How Are the CEOs of Health Nonprofits Among the Richest People in the U.S.? Two Words: Phantom Stock.
A fascinating and disturbing story about how some healthcare nonprofits exploit tax loopholes and fabricate imaginary stock prices to ensure their CEOs can afford those lavish yachts and private jets.
A fascinating and extremely disturbing story about how some U.S. healthcare nonprofits exploit tax loopholes and fabricate imaginary stock prices to ensure their CEOs can afford those lavish yachts and private jets. š¤āļø
Everyone knows that to become Jeff Bezos-rich or Elon Musk-rich, cash pay is not enough. You need equity. You need stock. You need stock-based compensation, such as stock options. Then there are a lot of forces working in your advantage: stockās magic of compounding, optionsā non-linear (think exponential) payoff and so many different ways to minimize or avoid taxes, such as trusts and deferred compensation - things you canāt get with just cash. Itās a beautiful thing.
For instance, according to a recent in-depth investigation by Stat News, 79% of total CEO compensation of the largest 7 healthcare insurance companies is stock and stock-based financial instruments. For example, Cignaās CEO became a billionaire purely from Cignaās compensation.
But what if youāre a CEO of a nonprofit and really want to have the same private jet that Taylor Swift is flying on or the same yacht that Larry Ellison is riding on, but those pesky IRS rules donāt allow you to get rich because, well, itās a nonprofit.
Say no more. We at Wall Street Bros created a clever āget rich quickā trick for CEOs just like you. š°š°š°
How do CEOs get rich? Well, through stock and stock options, of course.
But wait, nonprofits arenāt supposed to issue stock because they are not profit-maximizing entities, by definition, right?
Well, there is a clever financial trick to solve that problem and to exploit the IRS loophole.
Introducing: phantom stock.
Phantom stock is not real stock. Itās fake stock, where you set your own stock price and issue as many shares as you want. There are no shareholders to complain about stock ādilutionā and other ethical issues because, well, the stock is a product of your imagination.
While the stock is fake, the money is real.
And just so everyone thinks this is legit, we're going to come up with a different name that sounds legal-ish. How about ānon-qualified deferred compensationā? It has the word ācompensationā in it and it doesnāt have the word āstockā. Thatās how you trick the regulators. Clever, huh?
Is phantom stock legal? Enough with the questions. Do you want the private jet or not?
1. What Exactly is Phantom Stock? And Why is it Such a Sweet, Yet Semi-Legal, Form of Executive Compensation for Healthcare Nonprofits?
Why is executive compensation at some nonprofit organizations among the highest in the country? Two words: phantom stock. Itās a semi-legal way to pay executives, fraught with conflicts of interest, being utilized, for instance, by Mayo Clinic, Fidelity Charitable, and many other nonprofit organizations.
The largest part of the executive compensation in these organizations is not cash. Itās incentive-based compensation, such as āphantom stock,ā the price of which is decided by - drum roll - the executives themselves!
So what is phantom stock? And why is it so attractive to executives, but not so much for anyone else at the nonprofit organization? (Sources: RSM, Investopedia.)
1ļøā£ Phantom stock, commonly known as ānon-qualified deferred compensationā (NQDC), is a fake stock price constructed by the organizationās management based on arbitrary metrics. There is no real stock price. While for public companies, the stock price is āvoted onā by millions of investors every nanosecond and can potentially dramatically go up or down, the stock price at nonprofit organizations is based on some theoretical āincentiveā formula and is typically very predictably gradually going up. This formula is usually selected to be non-volatile on purpose. The executives argue, often hypocritically, that earnings are not a goal for a nonprofit, so the formula should be based on things like the number of patients, the amount of charitable donations, or the asset base. The āstock priceā is usually set quarterly, or whatever the reporting period is. Just like with public companies, this fake phantom stock could also have so-called āstock optionsā which are an even faster way for the executives to get richer.
2ļøā£ Phantom stock and stock options have a vesting period, typically one to three years. Then they have a pretty long exercise period, typically up to 10 years, when the CEO and other executives can sell their phantom stock and exercise their options whenever they please.
3ļøā£ Itās important to note that while the phantom stock exercise flexibility makes this optionality very valuable to executives, inversely, it could be quite a burden for the whole organization and its members (such as patients and physicians) because the desire of a CEO to cash out in order to buy a new yacht may not necessarily be the best time for the organization to incur such expense. In this regard, the term ānon-qualifiedā means that, unlike traditional deferred compensation, phantom stock cannot be expensed at the time it is granted (i.e., typically at its lowest value), but rather, at the time when the CEO decides to cash out, putting a financial burden on the organization. Itās a zero-sum game: if the CEO cashes out big, the organization has to pay.
4ļøā£ Phantom stock compensation is a great tax deferral mechanism for executives. As you know, executives use all sorts of tax loopholes to avoid paying taxes, such as the Grantor Retained Annuity Trust (GRAT) and other accounting schemes. But here, you can defer your taxes into the future because the made-up āstock priceā is almost guaranteed to be going up.
5ļøā£ Unlike public companies, which may face outrage from their shareholders for āshare dilution,ā nonprofits, since there is no real stock, can issue as many shares to their executives as they want (and they want a lot!). No one would ever complain because the shares are artificial (but the money is real!).
6ļøā£ Phantom stock is a great tool for executives to keep regulators off their back. If you pay a CEO $50 million in cash, you may face serious questions from the IRS or the SEC. But if you pay a CEO $50 million in āincentive compensationā (or some other bullshit term these organizations may use), you are safe because the compensation is based on a āpreset formulaā. (Of course, never mind that the executives themselves āpresetā the formula.)
7ļøā£ NQDC was originally put forward by the IRS (code section 457) as a type of retirement plan that would provide supplemental retirement benefits to an executive. However, as the āretirementā part was only a recommendation, some nonprofits have been abusing this program offering their executives the flexibility of cashing out before retirement, and in fact, at any time the executive finds convenient.
While phantom stock has made executives of nonprofit healthcare organizations some of the richest people in the country, nothing still beats the Cigna CEOās $1 billion (!) payday.
2. Free Advice to the SEC: Examine the Volatility of Comp Numbers
As you may be aware, the U.S. Securities and Exchange Commission (SEC) not only overlooked Madoffās crimes due to its incompetence, but it also consistently dismissed whistleblower Harry Markopolosā detailed account of Madoffās crimes since 1999. As argued by Markopolos and his colleague Dan diBartolomeo, to identify potential criminal activity, there was no need for an in-depth analysis of Madoffās āaccountingā. A simple review of his returns would have sufficed: there was no volatility! Every reporting period, returns were āsmoothā and positive, an outcome that would have been impossible with the actual portfolio.
In the context of executive compensation for nonprofits, detecting the existence of phantom stock is straightforward, as I elaborate below. One simply needs to observe the volatility (i.e., spikes) in the compensation reported on the executiveās W-2 forms. Executives, driven by greed, would eventually want to liquidate their fictitious phantom stock - perhaps to fund an impulsive purchase of their tenth house or third yacht. This is when a spike in reported compensation becomes evident.
In other instances, CEOs adopt a more clever approach. They attempt to sell their phantom stock in a more āsmoothā manner. In such cases, the SEC (and the IRS) might want to examine the dollar magnitude of the figures.
Itās not that complicated.
3. Case Studies
Letās examine six instances involving healthcare organizations where the executives may have lost sight of their nonprofit organizationsā mission. All the data is publicly available, sourced from the Form 990 that every U.S. 501Ā©(3) tax-exempt organization must file annually.
3.1. Lloyd H. Dean, CEO of Dignity Health: $35.5 Million
According to its most recent tax filing, āDignity Health is committed to making the healing presence of God known in our work by improving the health of the people we serve, especially those who are vulnerable, while we advance social justice for all.ā (Sources: ProPublica, MSN.) Certainly, Dignity Healthās CEO, Lloyd H. Dean, and other executives feel the material presence of all that cash. In fact, as of its most recent 2022 tax filing, the executive compensation represents a mind-boggling 74% of its net earnings.
3.2. Howard P. Kern, CEO of Sentara Health: $33.2 Million
According to its website, āSentara Health is committed to always keeping patients safe, treating them with dignity, respect, and compassion, listening and responding to them, keeping them informed and involved, and working together as a team to provide quality healthcare.ā Apparently, this doesnāt prevent its CEO, Howard P. Kern, from becoming one of the richest people in the industry.
3.3. Peter S. Fine, CEO of Banner Health: $25.5 Million
According to its website, āas a nonprofit, Banner Health exists to provide health care services to the communities it serves, rather than generate profits.āĀ They seriously couldāve tricked me with this statement. Theyāve actually been running like a for-profit organization, and Mr. Peter S. Fine is doing just fine because of that, thank you very much.
3.4. Ernie W. Sadau, CEO of Christus Health: $17.9 Million
According to its most recent tax filing, Christus Healthās mission is āsupporting the health care ministries of the sponsoring congregations in extending the healing ministry of Jesus Christ in conformity with the Roman Catholic Church.ā That has not prevented its CEO and other executivesĀ from beingĀ paid handsomely, even when theĀ organization wasĀ losing money. In fact, as of its most recent 2022 tax filing, the executive compensation represents aĀ whoppingĀ 54% of its net earnings.
3.5. Craig B. Thompson, CEO of Memorial Sloan Kettering Cancer Center: $8.1 Million
According to its website, āWe [at Memorial Sloan Kettering Cancer Center] inspire trust by having the courage to say what we mean, matching our behaviors to our words, and taking responsibility for our actions. We value and support transparency, knowing that open, honest communication is critical to our success.ā If they are so transparent, perhaps they could explain why there was an almost 3-fold jump in their CEOās most recent compensation number, despite the 50% drop in net earnings. Iām being facetious - of course, we know why: The CEO cashes out his stock whenever he is pleased.
3.6. James D. Dahling, CEO of Childrenās Hospital of the Kings Daughters: $8.9 Million
According to its most recent tax filing, Childrenās Hospital of the Kings Daughters is ādedicated to the mission of providing the best possible care and services for all children who come to us because of sickness and injury.ā Thatās an honorable mission. However, I question, what exactly did Mr. James D. Dahling sell in 2020 to generate such a spike in his already pretty hefty compensation.
Itās worth noting that James D.Ā DahlingĀ retired at the end of 2022.
4. But Waitā¦ What Is the Mission of Healthcare Nonprofits Anyway?
The mission of healthcare nonprofits is multifaceted, reflecting the diverse needs and challenges within the healthcare sector. These so-called IRS Section 501Ā©(3) tax-exempt organizations are supposed to play a critical role in addressing gaps in healthcare delivery, research, and education, often focusing on areas that are underfunded or neglected by the private and public sectors.
Nonprofit organizations, including healthcare nonprofits, can indeed make a profit. However, the key difference between nonprofits and for-profit organizations is that a nonprofit organization cannot distribute its profits to any private individual. Instead, according to the National Council of Nonprofits, the profits are typically used in the following four ways:
1ļøā£ Reinvested in the Organization: The profits can be reinvested back into the nonprofit to further its mission. This could include expanding existing programs, starting new initiatives, or enhancing the organizationās infrastructure.
2ļøā£ Building a Reserve Fund: Nonprofits should try to have some level of positive revenue to build a reserve fund to ensure sustainability.
3ļøā£ Paying Reasonable Compensation: Nonprofits may pay reasonable compensation to those providing services. This includes salaries for staff members, fees for contractors, and other operational expenses. (Note that executive compensation is not mentioned at all.)
4ļøā£ Donated to Other Nonprofits or Beneficiaries: In some cases, the profits might be donated to other nonprofit organizations or directly to the beneficiaries that the nonprofit serves.
Remember, the idea behind these rules is to require charitable organizations to dedicate as much income as possible to the charitable purpose they purport to serve. This is because tax-exempt charitable nonprofits are formed to benefit the public, not private interests. (Sources: National Council of Nonprofits, Forbes, Legal Zoom.)
Many academics argue that healthcare nonprofits have their role in a society beyond the provision of āfree careā. They argue that focusing only on the free care they provide and ignoring nonprofit hospitalsā contribution to the public good would exacerbate harm and inequality in the current system. For instance, a brand new JAMA paper discusses the critical issue of nonprofit hospital tax exemptions, arguing against proposals that condition these exemptions on the provision of free care. It highlights the complexities and unintended consequences of such measures, emphasizing that nonprofit hospitals play a vital role beyond just providing free care, including promoting public health and offering various community benefits. The piece advocates for improving nonprofit hospital accountability through better governance and fiduciary responsibilities, rather than imposing restrictive free-care requirements that could lead to financial distress for hospitals and reduced services for underserved populations.
5. Are All Healthcare Nonprofit CEOs Crazily Rich?
While there are clear outliers, itās not accurate to say all healthcare nonprofit CEOs are exorbitantly rich. In fact, most nonprofit executives appear to take their job very seriously and maintain reasonable compensation. Being reasonable means:
š¹Adhering to the mission of the nonprofit organization as mentioned above.
š¹Having a āreasonable compensationā as defined by the IRS. This typically involves comparison with peer organizations, excluding the outliers such are the ones mentioned earlier. Most nonprofit healthcare organizations compensate their executives in cash. If deferred compensation is offered, it follows the traditional model - expensed at the grant date (i.e., at its lowest value). This compensation could accrue interest or be indexed for inflation, but does not include anything akin to āphantom stock.ā
6. My Take
Whatās happening in the boardrooms of some of the largest nonprofit healthcare organizations in the world is terrifying. Since these entities are not publicly traded, executives create their own āsandboxā stock market. In this market, prices almost always go up, and the number of shares issued to executives seems almost infinite. This occurs because there are no real shareholders to complain about stock dilution and implement other ethical checks and balances. This semi-legal practice, crafted by Wall Street bros, is known as phantom stock. Often, it forms the largest portion of executive compensation. It begs the question: Where are the SEC and the IRS looking? These nonprofit organizations are granted tax-exempt status for a reason. Yet, they appear to be engaged in dubious practices, developing creative financial compensation schemes for their executives and competing over whose nonprofit CEO is wealthier. Iām truly disgusted.
In their pursuit of dollars, some healthcare nonprofits have neglected their mission. By legal statute, they are NON-profit and are supposed to serve patients, physicians, and the community, not enrich the executives.
I hope my analysis, the first of its kind, will bring to light the severe situation present in this country within some nonprofits.
ššššš Hi! My name is Sergei Polevikov. In my newsletter āAI Health Uncutā, I combine my knowledge of AI models with my unique skills in analyzing the financial health of digital health companies. Why āUncutā? Because I never sugarcoat or filter the hard truth. Thank you for your support of my work. Youāre part of a vibrant community of healthcare AI enthusiasts! Your engagement matters. ššššš
Why are boards of directors of healthcare nonprofits approving these lavish compensations for their CEOs?
Two main reasons:
1. Boards are in bed with CEOs, merely implementing a "tit for tat" arrangement. To understand this, it's crucial to trace back to how board members were selected in the first place. Typically, this is done by a nominating committee, where the CEO either has a direct vote or direct input. Remember, being a board member of a large healthcare nonprofit is a well-paid position. Thus, the board (specifically, the compensation committee of the board) is merely returning the favor to the CEO by granting this lucrative compensation. This represents a major conflict of interest, and it's perplexing why both the SEC and the IRS remain silent.
2. As I mentioned in the article, the initial compensation award is often a fraction (often 3, 5, or 10 times smaller) of what's reported in Form 990. This discrepancy arises because a significant portion of the executive compensation is deferred compensation. Specifically, phantom stock, which is fake stock whose price almost always increases, is classified as "non-qualified deferred compensation" (NQDC). It's reported on the executives' W-2 report and on Form 990 when they decide to sell the phantom stock to purchase that 11th house or private jet. They can sell whenever they wish, and the nonprofit must immediately come up with the cash, potentially straining the organization. Therefore, what's reported to the IRS as executive compensation is the price (the amount) at which they SELL their stock, not the price at which they RECEIVE the stock, which could be two very different numbers.
Related articles:
1. There are 57 people working at nonprofit organizations in Cleveland who make more than $1 million a year. 56 of them work in healthcare: https://www.cleveland.com/news/2024/01/nonprofit-millionaires-top-57-paid-greater-cleveland-nonprofit-employees-predominately-in-healthcare.html.
2. $1 Million-a-Year charitable hospital executives in Connecticut who may not need holiday gifts: https://healingandstealing.substack.com/p/connecticuts-fortunate-forty.
3. The CEO of Ascension moved over to a hedge fund and is paying himself $12 million a year to manage the investment: https://thehealthcareblog.com/blog/2024/02/05/the-moneys-in-the-wrong-place-how-to-fund-primary-care/.