(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Federal Reserve Official Calls for Full Expensing of Executive Pay

The American system of corporate governance has two fundamental guiding principles, noted Michael H. Moskow, chief executive officer of the Federal Reserve Bank in Chicago, Illinois, in recent remarks at Loyola University. The first principle is that management incentive should be aligned with shareholder goals and the second is that transparency and disclosure of a company's true financial condition should be sufficient for shareholders to effectively evaluate performance.

In adherence to these principles, he endorsed the full expensing and deductibility of all forms of executive compensation, including stock options. He also took a stand against the routine resetting of option strike prices, calling the practice "a potential moral hazard" because it can relieve managers of downside risk.

In his view, a key example of failing to follow sound corporate governance principles relates to executive compensation. He noted a general movement 20 to 30 years ago to better align the incentives of managers with those of shareholders by linking managerial compensation to the price of the firm's stock. Companies used a number of tools to do this, including market-based bonus pay, managerial stock ownership and stock options. While in theory, each of these tools is completely consistent with effective corporate governance practices, he noted, in practice the option awards often resulted in lessw than desirable outcomes.

He believes that options may have been overused as a tool of management compensation. One possible explanation for the excessive use of options can be found in tax code provisions stating that executive compensation above one million dollars must be performance-based in order to be tax deductible. In addition, options contracts themselves were often poorly designed. For example, by not indexing the strike prices of these options to the overall market or a specific industry, managers were handsomely rewarded from an overall run-up in stock prices even if their firm was only turning in average or even below average performance relative to its peers. This experience with stock options shows that corporate governance problems can arise when the first principle of corporate governance is violated, which is failing to align the incentives of managers and shareholders.

The Sarbanes-Oxley Act is the beginning of meaningful reform based on the two guiding principles of corporate governance, noted Mr. Moskow. For the first time, CEOs and CFOs must certify that their companies' financial reports not only satisfy Generally Accepted Accounting Principles but also fairly represent the financial condition of the company.

Noting that more must be done "while the reform iron is hot," Mr. Moskow called for eliminating accounting rules or provisions of the tax code that influence the manner in which boards of directors choose to compensate executive officers. For example, he stated that firms should be able to fully expense and fully deduct all forms of executive pay. One rule that would be eliminated is the current $1 million cap on non-performance based compensation that is tax deductible. This would reduce the incentive for corporations to pay their executives with stock options rather than with straight salary or cash bonuses, he asserted.

Boards should design their executive compensation plans to reward managers for exemplary firm performance, he explained, not to exploit tax and accounting rules that imply preference for one form of compensation over another, he claimed. Even in an environment where all forms of compensation receive equal tax and accounting treatment, however, stock options will remain a significant part of many executives' compensation. Calling for these options contracts to be carefully designed, Mr. Moskow suggested linking the strike prices to the performance of the company's stock relative to a market or industry index. This would insure that overall run-ups in the stock market do not benefit managers whose companies are underperforming. It also would ensure that overall declines in the stock market do not penalize managers whose firms are doing well relative to their peers. Indexing also will reduce the incentive to re-set option strike prices at firms whose stock price has declined.

On this latter point, Mr. Moskow does not understand the justification for re-setting option strike prices. Not only should managers be rewarded for good performance, he reasoned, they should also be penalized for poor performance by having their options lose value. The routine re-setting of strike prices creates a moral hazard, he concluded, because managers may act as if they do not bear the downside risk of a declining stock price.