax-deductible preferred stock.
The theorem implies that firm value increases as tax payments decrease. So, there are compelling advantages for firms to issue both tax-deductible debt and preferred stock and to compensate managers with the latter because the deduction of interest payments and dividend payments will increase after-tax earnings and hence firm value. Firms that avoid adopting this compensation structure would be viewed skeptically by investors because they would be perceived as placing managers’ above stockholders’ interests.
Managers holding large amounts of restricted preferred shares are incentivized to be responsible custodians of corporate assets because they will have skin in the game. The price of the stock and manager wealth would plummet if dividends were cut because of negative or insufficient income. Plus, the shares are noncumulative so managers cannot claim past unpaid dividends before common dividends are paid, which would put even more pressure on the stock price.
Finally, the number of restricted preferred shares awarded will be based on the par value of the stock and not its market value. The $10 million compensation will translate into 400,000 shares, assuming a $25 par value preferred, regardless of its market value at the time the compensation is awarded. This will encourage managers to be responsible custodians of corporate assets and dis-incentivize them from gaming earnings. For instance, managers could slash earnings in a particular year and not pay preferred dividends, which reduces the preferred price to say $15. Because of poor performance they are awarded 800,000 shares the subsequent year, at which time normal earnings revert, dividends are restored and the preferred price increases significantly, which can result in a significant gain.
Preferred Is Better Than Common
Well why not award restricted common instead of restricted preferred stock? Because the latter offers several advantages relative to common stock:
The fixed dividends paid by restricted preferred stocks will deliver the same financial leverage benefits of debt needed to boost return on common equity (ROCE), as long as the return on assets (ROA) is greater than the after-tax cost of preferred stock cost 14 ; except that managers would not make asymmetrical bets—heads I win, tails you lose—with OPM but with a pool of money that includes their own compensation. If the firm cannot make dividend payments because of insufficient income, the preferred stock price would decline significantly and so would manager wealth. That is, they will have skin in the game.
Dividends paid by the restricted preferred stocks would be higher than common stock dividends, which would help managers meet personal expenses because most of their compensation is deferred. The dividend payments serve as payment for the time value of money because the compensation for services already rendered is paid in the future. The payments should be designated as qualified so that they are taxed at the capital gains tax rate of 15%, which is less than half the 32% highest marginal rate that managers pay. That would boost their after-tax income.
According to Bildersee, 16 preferred stocks have lower betas than common stocks and so are less volatile than common stock prices. So, managers need worry less about a bear market reducing the value of their future compensation. As long as dividends are paid, the value of the preferred shares would remain relatively stable and could rise if interest rates declined because of an economic downturn. Like debt, preferred share price varies inversely with changes in interest rates, assuming that dividend payments are not in jeopardy. More on this in the next section.
Common stock awards are somewhat akin to owning lottery tickets because changes in common stock prices are not solely the manifestation of corporate performance. Stock prices change because of a whole host of reasons, some not tied to manager performance. For example, a manager who has done a superb job but whose stock awards vest during a bear market caused by an exogenous shock (e.g., in 2008 the S&P 500 declined 37% because of the financial crisis) will reap less reward than a manager who performed poorly but whose stock awards vest during a bull market caused by exogenous events (in 2013, the S&P 500 increased by 32.4% because of the economic recovery). Needless to say, management compensation should bear a direct relationship to achieving corporate goals and not depend on the volatility of common stock prices.
One could contend that restricted preferred stock does not allow for significant upside if corporate goals are met or exceeded. True, but managers can expect an increasing amount of compensation, more restricted preferred stock and cash for meeting or exceeding expectations. Since a majority of their compensation is in the form of preferred stock, with limited upside because of a fixed dividend, they cannot game the system where they could boost the value of their holdings in the short-run by taking outsized risks, as they could with common stock and stock options, knowing fully well that in the long run their decisions could lead to corporate bankruptcy. This scenario is particularly true for managers who have large holdings that will vest within 2 to 3 years. The inability to earn outsized gains makes preferred shares an attractive alternative for manager compensation.
The Downside Can Be Managed
The rub is that managers might focus on their own interests—dividends paid by restricted preferred shares—to the detriment of common stock investors. To prevent this agency problem, manager compensation can be tied to the level and the growth rate of income available to common shareholders which is income after preferred dividends are paid.
A small percentage of the restricted preferred awards can be convertible into common stock upon vesting to provide an ownership stake. 17 The goal is to maintain managers’ long-term skin in the game by maintaining a symmetric payoff structure. Sanders and Hambrick 18 determined that large stock option awards induced CEOs to not only make larger bets but also high-variance bets. However, they usually were not good bets. The skewed payoff structure of call options can result in significant rewards to option-laden CEOs even when they deliver more big losses than big gains. In contrast, the payoff curbs outsized gains if say only 20% of the restricted preferred stocks are convertible into common stocks. 19
The value of manager compensation would decline substantially if interest rates increase significantly, like they did in the 1970s because preferred stocks being level perpetuities are long-duration securities. To prevent this scenario, the firm can put a collar around the value of manager compensation by shorting long bond futures contracts. If interest rates increase significantly, the profits from the short position will be distributed to the managers to compensate for the decline in the value of the stock. If interest rates decline significantly some of the increase in the value of the stocks would be kept by the firm to compensate for the short position loss.
The compensation structure will not work for companies that do not use financial leverage or are significantly underleveraged, that is, where interest expense is below the EBITDA ceiling. This is not a drawback because these corporations are not making imprudent bets with OPM and are not the cause of systemic failures.
Conclusion
The compensation structure outlined does not require a complex and onerous set of regulations that imposes the heavy hand of the government and which managers could circumvent. The free-market will determine the rewards that managers will earn. Their wealth is more closely tied to corporate performance with restricted preferred stocks than with common stocks. It does hold managers’ feet to the fire because any attempt to stay with an asymmetrical compensation structure that benefits them at the expense of other stakeholders will be viewed adversely. Managers are incentivized to be responsible stewards of corporate assets because they will have skin in the game. This compensation structure will work especially well for financial institutions because it would discourage them from taking irresponsible risks for the sake of short-term gains at the expense of long-term systemic failures that have led to the economic disaster of the previous decade. Furthermore, financial institutions should be allowed to use these shares to meet capital requirements, which offers another incentive to adopt this compensation structure.
Footnotes
Declaration of Conflicting Interests
The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The author received no financial support for the research, authorship, and/or publication of this article.
