CEO compensation

Hero CEOs need to look in the mirror about economic inequality

Posted on by j.giglio

In a strong rebuke to President Trump’s response to the recent violence in Charlottesville, Virginia, a chorus of masters of the universe, titans of industry, and corporate rock stars lined up like soldiers to take head shots at the president, criticizing him by name for his handling of the violence.

Many were so appalled by what the president did and did not say that they resigned from his business advisory councils. The media certainly milked it for all it was worth, some characterizing senior executives as heroes for speaking truth to power.

Nothing stokes cable ratings like a sustained campaign of outrage that feeds into the attention deficit disorder of the American news cycle. But perhaps some of that outrage should be directed at the crusading corporate giants themselves.

Perhaps it is only a matter of time before chief executive officers show the same passion and anger when it comes to speaking out against the economic inequality that has risen so sharply since the mid-1970s. For example, CEOs could voluntarily take less compensation and use their concentrated political and economic power to support a national living wage.

After all, the Gods of Fortune have continued to smile down upon corporate executives with outsized payoffs. The average CEO earns something close to 300 times the pay of the median American worker, whose real wages have been stagnant for decades. This ratio is up from roughly 40 to 1 in 1980. In contrast to this growing gulf between the haves and the have-nots, the ratio of CEO to average worker pay in Japan is 16 to 1. In Denmark, it is 48 to 1 and in the United Kingdom 84 to 1.

CEOs do not have to worry about saving for retirement or their children’s college education as they enjoy expensive perquisites from country club membership to second homes a little smaller than Rhode Island, to the personal use of corporate jets.

Is it any wonder that the public is mad as hell? They make the connection between business executive pay and growing economic inequality.

A few decades ago, executives were paid mostly in cash. Much of the story of executive compensation in recent decades comes down to two words: stock options.

To align incentives between shareholders and management, boards of directors use equity compensation by granting stock options. Today, they comprise two thirds of the typical executive’s pay.

Stock options give the executive the right to buy a company’s stock at a predetermined price sometime in the future. If share prices rise above the negotiated strike price, the executive stands to reap significant gains. If the options become worthless, the CEO breaks even, having paid nothing for them.

The result is a win-win for executives, especially when supplemented through the use of stock buy backs and the labyrinthine of accounting shenanigans such as excluding depreciation and amortization in calculating earnings for performance based compensation.

The stock buyback binge of $4 trillion since 2008, much of it with borrowed money thanks to low interest rates since the Great Recession, has resulted in firms reducing the number of outstanding shares by which profits have to be divided. So the share repurchases lift per-share earnings, improving a key metric for determining CEO compensation.

Solutions to the CEO compensation issue include tightening the cap on tax deductibility of CEO pay and disallowing deductions for excess salary, stock options, and perks. Fat chance, these reforms will happen when the positions of too many politicians closely reflect those of their big money donors.

Cynicism about those in positions of power seems to be confirmed afresh each day by the latest tweets, pandering, and headlines. As a general rule, assume the worst about elected officials and the thinly veiled plutocracy. That way you will not be disappointed.

Originally published: September 12, 2017

Stock options for executives carry unintended consequences

Posted on by j.giglio

If you are Rip Van Winkle awakening from a 20-year slumber, you might not know about America’s outrageous compensation for chief executive officers. But almost everyone else does. The flow of most income and wealth gains to the few highest earners comes at the expense of everyone else.

Let’s not forget that Americans’ real median incomes have been stagnant. Annual U.S. household income reached $57,263 this past March but is still below the $57,342 median in January 2000, according to Sentier Research. Any wonder why Americans are angry?

In contrast, a recent AFL-CIO study found that heads of the Standard & Poor’s 500 companies are paid about 330 times as much, on average, as production and non-supervisory employees.

CEO compensation took off in the 1990s because activist shareholders, board members and academics, all mating like alley cats, pushed to better align management’s interests with those of shareholders. So corporations began to award stock options to senior managers

Executive stock options have been a controversial topic for some time because of the fortunes executives have made under these programs. Stock options come in several forms. In the most common, executives granted stock options have the right but not the obligation to purchase shares of their company’s stock at a favorable set price within a specified time period.

Stock options are often used in lieu of signing bonuses as a tool to attract talented executives. In theory, they also align shareholder and management interests. The idea is that granting stock options gives executives skin in the game and creates incentives for them to make decisions that lead to higher stock prices. Vesting periods for options give current managers incentives to remain with the firm.

While beneficial in some ways, this formulation has its downsides. It tempts executives to focus on the short term at the expense of long-term shareholder value. Let the next guy worry about the Ohio factory whose leaky roof should have been replaced years ago while management focuses on managing quarterly earnings figures to meet investor expectations and lift stock prices. Management may decide not to invest in research and development on projects whose payoff is down the road.

Recent revelations about Valeant Pharmaceuticals International offer a treasure trove of teachable moments. Conventional pharmaceutical companies spend about 20 percent of sales on R&D for new drugs. Valeant executives devoted only 3 percent to R&D. The firm also had to restate its 2014 and 2015 earnings because millions in sales had been recognized during the wrong period and an array of costs excluded to allow it to report fantasy earnings of $2.74 a share when each Valeant share earned 14 cents.

But wait, there’s more. While CEO Michael Pearson received a base salary of $2 million, his executive pay was tied to Valeant’ s stock price. He owned stock and options worth more than $3 billion, putting him on the Forbes billionaire list before the recent scandal crushed the stock.

Today’s business world is a playground for feckless conduct that pats you on the back for behaving badly. Maybe it is time to put an end to that by prohibiting hired gun managers from buying and selling stock in their companies, just like we bar professional athletes from betting on their own games. In lieu of stock options, give them big cash salaries plus generous bonuses linked to how profitable their companies are over several years as an incentive for them to manage for the long term.

When future historians look whether stock options are an effective way to align the interests of managers and shareholders, they will ask some basic questions: Do they motivate executives to act in the best interest of shareholders? What costs do stock options impose on the company and its shareholders?

The answer is that they may indeed accomplish those things, but with a lot of unintended consequences.

Originally published: May 14, 2016

How Wall Street execs cook the books

Posted on by j.giglio

One reason no one much likes corporate America these days is executive compensation. The subject is rarely out of the headlines and serves as compost for many articles and books written in pornographic detail.

CEO compensation discussions have struck a particularly pessimistic note since the 2008 financial crisis, when the high cicerones of finance rolled the dice, pocketed their winnings and relied on taxpayers to make the markets right again.

In the 1970s and ’80s, public corporations began adding stock options to already generous CEO salaries and bonuses, with the hope of giving them an incentive to boost corporate fortunes as measured by increases in the company ‘s stock price. Instead of promoting shareholder interests, the approach has created an incentive for executives to manage corporate resources to maximize management’s wealth.

Overall executive compensation jumped from a median of $1 million in 1980 to $10.8 million in 2013 for CEOs of companies listed on the Standard & Poor’s exchange, with stock-based compensation accounting for two-thirds of median CEO compensation. The ratio of executive pay to that of average workers has grown from 29.9-to-1 in 1978 to 295.9-to-1 in 2013.

American firms spent nearly $1 trillion last year on stock buybacks and dividends that elevate a firm’s stock price to new highs and help fuel a bull market in which captains of industry flourish regardless of a company’s underlying health.

For example, several weeks ago, General Electric announced that it will return $90 billion to shareholders through a series of dividends and share buybacks. Apple pursued a $90 billion stock buyback last year, Exxon Mobil spent $13 billion on stock repurchases, and IBM has spent $108 billion on buybacks since 2000.

But there are clouds. Does this strategy make productive use of the firm’s resources and create long­ term value? Should increased CEO compensation be tied to improvements in firm performance that result from factors such as low interest rates or an expanding economy that have nothing to do with an executive’s performance?  What is the overall impact of this incentive for senior management to “manage earnings” or to artificially  inflate profits?

Here’s how it works:

“Why do you suppose professional athletes are forbidden from betting on the games they play in?” “That’s easy. So they won’t be tempted to make their bets pay off by shaving points and so on.” “And yet we allow senior executives to bet on their games.”

“By buying stock in the companies they run?”

“Sure. We even encourage that kind of betting by showering them with stock options.”

“Even as they can manipulate the final score by cooking the books to drive up the company’s stock price.”

“All in compliance with Generally Accepted Accounting Procedures. So shouldn’t we prohibit managers from buying and selling stock in their companies, just like we prohibit professional athletes from betting on the games they play in?”

“Makes sense when you put it that way. How would you pay them?”

“Give them big cash salaries, plus generous bonuses based on how profitable their companies are over a longer period like five years. In other words, they don’t get paid for making decisions; they get paid for living with the consequences of their decisions. As an incentive for them to manage their companies wisely.”

“So their bonuses would be deferred?”

“Yes. That’s what you want -to encourage them to manage for the future.” “Not to mention removing the incentive to cook the books.”

“That goes without saying.”

There may be some cause for optimism. In an effort to restore public trust, the 2010 Dodd-Frank financial legislation gives stockholders of public corporations an advisory vote on the pay packages of CEOs and senior management. This power, known as “say-on-pay,” is a baby step toward reining in excessive CEO compensation that is disguised as performance based.

Perhaps it would make sense to make this provision mandatory. Sunlight, as the saying goes, is the best disinfectant.

originally published: May 2, 2015