(Bloomberg) After Exelon Corp. earned less than top executives needed to reach their annual cash bonus target last year, the board of directors provided a way to help bridge the gap: nonexistent profits.

The board tacked on six cents a share—equal to $85 million—that the Chicago-based power company never made, augmenting earnings solely for the purpose of calculating bonuses. Exelon said that it would have earned the sum except for a regulatory setback on electricity rates and that the pennies helped thousands of employees avoid smaller payouts.

The six cents helped executives receive their fourth above-target bonus in five years as the company’s operating profits and its market value fell by more than half. Amid the slide, the board awarded more than $20 million in cash bonuses to top managers as tax-deductible “performance-based pay.”

Exelon and dozens of other corporations demonstrate how such tax-advantaged bonuses—which cost the U.S Treasury $3.5 billion a year, according to the congressional Joint Committee on Taxation—can reward even subpar shareholder returns. Chief executive officers at 63 companies in the Standard & Poor’s 500 Index got cash incentive-pay increases last year after their share returns underperformed the index’s, according to data compiled by Bloomberg.

“Taxpayers are losing billions of dollars; shareholders are being taken for ride,” said Robert Reich, the secretary of labor under former President Bill Clinton.

Aiming Lower
Even companies with robust income amplify executives’ cash bonuses by setting comparatively low targets, Bloomberg data show. Since 2006, Marsh & McLennan Cos., Valero Energy Corp. and Walt Disney Co., among others, repeatedly paid above-target bonuses after setting profitability goals below analysts’ expectations, often by 5 to 10 percent or more. Disney pegged management’s targets below consensus estimates each year since 2007, the data show.

The cash performance bonuses are only one component of compensation, said Eric Hosken, a partner at Compensation Advisory Partners LLC in New York. Boards and their consultants focus on total pay—including salary and stock-based awards—and they balance varied objectives: attracting and retaining talent, minimizing corporate tax burdens and trying to align managers’ interests with shareholders, Hosken said. Deciding how likely a CEO is to hit a particular target “is just different levels of guessing,” he said.

Directors at 74 of the S&P companies set targets lower than Wall Street analysts’ average earnings estimates at least half the time since 2006, according to data compiled by Indiana University researchers and reviewed by Bloomberg News.

‘Should Align’
Analysts interpret corporate earnings goals for investors, so their estimates “should align pretty closely with the company’s own predictions for its performance,” said Jun Yang, an associate professor of finance at Indiana’s Kelley School of Business and one of the researchers who conducted the study.

Significant gaps between analysts’ estimates and bonus goals may mean directors are “deliberately setting performance targets low so the management doesn’t have to meet market expectations in order to get paid,” said Robert Jackson Jr., a Columbia University law professor who helped the federal government oversee executive pay at companies bailed out during the financial crisis.

On average, management’s bonus goals were 2.6 cents a share easier to achieve than the analysts’ estimates at the time the goals were set, according to research by Yang and Daniel Kim, a former Indiana Ph.D. student who’s now an assistant finance professor at Peking University.

About 40 percent of the S&P 500 companies have used earnings per share to help determine annual cash bonuses since late 2006, according to the academics’ as yet unpublished paper on incentive pay targets.

Deductions Capped
“If the performance metric is bogus, then firms are abusing the tax code” to deduct the incentive pay, Yang said in an interview.

At issue is a 1993 federal law that capped tax deductions that public companies take for top executives’ pay at $1 million each. Former President Clinton, who proposed the limit, agreed to exempt performance awards. After Congress enacted the measure, it was left to the Internal Revenue Service to enforce.

The IRS created rules so vague that any company can define performance “more or less as it chooses,” said Michael Doran, a lawyer in the Treasury’s Office of Tax Policy under Clinton and former President George W. Bush. Doran, now a Georgetown University law professor, favors making all compensation tax-deductible and said the current rules have merely served to undermine the concept of “performance.”

Failure Pays
“Officers can receive payments that satisfy the exemption even if the stock price is falling, revenues are falling and earnings are falling,” Doran said. “Failure can be treated as success for purposes of the exemption.”

House and Senate legislation introduced this year would eliminate the exception for performance pay.

“My focus is on making the tax code fairer,” Senator Richard Blumenthal, a Connecticut Democrat and co-author of the bill, said in an interview. “Not to stop, necessarily, compensation to executives who truly merit it, but to assure that all of us are not, in effect, subsidizing tens of billions of dollars in corporate bonuses.”

Blumenthal’s legislation would make all executive compensation subject to the $1 million cap for deductibility. A House proposal would halve the limit to $500,000 per person.

Bonuses Grow
The IRS rules spurred growth in cash bonuses that outpaced other components of CEO pay, said Mark Reilly, a partner at 3C Compensation Consulting Consortium in Chicago. From 1995 to 2010, the median cash bonus for CEOs at the 30 companies of the Dow Jones Industrial Average swelled 227 percent, compared with 159 percent for long-term incentive awards and 153 percent for combined cash and long-term incentives, according to Reilly’s research.

Exelon, the largest U.S. operator of nuclear power plants, has been challenged in recent years to recognize performance that isn’t reflected in the stock price, said Gary Prescott, the company’s vice president of compensation. Managers’ obligations also include “keeping the lights on, keeping cities illuminated,” he said.

Former CEO John Rowe’s incentive cash bonus grew almost 49 percent to $2.5 million from 2007 to 2011, his last full year in charge. His total annual compensation in 2011 was $11.7 million, 1 percent higher than in 2007. Rowe, who retired in March 2012, didn’t respond to requests for comment.

Six Cents
The 68-year-old former executive collected more than $90 million in salary, bonuses and retirement pay through the end of his last five years with the company, filings show.

It’s not fair to focus only on annual cash incentives, wrote James D. Firth, an Exelon spokesman, in a letter to Bloomberg News. They made up less than 10 percent of top executives’ total pay last year, while share-based awards accounted for 40 percent, based on company disclosures. The stock-based pay has dropped in value in recent years, reflecting the company’s share price decline, Firth wrote.

As for the hypothetical profit the board added to the 2012 bonus calculation, directors made the adjustment to offset unexpected rate decisions by Illinois regulators that cut earnings by about six cents a share, Prescott said.

The compensation committee excluded that effect from its bonus calculations “since the outcome of these deliberations was not known at the beginning of the year when the budget was established,” according to Exelon’s 2013 proxy statement.

Regulatory Decision
More than 20,000 employees participate in the annual incentive program, and they “should not be penalized for a regulatory decision that was beyond their control and did not reflect their performance,” he said. The company is suing to recover the lost six cents in state court.

Exelon’s performance pay meets IRS regulations for being deductible, Prescott said. Under the rules, incentive targets should be objectively set in the first quarter of the fiscal year; the outcome must be substantially uncertain; and a third party with knowledge of the relevant facts should be able to determine whether the goal was met. Shareholders must approve the broad outlines of a company’s performance plan every five years. Still, corporate directors have wide latitude in deciding what constitutes performance and how to measure it.

Wynn Resorts Ltd., the Las Vegas-based casino company, bases its bonuses on a form of EBITDA, or earnings before interest, taxes, depreciation and amortization. It set CEO Steve Wynn’s target for a full payout in 2011 and 2012 lower than the prior-year results. He blew through the goals each year, collecting a $9.1 million tax-deductible bonus in 2011 and $10 million in 2012, proxy filings show.

Same Measure
By contrast, rival Las Vegas Sands Corp. used the same measure for CEO Sheldon Adelson while setting targets at least 25 percent higher. He made the goal and a $6.3 million cash bonus in 2011. He missed in 2012, and received a $2.9 million partial payout. Michael Weaver, Wynn Resorts’ senior vice president of marketing, declined to comment.

Miller Energy Resources Inc., an oil-and-gas exploration company in Huntsville, Tennessee, made CEO Scott Boruff’s performance goal to achieve “a higher percentage increase” in stock return than the company’s peers. After shares fell 5.9 percent by year’s end, the board awarded Boruff $1 million anyway, saying he’d achieved a “lower percentage decrease” than Miller’s competitors, according to the proxy.

“I think we probably should have been more artful in our selection of language,” said retired Air Force General Merrill McPeak, 77, the compensation committee chairman.

Changing Criteria
Hovnanian Enterprises changed its performance criteria three times in the five years after the mortgage crisis canceled executives’ bonuses in 2007. From 2008 through 2012, the Red Bank, New Jersey-based homebuilder awarded CEO Ara Hovnanian $5 million in incentive pay at or near the yearly maximums as the company’s share value lost 86 percent.

In deciding the 2011 bonus, Hovnanian directors compared adjusted EBITDA to unadjusted prior-year results. By excluding losses on the extinguishment of debt, inventory impairment and land option write-offs in 2011, the comparison showed an $84.8 million improvement worth a $949,500 bonus to Ara Hovnanian. Without the adjustments, there’d be no bonus, filings show.
Incentive payments helped retain the company’s namesake boss during lean times, said Hovnanian Executive Vice president Larry Sorsby, in an e-mail. Ara Hovnanian’s total pay, including salary, bonus, perquisites and the value of options exercised and shares vested fell by 85 percent after 2006, commensurate with the drop in shareholder returns, Sorsby said.

Making Adjustments
For bonus-setting, companies frequently use the “adjusted earnings per share” that management presents to investors as an alternative to audited results filed with regulators. Executives exercise discretion when making these adjustments, which vary and typically exclude large one-time events, including litigation and merger-related costs. Because the adjustments are promoted as better portraying continuing operations, Wall Street analysts also concentrate on adjusted earnings in their reports.

The Indiana University analysis covered the period from December 2006 to November 2012. Bloomberg News did its own review, updated to include the 2013 proxy season, using bonus targets from companies’ proxies and Bloomberg’s database of analysts’ earnings estimates.

Walt Disney Co. awarded CEO Robert Iger $82.4 million in annual cash bonuses since 2007 while setting the average annual target about 7 percent below the consensus estimates. Last year, Iger collected a “fully deductible” $16.5 million cash bonus, 38 percent above the goal, according to the 2013 proxy statement. It was based predominantly on an evaluation of four financial measures, including an adjusted earnings per share range with a midpoint of $2.78, or 4.1 percent below the consensus estimate when set in November 2011 and 9.4 percent below the earnings result.

Delivering Results
“The bonus program is designed to reward performance, and the company has delivered superior results by any measure,” said David Jefferson, a spokesman for the Burbank, California-based entertainment and media company.

Valero Energy, which claims “full deductibility” for annual incentive awards, bases 40 percent of its CEO bonus on EPS and return on investment. The San Antonio, Texas-based refinery company set the earnings component at least 37 percent lower than analysts’ consensus estimates in 2011 and 2012, helping to produce $3.7 million in incentive payments each year for boss Bill Klesse. In 2007, the earnings target was at least 17 percent below consensus. The CEO’s bonus that year: $3.7 million.

“Earnings per share is only one of several metrics Valero uses to set bonuses,” spokesman Bill Day said. The company sets targets “without regard to Wall Street expectations,” which aren’t refined and get updated regularly, he said.

Deductible Pay
New York-based Marsh & McLennan, which says it generally seeks to structure incentive pay as tax-deductible, paid $24.5 million in annual bonuses to two CEOs during the seven-year period, setting EPS targets lower than the consensus estimates at least four times. Sixty percent of the CEO bonus is based on EPS. In 2011 and 2012, the company disclosed only percentages for its incentive targets and results. Spokeswoman Laura Cora declined to provide specific numbers.

The risk, strategy and human resources consulting company “has delivered for its shareholders,” Cora said—including for 2010-2012 an “annualized total stockholder return of almost 20 percent versus less than 11 percent for the S&P 500.”

Analysts Questioned
Exelon’s compensation committee set cash bonus targets below analysts’ consensus estimates five out of seven times since 2006, when the SEC began requiring fuller disclosures on executive pay. In 2010, the company’s target was 10 cents a share higher than the analysts’ estimate; in 2011, the target and estimate were the same. Firth, the company spokesman, said the company doesn’t consider analysts’ views when setting its compensation goals.

“It would be erroneous to expect that an analyst consensus would be a more reliable projection of earnings than Exelon’s own internal estimate,” he said.

Company bonus targets averaged 6 cents below the earnings results from 2006 through 2012, while analysts’ estimates averaged a penny above earnings, Bloomberg data show.

“What I see in Exelon is a company whose performance incentives have incented mediocrity at best,” said Scott Klinger, an associate fellow at the Institute for Policy Studies in Washington. The group opposes tax deductibility for executive performance pay.

Prices Drop
Known as the president’s utility for delivering electricity to Barack Obama’s South Side Chicago neighborhood, Exelon is the product of a merger that former CEO Rowe negotiated in 2000 between regulated utilities in Chicago and Philadelphia. Operating income improved each year through 2008.

The recession that began in December 2007 damped demand for power. In the recovery, hydraulic fracturing freed new deposits of natural gas, sending prices lower as conservation practices kept U.S. retail electricity sales below the 2007 level through 2012, according to the U.S. Energy Information Administration.

In awarding the 2012 bonuses, Exelon’s board added 10 percent to management’s results, the proxy states, to recognize the completion of a merger last year with Baltimore, Maryland-based Constellation Energy Group Inc.

The compensation committee “focused on finding an appropriate balance between rewarding our strategic success and continued strong operational performance during this pivotal year with our recent stock price performance,” the proxy says.

Dividend Cut
That strategy has yet to propel Exelon’s rebound. Since the merger closed on March 12, 2012—and CEO Rowe retired the same day—Exelon’s shareholder returns have declined 18 percent while the S&P 500 Index’s climbed 27 percent and the S&P 500 Utilities Index’s rose 10 percent.

In February, new CEO Christopher M. Crane announced a 41 percent dividend cut to preserve $740 million in cash. Days later, the company mailed out shareholder proxy statements announcing about $4.3 million in “qualified performance-based” bonuses last year for four named executive officers, describing the payments as “deductible for federal income tax purposes.”

“If shareholders aren’t getting rewarded, then management shouldn’t get rewarded,” said Neil Stein, a portfolio manager at New York hedge fund Levin Capital Strategies LP, which cut its Exelon holdings by two thirds to 435,148 shares in the first quarter. “The company benefited when prices were going higher, and their earnings were going up because of it,” Stein said. “To the extent that things are going the other way, they should be penalized as well.”

—With assistance from Phil Kuntz in New York and Anita Kumar, Michael Novatkoski, Michael Weiss and Nick Tamasi in Princeton, New Jersey. Editors: John Voskuhl, Gary Putka

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