Executive Compensation Blog

Delaware Chancery Court Judge William Chandler — who you may recall recently entered judgment against Disney shareholders in a derivative suit over Michael Ovitz’s $140 million severance package — warned in a speech Tuesday that excessive executive compensation will lead to government regulation unless directors take action.

Given his position, it would be foolish to ignore the Judge Chandler’s opinion. But it is hard to see what legislation to limit executive compensation would be both effective and able to pass Congress. IRC Section 162(m) hasn’t exactly carried the day for shareholders …

In a speech to the Stanford Directors’ College, Fred Cook described his theory of how annual stock option or other equity-based grants became the norm in executive compensation. He essentially blames consultants:

Consultants … annualized option grants to include them in their annual surveys, even if the early adopters of options never intended options to be granted regularly to the same executives year after year. It was compensation professionals, with their penchant for order, regularity, measurement and comparability, that made stock option grants a regular part of the annual compensation cycle.

Cook believes this annualization caused directors and executives to forget that the original purpose of stock options was to align management interests with shareholders — not to increase total compensation. He believes the only way to get off the survey “treadmill” is a renewed focus on total compensation rather than annual compensation.

Some recent articles applying the proposed 409A regulations that I find interesting:

• Wrap-around 401(k) plans from Sungard Corbel
• Foreign benefit arrangements from Pillsbury Winthrop
• For those of you with GRIST, a good article on the dangers facing mirror 401(k) plans 

GRIST also has a commentary on the growing interest in clawbacks following earning restatements. Personally, I think this is long overdue: The "performance" in "pay for performance" does not include cooking the books.

Greg Ash and Ken Mason of Spencer Fane have posted a PowerPoint presentation on 409A. Forget the Supreme Court — this is the news of the week!

In a result that should surprise no one, a survey by the aptly named RevenueRecognition.com (and IDC) found that "more than half of all public companies have modified revenue recognition policies to comply with Sarbox." (What have the other half done?)

Still, it is worth noting that the study shows that 28 percent of companies rated their own Sarbox compliance processes as highly or moderately inefficient. Correcting for optimism, it’s a good bet that means everyone needs help.

Former DuPont CEO Ed Woolard recently taped a speech in which he blasted excessive executive compensation for diminishing business leaders’ public image. NY Times reporter Gretchen Morgenson jumped on the bandwagon, and now other newspapers are reprinting her article to some applause.
It’s hard to disagree with Woolard’s criticism of chasing the median salary, but his entirely sensible recommendations may require more fortitude than most compensation committees possess:

Seriously consider implementing internal pay equity. Pay only for outstanding performance. Quit giving people money just because Joe and Sally are getting it.

Consider going to an independent consultant that deals only with the board and you deal with the HR and the CEO. Keep the consultants away from the CEO and the HR people, because they all benefit too much by being able to "cook the cake" together.

Lastly, take a look at stock option packages. Not just for one year. …

If you’ve given huge stock option packages for the last five years, look at the value of those. There’s nothing in the Bible that says that you have to give increased stock options again every year.

While the Bible may not dictate annual stock options, social pressure may say otherwise. Who wants to tell a CEO that he doesn’t need any more stock options to motivate himself? I think most compensation committees realize that executive compensation typically has a small impact on the bottom line. It’s easy to cave in to a demand for a big grant when you can rationalize that it will only cost shareholders a tiny fraction of a penny per share.

Mutual fund giant Fidelity Magellan has a new boss: Harry Lange. Will Lange be able to turn around Magellan, which has lagged behind the S&P 500 for a decade?

I’m going to go out on a limb and say “no.” Not because Magellan is so large — although trying to get above market returns from $50 billion is quite the challenge — but because (as far as I can tell) Magellan still suffers from the problem that plagues the mutual fund industry: poorly designed executive compensation.

The compensation of most mutual fund managers is determined in theory by a combination of assets under management and performance against a standard benchmark. In practice, however, it is driven mainly by assets under management, since there is little penalty for a benchmark-level performance. To a certain extent, this makes sense, since the near-term profitability of mutual funds is determined more by assets under management than actual performance.

But while current executive compensation practices in the mutual fund industry create strong incentives to maintain short-term profitability by keeping large amounts of assets under management, they create few long-term incentives to build customer satisfaction and loyalty. The manager who takes few risks with a large fund will be handsomely compensated, even though an average return will not please customers. Inevitably, this leads to stagnation and reduced long-term profit for the fund company. Thus, while I have no doubt that most of the large mutual funds are profitable, very few have any chance of acheiving “brand name” status similar to Berkshire Hathaway. Indeed, the poor performance of most funds is giving the industry a bad name that will surely be costly in the future.

It’s possible, of course, that fund companies really are more concerned with short-term gain than long-term, but I suspect the real problem is that they have simply can’t imagine how to create the right management incentives. Executive compensation must always reinforce accomplisgment of a company’s strategic objectives, which can’t always be measured in quarterly earnings.

AP business columnist Rachel Beck has written a column characterizing the present wave of accelerated stock option vesting as "legalized accounting gimmickry." It’s hard to disagree with her basic point: Everyone knows that this accelerated vesting is designed to prop up earnings reports by getting option costs off the books before FASB 123(R) becomes mandatory.

What is interesting is why companies feel obliged to go through this charade. FASB 123(R) affects reported earnings, but not actual profits. One would assume that security analysts have been taking all those option expense footnotes into account for years. It certainly must be troublesome for devotees of the efficient capital markets hypothesis that so many major corporations think their shareholders are dupes.

I must disagree, however, with Beck’s conclusion that by "speeding up vesting, companies are showing that options are largely a thing of the past." The size of option grants will probably decrease in the future — and they may disappear for more rank-and-file employees – but I see no signs that most companies are going to drop options entirely from their executive compensation packages.

Clark Consulting is preparing to release its 2005 survey of executive benefits. Among the key findings:

• 409A hasn’t significantly decreased the number of companies using nonqualified deferred compensation. (Surprise!)
• Companies are continuing to set aside assets for their nonqualified plans. (Surprise!)
• More companies are using Corporate Owned Life Insurance to fund their nonqualified plans. (Ok, that might be a surprise …)

If you are desperate for more from this survey, Hr.com (registration required) will be showing a Webcast of the survey results tomorrow at 1 p.m. EST.

The Boston Globe reports that the Massachusetts State Treasurer gave a speech Tuesday denouncing excessive and poorly disclosed executive compensation. According to the article, the Treasurer, who controls more than $20 billion in pension funds, is targeting six unidentified companies.

Is she right to believe that high compensation really can sap the bottom line instead of "incentivizing" management?

Well, it so happens that the WSJ has an article illustrating the huge impact expensing stock compensation can have on earnings. Cisco’s quarterly earnings dropped from 25 cents to 20 cents per share because of a $228 million (net of tax) compensation charge due to SFAS 123(R). Cisco reported sales of $6.55 billion, which means about 3.5 percent of revenue went to stock compensation. Another (admittedily imprecise) way of thinking about it is that Cisco reported shareholder’s equity of just over $20 billion last year, so the equity compensation gave away 1 percent of the company last quarter. (Take a look at the SEC filing here.)

How much of Cisco’s stock compensation charge is due to executive compensation can’t be determined from the SEC filing, but I’d wager it’s a goodly amount. Last year CEO John Chambers got a symbolic $1 salary, but he also reportedly had more than $200 million in unexercised options. I have a feeling his subordinates are still getting plenty of options, even if he is content with a few hundred million.