Senate Finance Committee Holds Hearing on Enron

Apr. 8, 2003
Senate Finance Committee Holds Hearing on Enron

GRASSLEY:
I'm going to go ahead and start the meeting. Normally I don't without a member of the Democrat Party being here as well, because that's the tradition of our committee to do everything in a very bipartisan way, but I've had the permission of Senator Baucus to move ahead and I want to do that. So, it gives me an opportunity to thank all of you for being patient. It gives me an opportunity to thank all of you for coming on a very important hearing.
This is a hearing in a serious of hearings on executive and deferred compensation, and, particularly, as it's related to the Enron investigation. We did have a hearing about a month ago in February when the Joint Committee on Taxation released a study involving Enron corporate tax forms. We then had staff director Lindy Paull, who now has left the Joint Committee on Taxation, report findings on both the general manipulation of the tax system, and also on non-qualified deferred compensation.

Way last year on April 18, Senator Baucus held a hearing on stock options and non-qualified deferred compensation. At that hearing I said that I am not bothered by the existence of executive or deferred compensation arrangements. If an execute wants to make what is essentially an unsecured loan to his or her company by not taking all of their compensation in cash and the money is completely at risk, my advice was well, go ahead. That money is not taken into account by the executive and the wages are not deductible by the company under those arrangements. It's a wash. If an executive works hard and does well there's no reason to not let them have what they want if their pay is and defer some compensation. But, if I can stop here, I want to make an observation. No one is complaining about the athlete who gets huge amounts of pay and endorsement contracts, not is anyone complaining about how much movie stars make, nor is anyone here complaining about how much money rock stars earn and can defer from their compensation. The answer is to that is no, no one is fussing about the entertainment set. This hearing is just about executives who abuse discretionary authority.

I don't care about the existence of executive compensation so long as it's all transparent and honest and ethical. What bothers me are abuses of the system. And that extends to any abuses of non- qualified deferred compensation. Congress provides significant tax benefits for qualified retirement plans. To control the revenue loss, Congress has placed severe limits on the deferrals and benefits of highly compensated employees. Those limits on qualified plan benefits place pressure on employers to supplement the benefits for executives.

In 2001 Congress even raised the limits for qualified plans. But, we raise them modestly. Those increases in the limits for qualified plans are attractive for a majority of workers. But, they were simply not geared for executives, directors and officers. It was very difficult for Congress to agree on the modest increases we made to retirement plan limits in 2001. Because of the difficulty in reaching that agreement, I do not believe that we would ever consider the levels of changes necessary to make qualified plan limits attractive to executives for all of their pay. We're simply not going to do it.
So, executive compensation arrangements continue to exist. Last year this committee added language to the chairman's mark, to S. 1971, so, first of all, repeal the moratorium on treasury's ability to promulgate regulations on deferred compensation arrangements. Next, to prohibit offshore rabbi trusts. Next, tax executives at the top rate on bonuses of $1 million or more, and, lastly, limitations on loans to executives.

Except for the last item, which was made moot later by the Sarbanes-Oxley Act, all these provisions will be in any pension bill considered by the committee. Last year I also introduced the Corporate Accountability and Bankruptcy Act. My bill was drafted to clarify that the bonuses and other excessive compensation of corporate directors and wrongdoers can be pulled back into the estate of a bankrupt firm.

Corporate wrongdoers how have violated securities and accounting laws should not be able to make off with outrageous sums of money from bankrupt companies. Why should they profit when shareholders and creditors and employees are left to finance the company's debts. Moreover, corporate officers and executives should not be permitted to keep large bonuses when a company has performed so poorly that it is then forced into bankruptcy.

Frankly, I don't understand why Enron's bankruptcy judge has not demanded the return of $53 million in deferred compensation that was removed near the end of Enron's existence. Under current law, that money should all be returned to the estate of Enron. Just to make that clear, however, I will be reintroducing my bankruptcy legislation and hopefully get speedy enactment.

Let me conclude by saying that I am greatly troubled by the facts in this Enron case. I hope we can learn from what happened. My view is that a great many of the failures of Enron were failures of corporate governance, literally no one was managing, supervising or exercising oversight over that organization and it has been a horrible scandal that has ruined the lives of many innocent people.

I have many other comments and observations about Enron, corporate governance, executive compensation, and bankruptcy rules. I will leave them for another time. And, since Senator Baucus isn't here and since Senator from Louisiana might have something to say, I'd be glad to let you have opening comments.

BREAUX:
Thank you very much, Mr. Chairman. Thank you for having the hearing.
I think that the original report that we got on Enron was received the same day we—that we had the hearing. So, it was really impossible to understand anything in the report which was very extensive and I think appropriate that we now have this opportunity to further learn from what really was a national tragedy from a budget perspective. And if we don't learn from the mistakes that were out there, then shame on us. We should use this as an example of trying to make sure that whatever allowed the debacle to occur is corrected, is fixed, is addressed and I think this hearing will be an opportunity for us to learn about what we need to be doing and I thank you for having it.

GRASSLEY:
Thank you, Senator Breaux.
It's now my privilege to introduce everybody on the panel all at once. We will hear from the panel before we have questions. We have Mary M. Schmitt, Acting Chief of Staff, in other words, acting in place of Lindy Paull where she was at one time while the new director takes over, from the Joint Committee on Taxation. She's been a long- time, very able executive of that committee. We have Pamela Olson, Assistant Secretary of Tax Policy, Department of Treasury. We have Charles Essick, Principal, Towers Perrin in Houston, Texas; Professor Kennedy, John Marshall Law School, Chicago; and Bruce J. McNeil, partner, Dorsey and Whitney, Minneapolis, Minnesota.

I would like to also announce that I'm going to leave the record open for one week. Also I will announce, so you won't have to ask permission, each of the witnesses that your statement, as a whole, will be put in the record as submitted. And then we have asked you to summarize, because Ms. Schmitt is reporting on the report of the committee, we've given her more time. She will have 15 minutes. It's my understanding that the rest have been advised of the usual practice of the Senate to have five minutes of summary before we have questions. And also let me announce that members who aren't here, as well as members who may come, we don't all get to ask all of our questions orally, so you might get questions and answer for writing from you. So, I'd appreciate those answers in about a two-week period of time.
We'll start with Ms. Schmitt.

GRASSLEY:
Could I ask, on this point, whether joint tax has a view that that was the arrangements between the law firm on this issue and the company?

SCHMITT:
Mr. Chairman, when we did our study, our investigation, we found that Enron consulted extensively with outside consultants, including Towers Perrin with respect to executive compensation arrangements. In general we did not ever find an arrangement that the company wanted to provide that they did not get an opinion letter for.

GRASSLEY:
OK.
Mr. Essick, this is a characterization that's not mine, but some people have suggested that your field is rather like a bean counter, some people say that you just compared the beans at Enron with those of other companies. Is that you were asked to do or was your assignment to see how high the other companies pay scale was to justify Enron's?

ESSICK:
Our role and the consulting work we do for Enron and for other companies, is to provide a competitive set of data based on certain principles. For example, in looking at Enron's compensation we looked at it in the context of the size of company, as measured by revenues, and later adjusted for market capitalization as well. We also provided information to them based on our experience on such things as incentive compensation designs. The methodologies that we used, documented, and there are standard methodologies used in our business, not for only for Enron, but for other large complex companies as well.

GRASSLEY:
Ms. Schmitt, did you find any disagreement ever expressed between Enron and Essick's, any evidence of anything like that?

SCHMITT:
No, Mr. Chairman.

GRASSLEY:
OK.
Mr. Essick, in retrospect does Enron's compensation to access executives seem excessive to you? I've expressed that it does—it seems that way to me.

ESSICK:
When we looked at the joint committee's report and we looked at the compensation that was provided to the top 200 people, the largest component of compensation that was shown was the stock option component. My understanding, from looking at the materials put together by the joint committee, is that the data that were shown for stock options reflects stock option exercised gains in those years. So, they are reflecting the growth in the stock price from the date of the grant of the option to the point of exercise of the option.

When we do competitive compensation analysis and we look at long- term incentives, in general, and stock options in particular, we look at stock options using the blackshoals (ph) option-pricing model on the date of award. And the reason we do that is it allows us to be able to have a comparison of value on the date of award compared to base salary and bonus opportunities at the same point and time.

To the extent that those options that are granted are held by the executive for multiple years and are not exercised until a later year, it may reflect multiple years worth of compensation showing up in the year 2000 or 2001 or whatever year it may be. And it won't be tied to that initial blackshoals (ph) value. It'll be whatever's happened to the stock price of the company.

To put some perspective on this, Enron's stock price for the 10- year period ended in the year 2000 rose 1,400 percent versus the S&P 500 at 400 percent. So, actual options exercised gains that would be reported in the W-2's would be significantly higher than the market numbers originally developed.

GRASSLEY:
About $53 million came out of Enron's coffers right before the company declared bankruptcy. Those amounts compared roughly to the money that a number of individuals held in their deferred compensation arrangements. Did you or anyone at Towers Perrin recommend that the money be released to upon the request of those executives?

ESSICK:
To make sure I understand your question, chairman, are you saying...

GRASSLEY:
Let me consult with...

ESSICK:
... deferred compensation money?

GRASSLEY:
... staff. OK. Well, whether or not you gave any advice to the companies of when that money ought to be released based upon the arrangements that you made with the company, the advice you gave to the company.

ESSICK:
We did not consult with them on the deferred compensation payments.

GRASSLEY:
OK. In other words, there wasn't any advice from Towers Perrin advising executives kind of to dash with the cash?

ESSICK:
We gave no advice on that topic.

GRASSLEY:
OK. Thank you.
Senator Breaux?

GRASSLEY:
I think you've opened up a very legitimate round of questioning here, Senator Breaux, that I think I want to follow up on just a minute. You may want to stay and join in if you want to. And, let me suggest where I'm coming from here. And, so, I guess my question would be to Mr. Essick, but I'm also going to ask Ms. Schmitt to enter in here.

Last year, before the Senate Governmental Affairs Committee, the chairman of the Enron compensation committee testified about executive compensation. My understanding is that the sum of his testimony was that he relied upon Tower Perrin for all decisions. My question to you is, in making decisions here, to describe for us—well, I don't think describe generally the relationship between Towers Perrin and Enron, I think you've done a good job to that. But, some points that I'd like to have you over would include did Enron board ever question or reject any of the finding of Tower Perrin? Did Tower Perrin ever provide advice that the Enron board did not want to hear, or was it a case of deciding the salary first and getting the justification later?

ESSICK:
In the work that we did for Enron it fell into several categories. In some cases what we were doing is providing market data on levels of pay and market incentive plan design practices. So, we would do a study at the request of either management or the board of directors, the compensation committee of the board, to test levels of pay in the competitiveness of incentive design practices.

There was a study that was done called the stress test, which was done in the spring of 2001. And the stress test was commissioned by the compensation committee of the board. And what they asked us to do was to test what the effect would be of higher volatility in their stock price and their financial results. They'd had a period of very rapid run up in stock price and financial results. And they wanted to see what would happen if they had volatility both up and down and the results.

At the conclusion of the stress test, or during the course of the stress test, there were—they were experiencing some downward pressure in their stock price. This was, again, the spring of 2001. And, in the course of that there were questions raised by members of management, and I don't remember any questions about this topic from the members of the compensation committee, as to whether they should consider repricing stock options. What that means is that if the stock option had been issued at $80 a share and the stock price is now $60 a share, should we restrike the option to be at $60? Which, in essence, gives you an opportunity to reearn the $20 since the stock went down. What we concluded in that study was even they were going into a period of higher volatility and more difficult times; they should stay the course with the designs they had. So, if the earnings went down, the bonuses would go down. If the stock price goes down there wasn't going to be a repricing. So, what we encouraged them to do was in essence to stick with what they had even if they were to experience more difficult economic times.

GRASSLEY:
OK. I'm going to come at this same thing for Ms. Schmitt with this approach; the compensation committee relied on Tower Perrin each year to determine compensation package for Ken Lay and two other executives. Now, I think the joint committee has basically said that the compensation committee essentially rubber stamped whatever management was seeking. What was your impression of the compensation committee? And did Enron, from your judgment, Ms. Schmitt, ever bring anything to Tower Perrin that Tower Perrin said no to?

SCHMITT:
Mr. Chairman, we did not find any evidence in the course of our investigation of any compensation, specific compensation issue, being taken to Towers Perrin and they recommending to the company that it not be adopted. In fact, what we said in our report issued in February that from our interviews of members of the compensation committee of the board of directors, it appeared that many members made decisions relying on the opinions of outside consultants including Towers Perrin without understanding the underlying facts of the arrangements that they were approving.

GRASSLEY:
OK. I'm going to go on to another issue. I wanted to ask Secretary Olson and for Senator Baucus's benefit I'll quit whenever he wants to ask questions. It takes a little while when you come from one committee to the other to get oriented. So, I want to give him an opportunity to do that.

Anyway, I read yesterday in the Wall Street Journal that the IRS issued guidance on Irish leasing companies. Now what is the abuse that you're trying to stop with those regulations?

OLSON:
Senator, this was a notice that we issued to stop and something close to evasion of tax, the transfer of employees purportedly to another company with the compensation then going offshore. And so the notice puts taxpayers on notice that the IRS will challenge those arrangements if they find them. It also encourages taxpayers to voluntarily come in and get their tax affairs straightened out.

GRASSLEY:
There's no doubt that, then, from Treasury's point of view, that that's an abuse of our income tax laws?

OLSON:
That's correct.

GRASSLEY:
Yes.
I'm going to ask Professor Kennedy, do non-qualified deferred compensation plans afford executives with tax preference unavailable to non-highly paid workers?

KENNEDY:
No, Senator, I don't believe so. The pressure that employers and executives have to set up these arrangements are because of the limitations imposed under qualified plans. I'm sure executives would prefer to have rights under qualified plans that the rank and file have, but because of the limitations, they're not afforded those. And, therefore, we've seen a surge in the development of these types of plans.

GRASSLEY:
OK.
I'm so sorry I did not know the presence of Senator Lincoln. And at this point I'd be glad to call on you for questioning.

LINCOLN:
I'm fine. I'll wait my turn.

GRASSLEY:
Well, you know—now is your turn.