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Wells Fargo scandal shows need to fix performance pay loophole

Greg Nash

The Wells Fargo scandal has reignited anger over Wall Street’s criminal activity and the havoc it has wreaked on ordinary Americans. That anger is all the more justified because the financial executives responsible for this damage take home millions in “performance pay,” mostly in the form of stock options and other equity.

The cruel irony in the phrase ”performance pay” is evident when one considers the kind of activity that is being rewarded: Wells Fargo created fake bank accounts and charged customers undue fees that ruined credit ratings while Carrie Tolstedt, the former head of the retail banking business where this fraud took place, retired with almost $125 million in mostly stock and options. Even now, she will reportedly be asked to forfeit only $19 million in unvested equity awards.

{mosads}It becomes even more maddening when we realize that the public is subsidizing these highly compensated shenanigans through an ill-conceived tax loophole. Then-presidential candidate Bill Clinton elevated CEO pay as a core issue of his 1992 campaign with a pledge to eliminate corporate tax deductions for executive pay that topped $1 million. Though his policy did become part of the tax code as Section 162(m), it came with an unfortunate exception for performance pay.

The logic of performance pay came from Chicago-school economists Michael C. Jensen and Kevin J. Murphy, who argued that executive pay should align CEO interests with what shareholders care about, i.e., higher stock prices. If CEOs were paid with stock options and equity, Jensen and Murphy reasoned, those executives would have a greater incentive to drive up stock prices and increase their own payday.

Once Section 162(m) became law, companies predictably started dispensing more compensation that qualified as performance pay. Median executive compensation levels for S&P 500 Industrial companies almost tripled in the 1990s, mainly driven by a dramatic growth in stock options.

Most of us think of skyrocketing CEO pay as simply a moral problem, but it comes with enormous economic costs. In addition to driving economic inequality, performance pay can (and has) made executives very wealthy, very quickly, which creates incentives for shortsighted and excessively risky decision-making. As Wells Fargo shows, it can also encourage outright fraud.

One notable study examined the relationship between the likelihood of a firm being investigated for securities fraud—such as misreporting financial results—and the “option intensity” of the firm’s executive compensation. The authors found that CEOs of “fraud firms” have greater option-based compensation, indicating that the greater the incentive for CEOs to maximize the company’s stock price, the greater the incentive the CEO has to engage in fraudulent activities to accomplish this goal. (The authors also tested whether the option intensity prompted the fraud allegations, but their results held.)

This may call to mind the backdating scandal of the mid-2000s, in which many companies were found to have eliminated any risk of losses for their executives by simply changing the date when stock options were granted. Typically, they backdated the options to an earlier date when the stock price was lower, thus making them more valuable. Backdating itself is not illegal if it is authorized by a company’s board, fully disclosed, and complies with reporting and tax rules. Secret backdating, however, is illegal, and indicates that corporations are underreporting their taxable income to the IRS.

Finance professor Eric Lie’s research was the first to show evidence of this illegal backdating trend and was hugely influential in the SEC’s investigations. According to Harvard Law’s Lucien Bebchuk and colleagues, about 12 percent of firms—or 2,000 in total—backdated CEO stocks from the mid-1990s to mid-2000s, which boosted executive compensation by 20 percent.

In addition to encouraging law-breaking, performance pay diminishes long-term business investments. According to economist William Lazonick, in order to issue stock options to top executives while avoiding the dilution of their stock, corporations often use free cash flow for stock buybacks rather than spending on research and development, capital investment, or increased wages and new hiring. 

Worst still, the American public is stuck with the bill for all this. Beyond the innumerable costs we’ve borne from the economic crisis and the current Wells Fargo scandal, the Economic Policy Institute calculates that taxpayers gave a $30 billion subsidy to corporations through the performance pay loophole between 2007 and 2010. In fact, the Institute for Policy Studies reports that John Stumpf, Wells Fargo’s CEO, received the most tax-deductible pay on Wall Street. Between 2012 and 2015, about the same time that Wells Fargo opened some 2 million fake accounts, Stumpf took home $155 million in “performance pay,” which translates into $54 million in tax subsidies for Wells Fargo.

Sens. Jack Reed (D-R.I.) and Richard Blumenthal (D-Conn.) are harnessing the current scrutiny of Wells Fargo to push for a bill that would control the unfettered use of performance pay by public corporations. S. 1127, also known as the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act, would cap tax deductions for a publicly traded corporation at up to $1 million in pay per employee, regardless of what form that pay takes. If successful, the bill would finally bring an end to an astonishingly bad policy.

Holmberg is the Roosevelt Institute’s Director of Research.

The views expressed by authors are their own and not the views of The Hill.

Tags Bill Clinton Jack Reed Richard Blumenthal

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