The case for cash for directors.

• Author: Kaback, Hoffer
• Position: Stock options for directors of corporations

Paying directors wholly or substantially in stock, on an imposed basis and as a general standard, may impede rather than further improved governance.

Demand for changes in corporate governance continues apace. One call for reform - paying directors' fees entirely (or substantially) in common stock and requiring directors to make a "significant" investment therein - has gained wide endorsement. It may already have the status of received wisdom.

The principal rationale offered for compensating directors only, or chiefly, in common stock ("Stock Comp") and for requiring significant common stock ownership ("Stock Own") is that these create a better "alignment" of directors' and shareholders' interests and, therefore, provide more assurance that directors will act in consonance with shareholders' interests ("Alignment"). Stock Comp and Stock Own advocates believe that paying directors' fees in cash ("Cash Comp") makes it less likely that directors will so act.

Stock Comp and Stock Own have surface appeal. Many prefer that those managing business ventures have a "stake" in the fortune of the enterprise instead of receiving fixed compensation divorced from its success or failure. This notion is endemic to, for example, venture capital and hedge funds. Stock Comp and Stock Own may accordingly appear to be little more than business common sense.

In this article, it is argued on the contrary that the core rationale of Stock Comp and Stock Own (the "Rationale") is badly flawed. That Rationale confuses means with ends and uses an inapposite mechanism (compulsory stock ownership) unrelated to that which is desired to be induced (good director performance).

Additionally, the Rationale is internally inconsistent in numerous respects. And, particularly significantly, Stock Comp and Stock Own lead to counterproductive results. They therefore may impede, rather than further, realization of improved corporate governance.

The Rationale

Proponents of Stock Comp and Stock Own ("Proponents") include commentators on corporate governance and players active in the corporate arena (see sidebar on page 16). Although reference is made in this article to several of them, the principal focus of analysis is the Report of the National Association of Corporate Directors Blue Ribbon Commission on Director Compensation ("Report"), because:

1. Its Stock Comp/Stock Own recommendations received substantial coverage in the business press.

2. It constitutes a manifesto urging the universal adoption of Stock Comp and Stock Own.

   Significantly, the Report labels Stock Comp and Stock Own as "Best Practices." It follows that Cash Comp is viewed as less than "best." The Report states that Stock Comp and Stock Own will lead to greater "legitimization" of director compensation, thus implying that Cash Comp is less than legitimate and virtually per se bad. In effect, the Report challenges the propriety - let alone the wisdom - of Cash Comp.

   Yet, as shown in this article, it is Stock Comp and Stock Own that involve: (a) practical complexities, (b) leaps of illogic, (c) unmanageable and distasteful results, (d) a misguided tying of director compensation to market performance of the company's stock, and (e) perverse results detrimental to good corporate governance. These themes emerge and re-emerge as one peels the Stock Comp/Stock Own onion, layer by layer.

   It is useful to commence the process with a tax-related issue, and build from there.

1. Tax Without Cash

   A character in one of Woody Allen's movies says that the worst sin is "buying at retail." In the business world, an equivalently serious transgression is producing taxable income without cash.

   Paying directors solely in stock (i.e., pure Stock Comp) creates that result. True, if directors' fees are apportioned between cash and stock, the director may have some cash (after paying tax on cash received) to pay some or all of the tax on the stock received. Some companies employ a 50/50 package; increasingly, however, others are utilizing pure Stock Comp.

   On the margin, pure Stock Comp creates negative cash flow because there is compensation income but no cash to pay the tax thereon. The Report recognizes this. It also acknowledges that tax-effective director compensation is a desirable goal. It suggests restricted and phantom stock as mechanisms to avoid the negative cash flow created by pure Stock Comp, while simultaneously admitting the problems attendant to utilizing those very mechanisms. At the same time, the Report suggests that one way to avoid the problems of restricted stock is to pay unrestricted stock to directors so that they can sell such stock at any time, while admitting that the director will recognize compensation income on receipt of such stock. (It fails to note, however, that sometimes a director cannot sell for six months because of short-swing profits liability.)

   Here is our first introduction to the Report's peculiar notions of cause and effect: The straightforward way to look at the situation is, first, to observe that Stock Comp creates compensation income without cash, and then to attempt to deal with this either by mechanisms of deferred tax or by permitting the director to sell off a large portion of the very Stock Comp he has just received. If the former, then the director receives no current compensation for his board service. If the latter, then query the entire notion of requiting Stock Comp, if haft of the stock received is in turn sold off.

   But the Report approaches this situation in a roundabout way: it first states that Stock Comp with "appropriate restrictions on resale" is the best way of tying directors' financial interests to the shareholders'. It then recommends the "tax-effective" techniques of phantom and restricted stock to avoid receipt of current income, while also noting the problems created thereby. It next lauds the "flexibility" of unrestricted stock as Stock Comp because the director can sell it. It then again notes the disadvantage of compensation income caused by that very receipt of unrestricted stock.

   Some directors presently choose deferred compensation and therefore elect to receive no cash from their board service. They choose to do so because it furthers their individual tax planning. In sharp contrast, Stock Comp is imposed on a board-wide basis. It therefore reduces individual directors' flexibility to manage their own finances.

   The Report offers (imperfect) solutions for ameliorating the problems created by pure Stock Comp. But the important immediate point is that under Cash Comp there is no need to search for solutions to these problems because the problems themselves do not exist.

   On principle, it is wrong to place a director into negative cash flow of any amount as a direct consequence of board service. People should not be made worse off, from a cash standpoint, for the privilege of having worked. Typically, taking paper equity instead of cash in payment for services rendered is rarely something imposed, at the outset, by a payor.

   As the amount at issue increases, however, this violation of principle may lead to tangible inconvenience.

   Irrespective of their net worths, directors may sometimes be illiquid. Moreover, for some directors serving on several boards, aggregate directors' fees may constitute an appreciable portion of personal income, or may even exceed regular employment income (e.g., an academic who does no outside consulting and serves on several Fortune 500 boards). Were all of a multi-board director's companies to embrace pure Stock Comp, he could easily face a substantial amount of tax without cash vs. the positive cash flow he would experience on Cash Comp boards.

   The after-tax cash differential between pure Stock Comp and Cash Comp can be non-trivial: on, say, $200,000 in total directors' fees per annum (three boards at about $70,000 each), a Cash Comp director nets $100,000 after-tax (assuming for simplicity a 50% tax rate); in a pure Stock Comp world, he winds up minus $100,000 after-tax (because he must pay that amount out of his pocket as tax on the $200,000 of Stock Comp compensation income). The spread is $200,000 in after-tax cash. Thus, for the identical board service, this director is, net, $200,000 worse off, per year, on pure Stock Comp as against Cash Comp boards. This effect would be magnified for a director serving on five or six major boards.

   To be sure, avoiding financial (or other) inconvenience to directors is not a goal of corporate governance. On the contrary, it is part of a director's role to be discomfited when his responsibilities so require. The good director must (and will) subordinate his personal inconvenience to the best interests of the company. However, all such inconveniences must be justifiable and serve a larger good.

   Proponents posit that that larger good exists. They hold, unequivocally, that Stock Comp and Stock Own will induce better board performance. Confining ourselves, however, at this early point in the...