Executive Pay: What is Not Said

"You have to listen to not only what is being said, but what is not said -- which is often more important than what they say." — Kofi Annan

There may be daily updates on this issue because I am reading, daily, misreporting of executive pay. This time, it's the Washington Post and it's about what was not said.

Capital One Chief Was Paid $17 Million in 2007
Capital One, the McLean credit card issuer, awarded chairman and chief executive Richard D. Fairbank a pay package it said was worth $17 million last year, almost entirely stock options. That compares with a package worth $18 million in 2006, the company said. Fairbank last year exercised stock options at a gain of $54.8 million, the company said. That sounds heroic, a CEO just getting paid from gains received by shareholders.

They got the "awarded" part right. Of course the $17 million number is likely a significant understatement of the value of those options but that has been in this blog before and will be again, but not right now.

The problem here is what was not said. It is true that he had a gain of $54.8 million on options. But as the media continues to miss the significant change in executive equity compensation packages, this reporter missed a little $18.3 million vesting event on restricted shares, understating pay by about 25%.

Now, there is another complexity here. A footnote indicates that:

"Values reported for Stock Awards are related to the vesting of Mr. Fairbank’s performance shares on March 31, 2007, delivery of which are deferred until the end of Mr. Fairbank’s employment with the Company. Therefore, Mr. Fairbank neither acquired any shares nor realized any value from such shares in 2007." Not true. If someone gives me $18 million in stock but I've told them to just hang onto it until I retire, it is difficult for me to argue that I didn't "realize any value" from that. That is a tax technicality.

This further highlights not only the complexity of executive pay but the need to understand both the tabular disclosures and the voluminous footnotes. And the accounting, the tax, and the other technical nuances.

What was not said here is important: When Capital One's stock price was flat for two or three years their interest turned to giving executives free shares of restricted stock. Now that the stock has lost half its value, how attractive those stock options look again so the executives can participate in the rebound. Flat price, guaranteed pay. Low price, guaranteed participation in the rebound. (See previous posts on Washington Mutual for the popularity of this approach.)

That's the real story, Washington Post. With your reputation for investigative journalism, how about spending a little more time on the shenanigans going on in the financial services industry right now. We are seeing various combinations of fraud, failure, and folly and even the least serious of those is an important corporate governance issue. Directors are paid to prevent folly, and not be a part of it.

New Issue of The Compensation Committee Adviser

Beware the Compensation Headlines: Apples and Oranges

I have often said that when one reads an article about executive compensation in any of the leading business publications – the Wall Street Journal, Business Week, Forbes – one should assume that the pay amounts cited are incorrect. While they are not always incorrect,...

To keep reading, click here: http://compensationcommitteeadviser.blogspot.com/

Those Darn Compensation Consultants

"Mortgage mess CEOs defend pay" - Cnn.com
"Countrywide's Mozilo resisted pay cuts" - WSJ.com
"Wall Street Executives Defend Pay at House Hearing" - Bloomberg.com

In all of the media coverage today, perhaps the most interesting tidbit was not what was said in the hearings but what was learned from some email messages in the course of the investigation. Beyond the left-vs.-right debate, the accusations and justifications, and the election-year posturing, there's this:

"The report says two compensation consultants hired in recent years urged the board to cut back on certain aspects of Mr. Mozilo's compensation. The first...advised Countrywide in 2004 when it was discussing an extension of Mr. Mozilo's contract.

"A second consultant...in 2006 recommended reductions in Mr. Mozilo's compensation, the report says. After the board's compensation committee proposed making those cuts, the report says, Countrywide management hired another consulting firm, Towers Perrin, to review the board's proposal. Though the firm was being paid by Countrywide, Mr. Mozilo regarded the Towers Perrin representative...as his own adviser, emails reviewed by the committee staff suggest.

"'The board made a number of revisions to accommodate Mr. Mozilo and (the consultant)," the report says. Among other things, the board put larger companies into the peer group used to gauge Mr. Mozilo's pay and gave him a $10 million bonus to stay on as CEO longer than planned.
The report cites an email (from the consultant) to Mr. Mozilo expressing disappointment that the board's final proposal "lowers your maximum opportunity significantly."

"According to the report, Mr. Mozilo replied: "At this stage in my life...this process is no longer about money but more about respect and acknowledgement of my accomplishments.... Boards have been placed under enormous pressure by the left wing antibusiness press and the envious leaders of unions...'."

Source: WSJ.com

The consultant expressed "disappointment" at the Board's actions. Wow.

(There was a fourth consulting firm involved as Countrywide's consultant to the Board Committee which is mentioned in their most recent proxy statement.)

"Lawmakers have argued that these consultants are merely getting paid to tell the board and CEO what it wants to hear." - Cnn.com

Apparently the Board was told by two, maybe three, different consultants that Mr. Mozilo's pay was too high. The Company even incurred the additional expense to file an amendment to its proxy statement with nice charts showing how Mr. Mozilo's pay was going to be lower under his new contract than under this old one.

Why does this really matter? Because a few companies with questionable pay practices end up in a Congressional hearing, which then leads to legislation regarding executive pay. That legislation is typically ill-conceived, fails to achieve its objective, and creates additional cost and constraints for all of the other companies. Like Sarbanes-Oxley, a law reacting to a few big companies' missteps penalizes thousands of smaller companies who have done nothing wrong. And that has a negative impact on American businesses, their employees, and our economy. I suppose in an election year I should claim that my position is "patriotic" but it's also one shared by many investors and even some other compensation consultants.

Who ever thought compensation consultants could have such an impact?

Disclosure: I am a shareholder of both Washington Mutual and Countrywide Financial but do not believe my financial interest in those companies influences the opinions expressed here. I do believe, however, that executive compensation practices directly impact shareholder value. I suppose I also should disclose that I once worked for Towers Perrin but never worked for the three other firms cited in the news today.

A Week Late but Never a Dollar Short, in Fact...

A Week Late but Never a Dollar Short, in Fact...
Fred Whittlesey
Compensation Venture Group, Inc.


The U.S. House of Representatives Committee on Oversight and Government Reform will hold a hearing titled, “Executive Compensation II: CEO Pay and the Mortgage Crisis” on Friday, March 7, at 10:00 a.m.

I hope it's on CSpan, even though I have never watched CSpan. But if I wanted to start watching a Congressional hearing at 7:00am Pacific Time, which I probably wouldn't, I'd know that my government is providing such access. These things are always archived on the web for later viewing anyway. No doubt YouTube will have it although I am concerned that explicit discussion of executive compensation could violate their obscenity standards.

The list of those testifying can be viewed here and a little background on the topic here. In the hearings will be CEOs and Chairs of Compensation Committees from Merrill Lynch, Citigroup, and Countrywide. I would add one more to the list but couldn't find a link allowing such suggestions other than the "contact us" link on the Committee's website and who knows who actually reads those.

Because it seems that while they're on the topic of the mortgage crisis they wouldn't want to exclude Washington Mutual, here in Seattle our local poster child for the mortgage crisis, destruction of shareholder value, and continued delivery of lucrative compensation to those responsible for the crisis and destruction. While other banks fired their CEOs, triggering big payouts, WaMu doesn't require them to be fired in order to continue receiving high levels of compensation unrelated to performance. Read on.

The furor had barely died down over the last SEC filing disclosing WaMu's equity compensation grants to executives - hidden beneath the misleading headline suggesting that the CEO had given up his bonus for the year. This, by the way, raised the question of why he should have been getting a bonus in such a disastrous year. The answer: That's how the plan operated - we did the calculations and despite the clear disaster, the plan didn't seem to think it was a total disaster.

Which leads right into the latest controversy with Monday's filing: The 2008 bonus plan pays the executives a bonus if certain parts of the income statement are positive, even if the company loses money. Worse, the plan will allow the Compensation Committee to subjectively override any formulaic outcomes. And, those overrides could be up or down.

And, that subjective discretion costs WaMu shareholders because that renders the plan - which is not a plan but just a fancy discretionary bonus - nondeductible for tax purposes. At the target amounts disclosed that could cost WaMu shareholders about $3 million in lost tax benefits. But I suppose that's not "material" for a company, and management team, that destroyed about $25 billion dollars in shareholder value last year.

And, I could tell you a lot more about the corporate governance issues reflected in these plan designs but I won't. Let's just say that on our firm's Compensation Integrity scoring system that has a scale of 1 to 100, we're exploring how to accommodate negative numbers because we wouldn't want to exclude any companies due to system limitations.

Look Who's Coming to Dinner..or maybe a late continental breakfast

Look Who's Coming to Dinner..or maybe a late continental breakfast
Fred Whittlesey
Compensation Venture Group, Inc.

After the last entry "Change is Possible" - check this out:

Committee to Hold Hearing on CEO Pay and the Mortgage Crisis

The Committee on Oversight and Government Reform will hold a hearing titled, “Executive Compensation II: CEO Pay and the Mortgage Crisis” on Thursday morning, February 28, 2008, in 2154 Rayburn House Office Building.

The hearing will examine the compensation and retirement packages granted to the CEOs of three corporations deeply involved in the current mortgage crisis. This will be the Committee’s second hearing on executive compensation practices. On December 5, 2007, the Committee examined the role of compensation consultants in determining CEO pay.

Note that one of those "three corporations" happens to be Countrywide Financial.

I am no fan of government intervention (and not much of a fan of government in general) but this is very interesting and should make for some great executive pay drama on C-Span. Like the cast of "Guess Who's Coming to Dinner" the list of "witnesses" is an all-star cast. (Boy, doesn't "witnesses" make it sound like a criminal trial? - Yes, your honor, I DID SEE him exercise those stock options.) The who's who of highly-paid executives, people who approve the pay for highly-paid executives, and people who don't really like highly-paid executives should make for an interesting broadcast which likely is the real objective of the Committee. In an election year. Pardon my cynicism.

I hope they're serving some nice coffee and pastries at this hearing because these executives are accustomed to quite a nice set of perks, which won't be detailed here because I'm not interested in inflaming the issue. But it is fun to read last year's proxy statements and see the details of their perks. Before they got fired.

Not to diminish the quote of Neil Armstrong, but this hearing is yet another small step for executive pay awareness but probably no giant leap for executive pay reform. Because the latter will require some big changes in how Compensation Committees, compensation consultants, and management teams interact. And so far those changes are about as far along as civil rights were in 1967, the year "Guess Who's Coming to Dinner" won an Academy Award. Yes, we already had the Civil Rights Act of 1964. But we know all about the time lag between ceremony and legislation and real change.

As Tillie said, "Civil rights is one thing. This here is somethin' else." Yes, high pay for executives is one thing, but what we'll hear about is this hearing is indeed somethin' else.

Change is Possible

Change is Possible
Fred Whittlesey
Compensation Venture Group, Inc.


Just a quick update. I've included the links so that you can view the original story.

13 January 2008
Los Angeles Times
For CEOs, Failure Can Be Lucrative

"This is another clear example of pay for failure," said Fred Whittlesey, principal consultant with Compensation Venture Group in Seattle. "How many more examples of this will we have to see before this gets fixed?"

"Every year, there's more talk about boards getting tough," said Whittlesey, who is a Countrywide shareholder. "But every year, they keep saying yes to these contracts."

14 days later...

27 January 2008
AP
Countrywide CEO Mozilo Will Give Up $37.5 Million in Severance Benefits

"Countrywide Financial Corp. CEO Angelo Mozilo, under fire over the size of his potential payout from the proposed sale of his troubled mortgage company, says he is forfeiting some $37.5 million in severance pay, fees and perks he was scheduled to receive upon his retirement. 'I believe this decision is the right thing to do as Countrywide works toward the successful completion of the merger with Bank of America,' Mozilo said in the prepared statement."

And then there's this one...

23 January 2008
Seattle Times
Wamu Leaders to Profit Even if Stock Stays Low

"That rationale was condemned as "outrageous" by Fred Whittlesey of Compensation Venture Group, a Seattle-based executive-compensation consulting firm. All shareholders should hit the roof when they see what they've done here," said Whittlesey, himself a WaMu stockholder. They've created another layer of poor compensation policy on top of the existing poor compensation policy. Rather than setting the options' strike price at Tuesday's closing price of $14.77, Whittlesey said, WaMu's board should have set it at $40 — the stock's approximate price before last year's swoon. One of the things you don't do with stock options is give them to people who drove the shares down so they can profit by bringing them back up," he said.

Let's watch the headlines.

Bwaa-hah-hah-hah! Truly Scary Compensation Stories

Bwaa-hah-hah-hah! Truly Scary Compensation Stories
Fred Whittlesey
Compensation Venture Group, Inc.

Yes, Halloween is a favorite holiday of mine and what a gift to have a couple of frightening stories appear in the media in the last few days.

Now, I think it’s important that compensation experts continually explore data, testing relationships between executive pay and shareholder value. I also think it’s important that so-called experts have some modicum of ability to interpret data and, more importantly, not be inclined to reverse-engineer their analysis to support a predetermined point. But unfortunately what I think about that and what continues to happen are quite different. (Costume idea: Pollyanna)

The first story: “Companies using compensation consultants pay CEOs more with no shareholder benefit, says study.” Oh, the horror, the horror. This “study” is filled with so many flaws, non sequiturs, and misinterpretations that I don’t know where to begin. It scares me that such flawed research, conducted by The Corporate Library (whose well-known axe grinding about executive pay is notoriously one-sided despite their claim of being the "independent and objective") can make the headlines in a fine publication like Financial Week. I have not seen the study itself, however, (because I wouldn’t pay good money for something like that) so perhaps it is the writer’s interpretation of the data that is the problem. That’s scary in its own right as few will read the study but many will repeat the headline they read. (Costume idea: parrot)

The study’s key conclusion according to Financial Week: That companies using compensation consultants did not have any better shareholder returns than companies not using (or at least not disclosing the use of) compensation consultants. I didn’t know, as a compensation consultant, that I was personally responsible for shareholder return but if it turns out that I am, boy will my hourly rate go up tomorrow. Either that or I ask for a percentage of the increase in shareholder value. Kind of like those private equity firms that get 20% of the gains, and 1% regardless of gains. To think I've been charging by the hour all these years. (Costume idea: Private equity guy with bulging pockets and cigar)

The scary comment directly from the source of the study: “Consultants do not increase the effectiveness of incentive plans.” “We did see some patterns” said Alexandra Higgins of the Corporate Library. I see some patterns, too, Alexandra. Bizarre patterns of thinking that link “incentive plan effectiveness” with “shareholder returns” and “the use of compensation consultants.” (Costume idea: Picasso painting)

Here’s one thought: what if the use of compensation consultants is normally distributed across companies based on their shareholder returns? Then, on average, companies with consultants and companies without consultants should have the same return. Apparently the problem is that as soon as the consultant enters the picture, we are so brilliant in designing executive compensation programs that shareholder return should immediately improve. And if a company underperforms then they’re not entitled to professional assistance with the complex topic of executive pay. (insert scream soundtrack here) Let’s not give any consideration to past returns, industry sector, market cap, or any other relevant factors because that might ruin the predetermined conclusions that the only thing worse than executives who get paid are consultants who work for them. (Costume idea: Larry, Curly, and/or Moe)

Four days later, Financial Week published the headline “Comp consultant: CEO pay gains among Dow 30 in line with stocks’ performance.” Ah, much better. Now we know that executive pay is really OK. Except that upon further scrutiny this consultant’s analysis apparently shows that CEO pay in those 30 companies grew 15.1% annually for the past 10 years while compounded shareholder return grew by 12.1% during that time. His opinion is that CEO pay “only modestly” outpaced returns. A little arithmetic highlights the result that CEO pay went up 4x while shareholder value went up 3x during that time. That’s a “modest” difference? Those private equity fees are starting to look more reasonable. (Costume idea: Gordon Gecko)

But I really loved this compensation consultant’s point that this was an important analysis because the Dow 30 companies are “where the trends typically come from and a lot of the (other companies) follow suit.” Yeah, right. Those gigantic mature no-growth firms certainly set the pace for the several thousand entrepreneurial growth companies in America. (Costume idea: Arnold Schwarzenegger and Danny Devito as Twins)

I don’t know whether to be scared that someone like this actually gets media coverage, or to just burst out laughing. No, I’m scared that someone either really believes that or, worse, has some bizarre motive for saying it anyway. Yet some CEO somewhere will think he or she is underpaid because they don’t have a pay formula that gives them pay increases of at least 133% of the rate of total shareholder return. Ah, to work for Google with a deal like that. (Costume idea: Nerd executive in Lamborghini)

I wish that such frightful lapses in analytical ability, common sense, and objectivity were limited to the Halloween season but unfortunately we’ll likely continue to see them for months and years to come. And that gives the real experts plenty to write about and plenty to fix. And yes, I make a living doing both but still only get paid by the hour. (Costume idea: Superhero in business casual, with eyeglasses)

The other scary story this week was the “say on pay” debate but that’s too frightening to even consider discussing in the same Halloween blog. Maybe that’s a topic for All Saint’s Day, which is apparently when shareholders expect boards of directors and executives to be honored once we compensation consultants figure out how to guarantee incentive plan effectiveness and above-average shareholder returns. (Costume idea: Barney Frank)

Pay Granted, Earned, and Paid: Bubble, Bubble Toil and Trouble?

by Fred Whittlesey
Compensation Venture Group, Inc.

The actual line from Macbeth was, of course, “Double, double toil and trouble.” Factual documented information often gets twisted into a widespread misunderstanding. And so we have executive pay.

For the past twenty or more years the media have reported executive pay as a “story” worth covering. This has escalated over the past few years as the topic has moved from the business section to the front page. There are a couple of reasons for this. First, the numbers are bigger. Apparently it’s more interesting to read that someone was paid $210 million than it is to read that someone was paid $10 million. Second, the reason for the pay has changed. $210 million for getting fired versus $10 million for running a successful company does indeed have a human interest angle.

But where do these numbers come from and how do we know they are right? The answers to that compound question are “the proxy statement” and “we don’t.” The SEC’s new proxy disclosure rules changed the Summary Compensation Table (SCT) from a report of apples (dollars earned and paid), oranges (dollars contingently paid), and bananas (stock options granted – the number, not the value) into a recipe for vegetable stew (accounting expense) – which would be alright if we were looking for vegetables, but we were really wanting to know about fruit.

Here is the root of the problem:

Most compensation professionals were trained, and continue to believe, that the amount granted in a single year, regardless of contingencies for future vesting or performance, is “pay” for that year. We do need to value those grants. By way of example, Steve Jobs, CEO of Apple was “paid” only $1 (there are no missing zeroes, there, just one dollar) in 2006. He received no bonus, no stock option grants, no stock awards. Just a buck.

The new SCT portrays what the accountants recorded as an accrued (read: estimated or hypothetical) and thus earned expense for the year. Some joke that the SCT now stands for “Summary Cost Table” but it is not that either unless your only view of “cost” is accounting expense and shareholders are move savvy than that. We do need to decide if the accounting numbers are useful in valuing those grants. Under this method, Steve Jobs was paid $1 plus the portion of the $577 million in restricted stock that he “earned” during the 2006 fiscal year. We'll know that number when Apple files their next proxy under the "new rules."

The media, of course, like to report what was paid, even if that represents an accumulated amount based on 10 years of work. Those big numbers sell newspapers. I think we can conclude that these numbers are far removed from any single year’s grants. Under this method, Steve Jobs was paid $577 million in 2006...oops, $577,000,001. We could talk about Mr. Jobs other job, as CEO of Pixar, or his Gulfstream, but we'll leave those for another blog day.

The Jobs/Apple example is extreme enough that it invites more scrutiny. But what about the CEO of one homebuilder whose three numbers for 2006 are $2,015,499 granted, ($2,296,918) earned, and $7,903,997 paid. Negative compensation? That guy must have had a really poor year but fortunately was “paid” almost $8 million in a year in which he “earned” negative $2 million.

This can make one feel like all of this data more witches’ brew than vegetable stew, and impossible to digest. Compensation professionals have never faced such a large amount of such confusing information. I think it is a fair estimate to say that it is at least “double double toil and trouble” to analyze executive pay. Shakespeare saw it coming.

It’s critical that a company and its Compensation Committee take a position on how pay is measured and use that consistently in benchmarking, analysis, and the decision process. An appropriate data collection strategy focused on the most recent data available, combined with attention to details of compensation design, will cut through the confusion and tell the correct story. Data from SEC filings is the most valuable and most accurate data available for executive pay, and it’s worth the toil and trouble.

Next blog: An example of the measurement problem

Executive Pay: Complex or Complicated? (Redux)

Fred Whittlesey

Principal Consultant, Compensation Venture Group, Inc.

Fellow, Salary.com, Inc.

This entry updates a previous blog item from June 2006

I was once in a Board of Directors meeting in which one director said the compensation plan I proposed was complicated and his fellow director corrected him saying that it was not complicated, just complex. Merriam-Webster helps us with this distinction:

Main Entry: com·plex
Function: adjective
COMPLEX suggests the unavoidable result of a necessary combining and does not imply a fault or failure

Main Entry: com·pli·cat·ed

Function: adjective

1 : consisting of parts intricately combined

2 : difficult to analyze, understand, or explain

Executive pay is complex, indeed the “unavoidable result of a necessary combining.” A leading life sciences company recently disclosed an intricate performance-based stock award program for executives. The award is divided up into three tranches, in each of which the pay amount is determined by a matrix of two performance measures relative to a peer group. Complex, but fairly easy to understand. I have to include some of the disclosure here for you to fully appreciate it:

Executive pay, to many, is complicated and difficult to understand. Base salary, annual incentive, stock options, RSUs, performance plans, multi-year cash bonuses, annual incentive awards paid out in restricted stock, deferred compensation programs, and more. Add to that some intricate time-based vesting schedules, performance acceleration, and performance vesting.

The trend in performance plans among small and mid-sized companies is further evidence that pay will continue to get more complex. As it does, sometimes it will be clearly disclosed as required by the SEC’s new disclosure rules. Sometimes it will be so complex, or so poorly explained, that it will seem very complicated. As I've said before, I believe compensation professionals have a responsibility to design plans that are appropriate for the business situation, no matter how complex that may be, and ensure it is properly communicated as to not appear complicated. Journalists have what is perhaps an even greater responsibility to take the time to understand these complex plans, no matter how complicated, and report them accurately to ensure the public does not misunderstand them and arrive at false conclusions about executive pay.

Stay tuned for the details of recent research we’ve done on these complexities. Just the data on vesting schedules is overwhelming, and then we’ll next discuss performance acceleration and performance vesting. By then, no doubt, there will be a new category of complexity that we’ll need to define and address.

Next blog: How things got so complicated

Integrity in the Compensation Consulting Business

Fred Whittlesey
Compensation Venture Group, Inc.

Consultants always dread making a mistake. Providing advisory services at the level of the Board of Directors sets a very high bar for accuracy - perfection, basically. Any slight error can draw into question an entire presentation and report and sap credibility. We learn this our first year as associate consultants and most of us carry the ethic of quality and accuracy with us throughout our careers.

It's a bit surprising, and a little amusing to boot, to read in Financial Week today that Enron Creditors Recovery Corp. has had to ask a US District Court judge to force a compensation consulting firm to correct its errors. I cringe when I learn that my firm has made a mistake and we bend over backwards to fix it quickly and at no cost to the client. I can't imagine having an issue escalate to the point where a federal judge's involvement is needed.

But that is the case with Enron's successor firm and Hewitt Associates. According to Financial Week, Hewitt did the calculations for distributing $89 million to former employees of Enron but distributed $22 million of that amount to the wrong people. I suppose the good news is that 75% of the money went to the right people and 75% is a solid "C" grade in school. Yet I can't imagine sending a client something that is 25% wrong. That's not very accurate.

Enron CRC apparently felt that Hewitt, while admitting its mistake (which Hewitt blamed on a "software glitch" - and wasn't a "software glitch" blamed for accidentally erasing some email messages sought in the Enron investigation?) was taking too long to issue corrections and has "continued to drag their feet" in the matter. That's not very responsive.

Besides getting it wrong, taking too long, and blaming the error on software (I wonder whose software it was - Hewitt's?) the question has been raised how one approaches an employee who lost their job and retirement savings in the Enron debacle and asks for a refund of incorrectly paid funds. A lawyer representing ex-Enron employees said that either Enron or Hewitt should pay back the money. Not that my opinion counts, but I would say that should be Hewitt. Maybe with an apology, and maybe without a court order. But that's just how I would do it if I was a consulting firm with $450 million in cash and equivalents at the end of my last fiscal year, and revenue of $2.8 billion - although Hewitt had a financial loss of about $116 million last year, so maybe they're a little more hesitant to part with what money they have.

At a time when all compensation consulting firms are being questioned on matters of independence and integrity (remember that Hewitt was at the center of the controversy with their consulting to Verizon - read about it here) stories like this do nothing but make these firms, and the industry, deserve the questions being asked - like why does it take a court order for you to fix your mistakes, and why are you engaging in business where you have an obvious conflict of interest that shareholders of your client find unacceptable, and why are you losing money as a result? Maybe that last question is answered by the first two.

Not Much Blogging, But Lots of New Thinking.

Fred Whittlesey

Compensation Venture Group, Inc.



Yes, it's been over five months since the last post to this blog, but that's because I've been channeling a lot of new content through other media and accumulating some blog topics to be launched under a new distribution deal this summer (stay tuned, as they say). So check out some of the other new information that deals with the latest compensation-related topics:

My presentation at WorldatWork's 2006 Annual Conference, The Real Meaning of ROI...for Compensation Professionals, was been named one of the highest-rated and best-attended sessions there and was repeated as a webcast in January and can still be heard through on-demand audio download (WorldatWork event code PSOWEB0637).

My podcast, Keeping Up...with Fred Whittlesey, created monthly for Global Equity Organization is now distributed through iTunes. My most recent guest was Anne Ruddy, President of WorldatWork - listen to it by clicking here.

The Compensation Committee Adviser was launched last fall as a blog-formatted update for Compensation Committee members

My presentation at the annual WorldatWork conference, The New ROI of Executive Pay, had a great turnout despite being slotted at the very end of the last day of a week of beautiful weather in Orlando.

I've been working with WorldatWork to deliver the first-ever online versions of some certification courses - I was honored to be the initiating instructor for each of these experiments in moving classroom-based education to a web-based format:

Accounting and Finance for HR Professionals (T2)

Principles of Executive Rewards (C6), and

Advanced Concepts in Executive Compensation (C6A) being presented for the first time in August

Next stop is the Global Equity Organization Annual Conference in London where I'll be co-presenting with Alan Judes of Strategic Remuneration on the topic "Two Nations Divided by A Common Language - Corporate Governance Influences in the US and UK."

And, I have been invited to write a chapter in The Compensation Handbook and I think my draft was due yesterday. Gotta go.

Corporate Governance and Executive Pay Across the Pond

Fred Whittlesey
Compensation Venture Group, Inc.

My monthly interview session for Keeping Up!, the podcast series sponsored by the Global Equity Organization, focused this time on the differences between corporate governance-based approaches to dealing with the executive and equity pay issues of the day. The Association of British Insurers (ABI) gave me a little Christmas present by releasing "Executive Remuneration - ABI Guidelines on Policies and Practices" on 14 December. We would have done the podcast interview the next day, but the windstorms and power outages in the Seattle area delayed us and gave me time to read and digest the document.

Why should we in the US care about what a bunch of British insurance companies think about executive pay? Because ideas about executive pay are flowing freely, like all information, across national boundaries. If you know the history of FAS123R, the relatively new accounting rule for share-based payments, you know that the term "share-based payments" comes from the UK. In the US we called it "stock-based compensation" and the Financial Accounting Standards Board proposed "equity-based compensation" until the IASB - a UK-based organization - used the new term in IFRS2, their version of our FAS123R (they of course consider FAS123R to be our version of IFRS2, which is actually more accurate). Much of FAS123R is taken from IFRS2 and if you think reading accounting rules is difficult, try reading them when originally drafted in a more formal English that we typically use in America.

But beyond the terminology issue there are important differences between the two nations' compensation cultures, and the gap is widening even as it appears that governance trends are on similar trajectories. I won't go into all of the details in this posting, but it is interesting to note some significant positions prevalent in the UK that are not (yet) found here in the US as represented by the ABI’s positions. For example:

*"Where a company seeks to pay salaries at median or above, justification is required." In the US there has been some attack on companies targeting the 75th percentile and the potential ratchet effect of everyone wanting to be "above average" - but note this says "at median." Companies that strive to pay at the middle point of the market must now "justify" that.

* "Annual bonuses should not be pensionable." That would be very disruptive to those companies in the US that still have pension plans, and supplemental executive retirement plans (SERPs) and is contrary to the notion that some of executives’ annual cash compensation should be at risk. Perhaps we should pay all salary and no bonus to executives? Or just eliminate executive pensions?

* "Contracts should not provide additional protection in the form of compensation for severance as a result of change of control." In other words, no golden parachutes. "Contracts should commit companies not to pay for failure." Here, here.

* "...inappropriate for chairmen and independent directors to receive incentive awards geared to the share price or corporate performance that would impair their ability to provide impartial oversight and advice." Cleary, stock-based compensation - excuse me, share-based payments - may not be an appropriate form of pay for boards of directors.

* "...future performance should govern the vesting of options or share awards. Performancing at point of grant is generally not considered a future alternative." (Performancing? I checked that word on Merriam-Webster's online dictionary and was told "The word you've entered isn't in the dictionary." Is that "the" dictionary or "our" dictionary? Microsoft Spell-Check didn’t like it either.) Shareholders in the UK have made it clear than any form of share-based pay to executives should be performance-contingent and not subject only to time-based vesting. Goodbye, plain vanilla stock options. Good riddance, restricted stock.

I could blog on about this and address all of the important points from the ABI's 20-page paper, but here's the point: Not only do we have ISS, Glass Lewis, CalPERS, CalSTRS, Fidelity, Dimensional, et al opining on and influencing executive pay policy, and driving shareholder voting accordingly, but we must keep our eyes and ears tuned to their counterparts in other countries as executive pay has become a global issue. We have been unable to converge on a set of policies here in the US that we can all agree are "good" and "bad" and we may find that those standards are influenced by organizations that many executives and board members have never heard of.

Cheers.

Hey, Look Over There!

Fred Whittlesey
Compensation Venture Group, Inc.

I have a large backlog of topics to address on this blog and until I do I'll direct you to some other content I've developed - look over there!

The Compensation Committee Adviser: Global Warming and Compensation Committees - Institutional Shareholder Services (ISS) adds the newest layer of opinion to the executive compensation debate, joining the IRS, SEC, Moody's and others in the executive pay debate.

Keeping Up...with Fred Whittlesey - a new audiocast (soon to be a videocast) sponsored by Global Equity Organization. My first guest was Mark Schwanhausser, Personal Finance Reporter with the San Jose Mercury News. Tune in 15 December when my guest will be Alan Judes of Strategic Remuneration - we'll discuss whether the US and the UK are divided by a common language when it comes to executive pay.

The Real Meaning of ROI for HR Professionals - My WorldatWork webcast presented on 01 November was an update of the presentation that received a "Best of Conference" award at the 2006 Annual Conference. You can view the webinar playback here.

The New ROI of Executive Pay - the topic of the last issue of The Compensation Committee Adviser has been accepted for presentation at WorldatWork's 2007 Conference in Orlando.

See the homepage of my firm's website to view some other available content that you may find useful.

We Have Problems with the Auditors? Who’s “We” Kemo Sabe?

Fred Whittlesey
Compensation Venture Group, Inc.

As you may have deduced from my posting Peek-a-Boo I See You (and your Black-Scholes assumptions) on 23 October 2006, I have some issues with the Public Company Accounting Oversight Board’s positions about option valuation. (This is minor compared to the position of some, like Ken Starr, who has issues with the mere existence of PCAOB.) PCAOB’s comments about assumptions used in option valuation and how these might represent fraud, of course, occur in the context of the many companies under investigation for so-called option backdating and whether those companies engaged in fraud.

As you may know, many of these companies have been found to be guilty of nothing more than administrative inefficiency, poor documentation, and other procedural (remember that term, “procedural”) shortcomings resulting from an emphasis on running their business – you know, customers, products, things like that – rather than administrative processes. Not ideal, but hardly evil.

How interesting, then, the article in today’s Wall Street Journal titled “Accounting Watchdog Falls Behind” which says “The regulator that oversees accounting firms has fallen behind in a key task: issuing inspection reports on how well the country's biggest firms are doing in their work auditing public companies.” Well, “so what?” you might say. Everyone falls behind sometimes, right?

But we should at least ask why. “The oversight board didn't give a specific reason for the lack of any Big Four inspection reports this year” says the article. “Rather, procedural issues related to the inspection process are at play, said PCAOB member Daniel Goelzer.” Ah, procedural issues.

It seems that there are all sorts of reasons that the PCAOB doesn’t get their work done on time. “He (Mr. Goelzer) said the board's inspectors can't begin their work until May of any given year, when auditors typically finish looking at clients' previous-year results. Also, the agency must take time to see that the inspections process is consistent for the different firms. Another possible delay: In some cases, an inspection raises issues that require the auditor to bring the company whose books were being audited into discussions with the PCAOB.” Maybe they also got a flat tire on the way to the meeting, or the sun was in their eyes, or their dog ate their report.

There was no mention in the article of the PCAOB being investigated over this even though it says “Investors and corporate board members say the increasingly long delay in seeing inspection reports is compromising their usefulness and make the board less relevant. This year's PCAOB reports on the Big Four will cover inspections done in 2005 of audits the firms conducted of 2004 financial results.”

The real kicker here? Remember that little or no public questioning has been done so far about the auditor’s role in the so-called backdating situations. Dozens of executives have lost their jobs but I haven’t heard of any auditors losing theirs. So this next comment in the article is particularly interesting: "’The inspection reports provide greater transparency into the audit firms, but from an investor and board member perspective too much emphasis is placed on the past,’" said Donald Nicolaisen, a former chief accountant of the Securities and Exchange Commission who now sits on the boards, and audit committees, of three U.S. public companies including Morgan Stanley. "’We know there were problems [with the auditors] three or four years earlier. The real question is how are they doing today?’"

“We” know there were problems three or four years earlier? This of course raises the oft-quoted joke in which the Lone Ranger, caught in an ambush, turns to his sidekick Tonto and says, "Looks like we're surrounded by Indians." Tonto replies, "Who's ‘we’, kemo sabe?"

Maybe Mr. Nicolaisen means that “We, at the Securities and Exchange Commission” knew there were problems with auditors three or four years ago. Let’s see, 2006 – 3 = 2003; 2006 – 4 = 2002. Isn’t that post-Sarbanes-Oxley? And there were still “problems with the auditors.” Maybe he is implying that “we” includes all those who relied on auditors’ guidance, opinions, and signatures on financial statements. Or perhaps this is the “nurse’s ‘we’” (known formally as the “patronizing we” – and Mr. Nicolaisen is saying that “you” knew there were problems with the auditors.

What does “kemo sabe” really mean, anyway? Some say it is “Apache friend” or “trusty scout.” Another theory is that it is a mischaracterization of “qui no sabe” which roughly translates from Spanish as "he who knows nothing" or "clueless." I am one who knows nothing about the Spanish language so I’ll have to take someone’s word for it as I am clueless.

The Tonto line is pretty funny, if you assume the last of those interpretations, as it was likely intended to be. What’s not funny is that the PCAOB is not being held to the same standard of perfection against which over 100 companies are being evaluated. Late? No problem. No document? No problem. Maybe the PCAOB can just backdate their report so that it appears that they completed their work on time. (Ouch.) Someone here is clueless and “we” need to identify who that is, kemo sabe.

Fortunately, the PCAOB may be a non-issue in all of this as the SEC is responsible for enforcement. As Harvey Pitt, former Commissioner of the SEC, said in an interview with the San Jose Mercury News on 17 October 2006 regarding the option backdating issue “The SEC is showing a great amount of balance in how it approaches these issues. It's not rushing to make headlines. It's proceeding in a way that is thoughtful and appropriate. That is the hallmark of good regulation and good enforcement.”

But to the extent the PCAOB influences the regulatory zeitgeist they need to be held to the collective standard of excellence or they're just not being a trusty scout.

To the Trucking Industry: Hire Me!

Fred Whittlesey
Compensation Venture Group, Inc.

An article in today's CFO.com email blast - "Will a Driver Shortage Cost Companies?" - highlights the need for ROI-based analysis of compensation practices. A spokesperson for GE Capital is quoted: "Truck driver turnover ranges between 130 percent and 140 percent, which equates to replacing employees every eight months, Tse says. "It takes a toll on the organization both from a resource standpoint and from a cost standpoint," she adds. As a result, trucking businesses are looking at ways to attract and retain employees by giving bonuses, increasing paid leave, and reducing paperwork."

This person goes on to point out that "When trucking companies can't stay staffed up, they're limited to how much they can haul." Hard to aruge with that logic. Take away my keyboard and it's almost impossible to post to a blog (given the sorry state of voice recognition software).

So, hire me! No, not as a truck driver, I wouldn't be very good at that even though I've never been at fault in an accident and haven't had a moving violation in over 15 years (that last one in 1991 on a three-point turn technicality was SO petty.) Hire me to help you understand the screaming opportunity to use ROI-based compensation analysis to fix the problem. OK, end of shameless self-promotion.

I have seen many executives agonize over a couple of percentage points in pay increases, then leave that meeting to go to the next one discussing capacity shortages, revenue shortfalls, and earnings impact. Hmmm. Just like this trucking article.

An ROI analysis would likely show that a turnover rate of 135% per year and an average turnover cost of, say, a conservative 30% of base wages (that by the way is extremely conservative) would easily fund a significant pay and/or benefits increase that would solve the attraction and retention problem and save not only the trucking industry but the downstream supply chain customers (like you and me), from this projected crisis.

It's pretty easy, but it requires someone in HR with financial savvy to talk to someone in Finance, and the combined viewpoint to get to the CEO and the Board of Directors. And in some organizations that is much more of a challenge than attracting, retaining, and motivating truck drivers. Isn't that sad?

Attend my webcast, The Real Meaning of ROI for Compensation Professionals, sponsored by WorldatWork on 01 November at 9:30am PST. (Sorry, there's another shameless self-promotion.) Remember to change your clocks on 29 October or you’ll get to the webcast an hour before I do.

The nice thing about web-based meetings is that we are insulated from trucking-based supply chain issues. But let’s hope the truck-transported coffee gets to our offices on time because if it doesn’t that could indeed be a crisis resulting from this trucking problem, especially in Seattle where that would be reasonable cause for calling in sleepy.

Peek-a-Boo I See You (and your Black-Scholes assumptions)

Fred Whittlesey
Compensation Venture Group, Inc.

I try to stay on top of what has become an almost-daily flow of news affecting executive and equity-based compensation. But I'll admit that I hadn't seen the Public Company Accounting Oversight Board's ("PCAOB" which apparently is sometimes pronounced "peek-a-boo" in accounting circles) new statement, issued 17 October, regarding the valuation of stock options, when I wrote the preceding blog post here 21 October. This is both a bit prescient and humorously ironic.

After more than three years of effort by many public companies to arrive at a "more accurate" valuation of employee stock options, as required by FAS123 and now FAS123R, PCAOB has caught wind that perhaps some companies may be aggressively using certain assumptions that lower the reported value of options granted, thus lowering expense and increasing reported profit.

Wow! I guess no one from PCAOB has been attending the many professional conferences over the past few years where accountants, actuaries, and others have been presenting their ideas on how best to accomplish this. Hardly a well-kept secret, this one.

What I find interesting is that the Board's Statement indicates that such practices may constitute fraud. As I said on 21 October, it continues to amaze me that widely-publicized broadly-practiced methods of calculating and reporting hypothetical "expenses" related to stock options now fall into the category of "fraud". I'm neither a lawyer nor accountant but I don't think one needs to be either to have observed that hundreds of companies have over the past few years reduced their option valuation assumptions and significantly lowered the reported expense accordingly.

This is why I advise all of my clients that the methods and numbers used for financial reporting, while required by the FASB and the SEC, should never, ever, ever be used for compensation analysis and planning purposes. When such tactics reduce reported expense and artificially inflate profit, they have an even more nefarious effect: reducing the "value" of stock options granted to employees and executives. And if the "value" of each option has been reduced then, as the logic goes, we need to grant more options to them. Which of course again raises expense. But these increases often go, this time, to the executive population rather than the broader employee population. Clever.

No one in the investment community is fooled by artificially low Black-Scholes values and no sophisticated investor accepts financial statements as published - they are reworked through extensive financial modeling, based on cash flow, not hypothetical profit - to determine a company's value. These analysts drive the market so there is a significant check-and-balance system around companies' reported option expense. No such system yet exists, however, for executive compensation. Despite improvements in disclosure, heightened investor attention to the topic, and the growing sophistication of Compensation Committees of Boards of Directors, these option valuation games can indeed be damaging to the corporate governance process. That can only be fixed by recognizing that the real money spent on "managing" option expense is an expensive financial reporting exercise and that real compensation decision-making treats that as only one input, and a minor one at that.

The Uncertain Value of (Backdated) Options

An article posted this week on CFO.com, "What's a Backdated Stock Option Worth?" discussed an issue underlying some of the current option backdating controversy: If backdating (however defined) occurred, what is the dollar amount of the event? The article highlights a fundamental discrepancy between two accounting rules, APB25 and FAS123. The author makes the point, reinforced by a consultant, that the Black-Scholes option pricing model - essentially required by FAS123 - says that a $5.00 discount on an option is worth less than $5.00. APB25 says it's worth exactly $5.00. So which is it?

One set of accounting rules for stock options, issued in 1972 (APB25) continued in effect until 2004. Sort of. A contradictory set of accounting rules issued in 1995 (FAS123) was made optional rather than mandatory because the Financial Accounting Standards Board (FASB) bowed to political pressure and made this "correct" accounting optional. But only until 2004 when the FASB made the revised version of the rule, FAS123R, mandatory, because it was more correct than FAS123. In other words, the FASB decided that APB25 was wrong and FAS123 was right, but allowed companies to continue using APB25 - or FAS123 if they wanted - for 10 years all because of politics. Well, there's a nice way to govern the financial statements of publicly-traded corporations.

Between 1995 and 2005 companies were faced with understanding two sets of rules and trying to discern when the optional rule (FAS123) was in fact not optional versus the ongoing mandatory rule (APB25). Hmmm...red means stop, and green means go. But, if you want red to mean go and green to mean stop, that's OK too. You just have to disclose which color means stop or go, and then drive accordingly. And during those 10 years, only 3 cars were stopping for a green light while the other 7,000 kept stopping at a red light, so things seemed OK. No one crashed.

Back to the CFO.com article. It goes on to discuss why or why not $5.00 is really $5.00 which, unfortunately, has become a cottage industry in America. This academic exercise has generated tens of millions of dollars in consulting fees for some fortunate actuaries and accountants. But it raises the question of whether a $1 million "backdating" is really only, say, $200,000 because that is what the FASB had decided but not enforced until 2004. That's a pretty wide discrepancy coming from a bunch of accountants, isn't it? And how interesting that the actuaries and accountants have profited greatly from this discrepancy. I haven't really heard of anyone being criticized for that.

So, let's recap: A backdated stock option "granted" at a price of $10.00 when the company's stock was trading at $15.00 was subject to two different sets of rules. The backdated stock option either was an "expense" of $5.00 or an "expense" of some other amount, based on the Black-Scholes option pricing model, but that other amount depended on several assumptions plugged into a statistical formula. And this only applies if one determined that the "measurement date" was different from the "grant date" and there is a fundamental discrepany there, too, between APB25 and FAS123. (And that is a topic for another blog, another day.)

Most important is the question of how two different sets of accounting rules can apply at the same time, and a critic, years later, can pick and choose which part of which set of rules happens to apply. (By the way, CPA firms are paid to ensure that a company knows the appropriate rule is followed correctly.) There are layers of complexity around the option backdating issue regarding the "grant date" and "measurement date" and when certain administrative processes created each of those. The author of the CFO.com article adds another layer that should be considered: if FAS123 was in effect, then a $5.00 discount from backdating was not a $5.00 event. Depending on the Black-Scholes assumptions, it was a little less or a lot less than $5.00. But many companies have admitted that they didn't pay much attention to their Black-Scholes assumptions because the FAS123 number was just a footnote and was not the accounting rule that they chose. So we really dont' know how much less than $5.00 it was. And if FAS123 was only kinda-sorta in effect, what of the grant date and measurement date issue - kinda-sorta also?

The FASB said in 1995 "here's a rule, we would like you to, but you don't have to, use it for real financial reporting, but follow it anyway." And, 6 to 10 years later, if you didn't use it properly then you might be an option backdater.

Huh? Exactly. For those of us in the compensation field it's fascinating to follow the ongoing debate and how so many people can continue to disagree about the value of a stock option, backdated or not. It's not so fun, however, to see scores of companies spending millions of dollars to help uninformed critics understand that the accounting rules in the 1990s were in many cases not rules at all, but a morass of indecision by the organization (the FASB) empowered by an important government agency - the Securities and Exchange Commission. The same agency that may now be filing charges against those companies for not following the confusing and contradictory rules. Didn't you know that you should have stopped at that green light and driven through the red light back in 1998? What the heck is wrong with you?

20-20 hindsight is fine for those who like to criticize the hometown quarterback's performance on Monday morning, because that's all in good fun and sport. But 20-20 hindsight 400 Monday mornings later about poorly-defined and ambiguously-implemented accounting rules borders on the absurd. No, it's not on the border. It's absurd.

Well, I guess life imitates art, and accounting is just an art, not a science. Or is it that art imitates life? I never can remember which way it is. It's so confusing. Just like APB25 and FAS123 and FAS123R.

How the Government Data, not Stock Options, Muddles the Relationship Among Wages, Corporate Profits, and Inflation

Fred Whittlesey
Compensation Venture Group, Inc.

Here we go, now stock options did something wrong again.

Have I not been saying for many years that the US Government data, coming from the Bureau of Labor Statistics, Bureau of Economic Analysis, and other agencies are just plain wrong? Most recently I pointed this out in The Myth of the Average Worker Pay Ratio. Today in the Wall Street Journal’s Outlook column we see a succinct explanation of some key methodological issues. This is a valid point confirmed by a today story in “How Stock Options Muddle The Relationship Among Wages, Corporate Profits, and Inflation." Those pesky stock options, they're at it again.

The basic story: American workers earn more pay than the government thought; the Commerce Department's Bureau of Economic Analysis has been understating employee income (no doubt fueling dissatisfaction among US workers when they see a continual stream of news saying it is so), and overstating corporate profits thus in turn overstating Gross Domestic Income (GDI). How interesting that this line of misinformation directly supports the left-wing contention that those greedy corporations are making more money but the poor rank-and-file workers are not. Erase, erase. (I would have thought that a Republican administration would have been on top of this and ensure that the story was fixed, to their advantage.) Further, this increase in “wages” is not inflationary because “corporations don’t think of stock option expenses ordinary labor compensation” says one tax and accounting expert. I guess that expert missed the 22-year debate over stock option expensing culminating in FAS123R.

But now just as the light bulb appears to have come on regarding stock options, the BEA needs to continue their education in compensation and understand that a because some firms are using restricted stock or restricted stock units (RSUs) the tracking of option gains may miss that too. They also are probably missing income and gains from employee stock purchase plans (ESPPs) and some of that is capital gain, not ordinary income. Of course, if they’re not including the Alternative Minimum Tax items and capital gains from Incentive Stock Options (ISOs) they are missing still more pay. Did they really forget to count that $289 million Omid Kordestani from Google earned last year?

I teach courses in Accounting and Finance, Executive Compensation, and Advanced Executive Compensation for WorldatWork, the association for compensation professionals. I invite the Commerce Department and Department of Labor to send their statisticians and analysts to my course – we even offer a webcast version so they don’t have to leave Washington DC – and I’ll help them understand all of the ways employees are paid in America as well as helping them understand the difference between GAAP accounting and tax accounting. (For example, the tax deductible "expense" resulting from an option exercise may reduce profit by IRS rules but is a cashflow windfall for the company.)

That can be my public service for the year and then I can return to helping companies in the private sector figure out how to pay their employees effectively, whether the US Government defines it as “pay” or not.

The New ROI of Executive Pay

Fred Whittlesey
Compensation Venture Group, Inc.

In May 2006, I presented at WorldatWork’s Annual Conference a session titled “The Real Meaning of ROI…for HR Professionals.” It was a financially-oriented look at how HR folks need to present their ideas – in dollars, just like the other areas of the business organization. I was thrilled to learn that it was named “Best of Conference” (though the dog show “best of breed” comes to mind) based on attendance and attendee evaluations and I have been invited to present it again, as a webcast, on 01 November. I was particularly pleased that such a highly technical and complex topic was so well-received by an audience not known for its financial savvy (sorry HR people, but I’ve been teaching the WorldatWork Accounting and Finance certification course for the last 10 years and there just are not many in our field with that particular competency). One of my professional colleagues said he had never seen so much information presented in such a short period of time (75 minutes).

Since receiving the invitation to present this webcast I’ve been pondering how it needs to be changed and updated because my presentation slides are never done, only submitted and immediately agonized over. I also was wondering, now that I had become my own hard-act-to-follow, what I might propose for next year’s Conference.

This week I participated in a two-day webcast on the new SEC rules for compensation disclosure (I know, you think I just had an attention deficit moment, but hang in there, I’m going somewhere with this). Somewhere during John Olson’s keynote address on day two I had one of those professional epiphanies, the “aha!” experience.

The costs of designing and administering executive compensation plans, particularly equity-based executive plans, is significant. Moreso for global plans. As accounting and tax rules have both constrained and enabled the features of these plans, the design and administration costs have increased. The new SEC disclosure rules add more cost, due to both the processes required and the documentation and reporting of those processes and decisions.

So, (in Seattle we love to start our sentences with “so” and I don’t know why) it became clear to me that we, as a profession and as a group of professions (accounting, tax, HR, law, plan administration) have never, ever attempted to calculate the total cost of the intricate equity-based compensation programs we collectively design, and relate that cost to the compensation delivered through those plans.

Well, I just lost some friends there and made some new enemies. As either Benjamin Franklin or Thomas Jones may have said, friends may come and go but enemies accumulate. Interestingly, there has never been a time when executive compensation – as a topic, a concept, a practice – has had so many enemies. The new disclosure rules will provide more fodder for shareholders, pay critics, and the media to take potshots at executive pay practices and, more critically, the members of the Boards of Directors approving those practices. And by extension, their advisors. There will be knee-jerk reactions, poor decisions, and then revisiting of those decisions a year later. That creates more design work, and more professional fees and internal costs, and may reduce ROI.

Here’s an idea: we measure the ROI of executive pay. Is that possible? Has it been done? Well, the ROI models I developed for last year’s WorldatWork Conference – and which I’ve been using for over 20 years after learning the concepts from my mentor Eric Flamholtz, the father of Human Resource Accounting - can be applied to this problem. There is a New ROI of Executive Pay and I hope to be presenting those ideas at the 2007 WorldatWork Conference. In the past few days I have constructed an interesting model that Boards of Directors will want to use to grapple with the uncharted territory we all are facing. It’s new, it’s financial, and it’s going to raise a lot of tough questions.

A Little Hard on the HR Profession, Huh?

Fred Whittlesey
Compensation Venture Group, Inc.

That was the one-line email I received after sending my article "The Governance Implications of Option Backdating," just published in the Corporate Governance Advisor, to a client of mine. He happens to be the SVP of HR. I won't post the entire article here but rather will refer you to the publication's website and will post the section that led to my client's comment:

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Where was HR in the Governance Process?

“How could this have happened?” continues to be asked. Just this week, one human resources (HR) publication suggested that the human resources function – which as a group seem to be continually looking for a way to attain a status on par with their financial and legal peers – should serve as the internal watchdog for option granting practices.[i] In at least one company, however, HR was not only failing as watchdog but was the fox in the henhouse.[ii] If HR is taking the stance, or supporting other managers’ stances, that “everybody’s doing it” or “we need to do it to be competitive” then they failed at one of the few ways that HR can really add demonstrable value. That lost potential value is easily seen in the accumulation of costs now being experienced by these companies.

The overwhelming cost being incurred by some of these companies to correct accounting, legal, and tax problems (plus any employee financial issues) shows that HR may have acted as a “cost center” than anyone imagined. The cost of certain option redemption programs alone arguably exceed any value that the HR department could ever add.[iii] Add to this the increased cost, and perhaps restricted availability, of Director & Officer liability insurance coverage; the impact on valid options that are now underwater due to share price declines; the associated turnover and difficulty recruiting; the list goes on.

If HR argued that it was a matter of employee morale in volatile stock price companies, as appears to be the case at Microsoft and Micrel, HR failed because there are ample solutions to this concern without violating rules and laws. It now appears that merely paying employees additional compensation in some form may have been a much less expensive approach to dealing with volatile strike prices than the creative but disallowed option timing and pricing tactics.

Since the passage of Sarbanes-Oxley, there has been a continual migration of tasks and functions out of the HR department to the finance and legal areas, and to outsourcing firms. The backdating situation highlights the need to ensure that any task with mission-critical financial impact is managed by financially competent professionals with appropriate Board oversight. We now have confirmed that putting option grant processes in the hands of recruiters or HR managers can be a recipe for disaster.

[i] “Stock Options Scandal Might Put HR in Watchdog Role”, Workforce Management, August 5, 2006.
[ii] U.S. v. Gregory L. Reyes and Stephanie Jensen, July 20, 2006.
[iii] Brocade Communication Systems, Inc. Tender Offer as disclosed in Tender Offer filing 005-5697706908006, May 12, 2006.

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(Wow, Blogger has nice code, even the footnotes automatically transferred in from a simple copy-paste out of Word of the referenced text. Pretty cool.)

My response to him? "Yes, but most of them deserve it, present company clearly excepted" which is the case on both counts.

Was I a little hard on the HR profession? Probably not nearly as hard on it as the current stock option scandal is going to turn out to be.

In closing, I suppose some of these option backdating companies' actions qualify them for a spot in the Stupid Compensation Plans file, but I won't add further insult to the extensive injury they're experiencing. [Stand-up comics would call that a "callback" (see my most recent blog) but this situation isn't funny and there needs to be some real change in compensation management processes.]

By the way, have you noticed how many companies now have the head of compensation and benefits reporting to the CFO, rather than the VP of HR? Hmm. A little hard on the HR profession, huh?

Blast From the Past: Stupid Compensation Plans

Fred Whittlesey
Compensation Venture Group, Inc.

I was doing an online search for things related to my name (one has to monitor that sort of thing) and found a link to an article in CFO.com titled "No Pink Cadillacs Here" from June 2000 regarding Mercury Computer Systems' giving Porsche Boxsters to "nearly two dozen" top executives. This was a result of the CEO's idea that they would earn these cars if they could "turbocharge the stock price" - the price tripled from January 1999 and they got the cars.

My none-too-subtle quote that the writer cited was: "I have a file labeled 'stupid compensation plans,' and this is going in it," says Fred Whittlesey, a principal at Compensation and Performance Management Inc., in Newport Beach, Calif. He thinks the executives' stock options are ample reward. "If I were a shareholder, I'd be upset," he adds. (CPM was the independent compensation consulting firm I founded and operated from 1991 through 2000.)

Of course, the CFO of Mercury - G. Mead Wyman - took issue with my comment, saying "When you look at our total budget for recruitment and retention, $250,000 a year for two years is not out of line with the things we do," he says. He was referring to the cost of the Boxsters. I was referring to the fact that this was a huge waste of what he says was the $250,000 cost for the stupid compensation plan.

Fair enough. So what happened since then? Mercury's stock price ranged between $11.50 and $13.50 (split-adjusted to current) during January 1999. By June of 2000, when the Boxster Bonus was given, it had indeed tripled. Where is it now? It closed yesterday at $13.60. The CEO, Mr. Bertelli, is still the CEO despite having created no sustained value for shareholders over the time period we're discussing here. Mr. Wyman retired in April 2002 when the stock price was still trading around $30. Nice timing.

So, while I started to have second thoughts about my quote, I have concluded that a Stupid Compensation Plans file is as important now as it was then and I was indeed right about Mercury Computer Systems and their Boxsters.

In a time when executives are expected to buy and hold their company's stock I should disclose that I purchased a Porsche 968 (in some respects the higher-end predecessor of the Boxster) in 1