Blogging Around

It's been quite a while since I added to this blog...since joining Buck Consultants I have a few constraints on what I can write and where. But there are many new pieces of content you'll find of interest:

On the CompensationStandards.com Advisors' Blog:

Rethinking Equity Valuation

Stop Before You Swap

Counterpoint: Or Might Stock Option Use Go UP?

IFRS: Here Before We Knew It

The Global Equity Organization (GEO) Podcast Series:

Keeping Up with Fred Whittlesey

And a couple of articles of interest:

Published by Stock & Option Solutions:

Differentiating Equity Grants: The Dilution Solution

Behavioral Economics and Equity Compensation

A chapter in GEOnomics 2009

You also an access many of my other articles and conference presentations the Buck Surveys site

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 1994 and still own that car today, holding it through booms and busts because I believe in its value (but really because I love to drive it). I wonder whatever happened to those Mercury Boxsters? We know what happened to the shareholders who bought Mercury stock in June 2000.

Financial Solutions for HR

Fred Whittlesey
Compensation Venture Group, Inc.

I think many were taken aback by my three-part infomercial published and distributed at the SHRM Conference. In it, I suggested that HR continues to overlook the need for financially-oriented business-based solutions as the field continues to get waylaid into concepts like "work-life" and such.

Not being a soccer (sorry, "football") fan, I have paid scant attention to the World Cup. Before you conclude that I just did a random change of topic from the preceding paragraph, read on. I probably wouldn't have noticed the blurb in the 03 July 2006 issue of Business Week, with a photo of face-painted, flag-waving fans, had they not printed this in red ink: "Companies pay a premium of 2% to 4% of an employee's salary. In return, the policy covers the cost of an AWOL worker's salary for up to two days..."

Following my reading of this article I Googled around and learned that World Cup-related absenteeism is apparently a worldwide HR issue (decidedly more pronounced outside the US than inside) and that there has been a fair amount of thinking and writing about how to address this thorny HR issue. How should HR deal with the possibility that 15% to 20% of the workforce - or more! - may no-show on a day when the home country team is playing? And if that turns into a two-day no-show due to those employees having watched the game in a local pub and suffered the morning-after consequences? This is HR's concern.

The solutions proffered range from wide-screen TVs in the workplace (Why is it better that the employee comes to work and then spends their time watching a soccer, sorry, football game? That one baffles me.) to other solutions including communication meetings with managers and employees to emphasize the importance of coming to work; arranging for flexible schedules so fans can watch the game and come to work earlier or later; ensuring good communication with non-fans so they don't feel slighted; and so on. The usual fluffy HR stuff.

The Business Week article reports that Dutch insurance broker SEZ developed a financial solution to this. (Apparently this is a severe problem in the Netherlands.) After all, it's not a "people problem" that people don't come to work, it's a financial problem. If the people don't come, they use a sick day, or a vacation day, or lose a day's pay. If we were to treat them like adults instead of schoolchildren, we would allow them that choice and hope they gave advance notice. The financial problem is that the company then has to hire a temp for a day or two, at roughly twice the price, or suffer the profit impact of the missing employee.

SEZ developed an insurance policy that allows the company to pay the premium of 2% to 4% of salary and in the event of a "loss" (loss of employee attendance) the policy pays enough for a temp (or that amount could presumably be applied to cover the lost profit). This was first offered about four weeks ago according to Business Week.

The result? About 600 employers purchased a policy.

While some employers are buying TVs so that employees can be paid to work while watching the soccer, sorry, football game others have hedged using a financial product and left the "work-life" nonsense behind. The employers maintain their profitability, the employee takes the day off to watch the game, and everybody wins. No HR needed. How about that?

Updating Option Backdating

It was inevitable that the option backdating scandal would breed a number of cottage industries, so we have a new backdating blog niche as highlighted in a San Jose Mercury News article. I won’t point out that I was blogging on this topic for the past few months including the well-known If You Give a Moose a Stock Option, but I guess to be included as a backdating blog one is only allowed to discuss backdating. Maybe I’ll limit this posting to that topic and see what happens. Or maybe the Mercury News writer doesn't have children and couldn't understand why anyone would give a moose a stock option.

Now that we’ve begun exploring what the backdating scandals mean for Boards of Directors, executives, employees, lawyers, and accountants, HR might be the next target, as discussed in Stock Option Backdating: Another Crossroads for HR? This is one of a three-part article being distributed in the daily conference newsletter (hard copy only, it doesn’t seem to be online) at the Annual Conference of the Society for Human Resource Management.

If you are interested in exploring the global ramifications of improper option granting practices, attend Global Equity Organization’s webcast International Implications of Grant Backdating on 6 July at 16:30 GMT (that’s 8:30am PDT for those of us on the west coast). I’ll be co-presenting with Bill Dunn of PriceWaterhouseCoopers and covering the variety of activities that have been lumped under the “backdating” label – spring-loading, smoothing, early granting, late granting, and opportunism – as well introducing the widespread financial, regulatory, and other implications of each.

This seminar is complimentary and has limited registration space. For more information, visit Web Seminar Registration or to register, visit http://www.regonline.com/100508

Executive Compensation: Complex and Complicated

Fred Whittlesey
Compensation Venture Group, Inc.

A photographer took a photo of a man walking down the street. When the picture printed out, only half the photo printed on one sheet and the other half on the next sheet. A journalist concluded by looking at the first half of the photo that a miracle had occurred – a man was able to walk down the street with only one leg, his left one! The next week, the journalist found the second photo and claimed yet a second miracle had occurred. This same man had his left leg surgically transplanted to his right side (no doubt because he is right-handed, the journalist concluded) and was already able to walk again! That story is only slightly less ridiculous than the one I read in the Wall Street Journal (page B1) on Thursday. It is what may be one of the poorest and most misleading articles every written on this topic: “Tech CEOs’ Pay Falls as Firms Cut Out Options.” If I put my 4-year old behind the wheel of the car and sent him off down the street I think he’d fare slightly better than this reporter did in covering this topic.

That same day I attended the Annual Conference of the Silicon Valley Chapter of the National Association of Stock Plan Professionals - a gathering of over 150 equity compensation professionals (plus one writer from the Wall Street Journal, not the author of the article cited above) - and made a presentation about understanding the increasing complexity of executive and equity compensation. From a selfish standpoint the timing of the WSJ article couldn’t have been better.

I was once in a Board of Directors meeting in which one director said the compensation plan I proposed was too 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. In this article, the reporter concluded that, like the one-legged man incident, a CEO had received an “86% pay cut” from one year to the next because he had received a large stock option grant, with multi-year vesting, when hired in 2004 (a "new-hire mega-grant") then only a small RSU grant in 2005. The company confirmed this was the rationale, but this didn’t affect the Journal’s reporting of it. The story went further and interpreted that - because companies have successfully lowered the expense they are reporting for stock options through actuarial tactics and because many companies’ stock prices continue to deteriorate – the same number of options granted on lower-priced shares represent a “pay cut” compared to the options on those higher prices shares that are now underwater and currently worthless. At the Conference, data was presented by the same firm that provided the WSJ with the data, showing that the mix of options and restricted stock (and restricted stock units) is changing for paying CEOs, but that data had some of the same problems and the presenter made some of the same misinterpretations.

In my presentation at the Conference, I cited an example of a Seattle company, Cutter & Buck, that just announced an intricate performance-based vesting schedule for its stock awards to executives. The award is divided up into literally dozens of different pieces that vest either over time or as a result of performance. Complex, but fairly easy to understand. I have to include some of the disclosure here for you to fully appreciate it:

Under each of these grants, the vesting of Sixteen and Sixty-six hundredths percent (16.66%) of the granted shares is subject only to the continued employment of the recipient by the Company, and Eighty-three and Thirty-Four hundredths percent (83.34%) of the granted shares are subject to certain performance-related vesting contingencies. Specifically, the vesting of Forty-one and Sixty-seven hundredths percent (41.67%) of the granted shares is conditioned upon the achievement by the grant recipient of certain pre-established individual performance objectives, which may include, for example, sales growth within the Company’s sales channels during the Company’s fiscal year ending April 30, 2007. Similarly, the vesting of Sixteen and Sixty-seven hundredths percent (16.67%) of the granted shares is conditioned upon the achievement by the Company of at least Eighty percent (80%) of its pre-tax operating income target (the “Income Threshold”) during the fiscal year ending April 30, 2007, and the vesting of Twenty-five percent (25%) of the granted shares is conditioned upon the Company’s achievement of pre-tax operating income levels in excess of the Income Threshold, with each additional percentage point by which the Company surpasses the Income Threshold resulting in the vesting of an additional Six Hundred Twenty-five thousandths percent (.625%) of the total grant, up to a maximum of One Hundred Twenty percent (120%) of its pre-tax operating income target for the period.

Executive pay is complicated – 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 vesting schedules, performance acceleration, and performance vesting features and it is indeed “difficult to understand, analyze, or explain.” Because journalists insist on measuring pay annually and don’t take the time to understand the complexity, however, articles like the one in Thursday’s Journal article end up reporting something that didn’t happen and is simply not true.

Pay will continue to get more complex. As it does, sometimes it will be clearly disclosed as likely to be required by the SEC’s proposed rules. Sometimes it will be so complex, or so poorly explained, that it will seem very complicated. 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.

Opcni bonusy: V USA zacina "pripad stoleti"

Fred Whittlesey
Compensation Venture Group, Inc.

I wish I could tell you what this article, published in Financni Poradce (CZ), says.

The sentence that caught my eye was “…San Francisco Chronicle Fred Whittlesey sef poradenske firmy v oblasti odmenovani zamestnancu Compensation Venture.” The article also mentions the SEC, Christopher Cox, CNN, Bloomberg, the Wall Street Journal, and Marvell Technology so I’m in good company.

I assume it must be an article either on CEO pay or option backdating but because it mentions a couple of the backdating poster children – Affiliated Computer Services and Comverse Technology – so I think I don’t need to know Czech to figure out which it is.

Whether it’s CEO pay or option backdating in the US, it is fascinating to me that the business media in the Czech Republic are talking about it. The US business community is not exactly serving as a global role model on either point right now.

If any blog readers are fluent, or even somewhat knowledgeable, of the Czech language please let us know what this article is about. I couldn’t find a free web-based translation engine that included Czech and I spent way too much time on Google trying to figure this out.

Here’s the link to the article: http://fpweb.ihned.cz/1-10083260-18537640-Q00000_d1-aa

50 Ways to Pay Your Board of Directors

Fred Whittlesey
Compensation Venture Group, Inc.

I think Paul Simon had it relatively easy when he composed Fifty Ways to Leave Your Lover as he only identified five of them in response to the woman’s question. My recent research into compensation practices for members of public company boards of directors finds there are 50 ways to pay your directors (so that they don’t leave and they love you). Yes, 50 different forms of pay are currently being offered to directors of public companies (excluding benefits coverage, deferred compensation plans, and various perks). I may be off by one or two but certainly not off by 45.

Director pay levels have risen by triple digit percentages over the past few years – due in large part to the increased undesirability of public board service in the Sarbanes-Oxley environment – and at the same time has become extremely complex as various roles have emerged and increased in market value. Additional pay is provided for independent board chairs, lead independent directors, committee chairs (with premiums paid for audit and compensation committees), committee service, and special committee work (with “special” often meaning “the company is being investigated and you don’t seem to be implicated so you’re on the committee - congratulations”). The combination of these roles multiplied by the use of cash retainers, cash meeting fees, initial option grants, annual option grants, initial share grants, annual share grants, and various hybrid forms of these quickly brings us to 50 forms of pay being used.

Most analyses of director pay, however, are rooted in the good ol' days when reporting the basic elements told the story – annual retainer, meeting fee, options. Now it is necessary to capture all of the elements of pay, value them, calculate actual pay delivered based on board activity levels, and then compare across companies.

Given that board pay structures range from high-risk entrepreneurial (options only) to low-risk not very entrepreneurial at all (cash and shares) it is necessary to understand how much pay will be delivered under various performance scenarios. The Coca-Cola Company’s recent announcement about director pay, the highly criticized attempt at pay-for-performance it is, reintroduced the notion that director pay like executive pay should have a direct link to company performance. Simplistic analyses of retainers, meeting fees, and option grants no longer provide accurate and meaningful data on director pay. A comprehensive gathering of all forms of data viewed through a performance model is required to understand the whole story.

In the software sector, a sample of 35 companies reveals that no two companies pay the same combination of 50 different cash, share, and option elements for the same reasons. That’s right – each company is different from all the others and it takes 50 columns on a spreadsheet to figure that out. (My statistician colleagues would argue that if this holds true across a larger sample then there are probably hundreds of ways to pay directors but that would blow the Paul Simon analogy.) Then it takes a few more spreadsheets to figure out who gets paid for performance and who doesn’t. As a compensation consultant that’s what I get paid for, so I’m not complaining. It just makes for a long answer when someone asks “what are other companies doing about director pay?”

Understanding pay levels and practices for public company directors has become just as complicated as being one. Maybe that’s appropriate. It requires some sophisticated data gathering and modeling, however, to understand how much they’re being paid and whether that pay is based on performance or merely based on membership and not even attendance.

If You Give a Moose a Stock Option…

Fred Whittlesey
Compensation Venture Group, Inc.

Publisher’s Weekly used the phrase “…the complexities that can follow a simple act of kindness” regarding the book If You Give a Moose a Muffin. For those who’ve read that story, or others from that series by Laura J. Numeroff, the complexities are never envisioned from the simple act of giving a moose a muffin.

Companies that recently have been accused of backdating or suspiciously timing the grants of options to executives and employees are about to follow a similar path and see an uncanny similarity to that bedtime story they’ve been reading to their children all these years. While these actions have attracted media attention, investigations by the SEC, and continued public furor over executive pay shenanigans, the story really is just beginning. On top of any ethical and criminal implications, the complex rules surrounding equity-based compensation make this fascinating (for an equity-based compensation geek like me).

Accounting
If you give a moose a stock option and it turns out that the option was granted at a price lower than the fair market value at the date of grant you in fact gave the moose a discounted nonqualifed stock option. A company that didn’t think it gave the moose a discounted option didn’t recognize an expense under APB25 for that option and didn’t appropriately calculate the Black-Scholes value for FAS123 reporting of the discounted option. Now, under FAS123R the amount of the expense on the income statement is incorrect (although ironically it is lower under FAS123R than it was under APB25 due to the quirks of option pricing models). As a result, all financial statements issued since the date of grant misrepresent the company’s financial condition, perhaps by a material amount. In the world of Sarbanes-Oxley, the Chief Executive Moose (CEM) and Chief Financial Moose (CFM) who knowingly signed off on those financial statements might now go to Moose Jail for reasons in addition to basic fraud and securities laws violations.

Of course, if bonuses were paid based on the incorrectly reported financial results those bonuses may need to be refunded to the company to the extent the bonus amount was inflated by the absence of expense for the discounted options.

Tax
If the moose thought he had an Incentive Stock Option, instead of a nonqualified option, he probably didn’t report ordinary income at the date of exercise but included that amount of the gain as income for purposes of the Alternative Minimum Tax. Poor Moose. It turns out he owed ordinary income tax in the year of exercise and is delinquent, owing taxes, interest and penalties. That’s one for the CPAs to sort out, especially if Moose exercised unvested options with an 83(b) election.

Adding to Moose’s tax woes, any options that vested after 2004, per Section 409A, were taxable at the date of vesting even if they are not yet exercised so Moose owes taxes, excise taxes, interest, and penalties on those paper gains too. And the company is liable for not withholding the required taxes on that taxable event, and thus further misreported its financial transactions. Hopefully the CEM and CFM can serve concurrent sentences.

Of course, gains from discounted options are not a tax-deductible compensation amount under Section 162(m) – the million dollar cap rule - for the CEO and four highest paid officers, so the company’s tax returns and financial statements are further incorrect.

Shareholders, Exchanges, and Regulators
If the company’s stock option plan, approved by shareholders, expressly prohibits the granting of discounted options, it seems those options in fact couldn’t have been granted from the plan but the securities lawyers can chime in on that. For SEC insiders I think this means the option grant was not an exempt transaction under Section 16(b)-3. Poor Executive Moose has problems with the SEC because he didn’t file the appropriate paperwork at the time of grant and may be guilty of insider trading. But the company has even bigger problems if they advised the executive on those filings and are liable for those incorrect filings.

And those shareholders might be angry that they approved a plan on the basis that no discounted options by the company would be granted at all and the company tricked them into voting in favor of the plan. Stock exchanges requiring shareholder approval of any grant except for certain “inducement” grants (which would have had to have been identified and disclosed at the time) means these grants would then be in violation of exchange rules. If the company’s proxy statement issued each year since the grant of the option said those options had been issued from the plan, but they now were not, those disclosures were all incorrect in addition to the failure to disclose the proper grant price. There are other potential legal issues but I’m not a lawyer so I’ll stop there.

Muffins and Jam
If you give a moose a muffin he’ll want some jam to go with it. If you give a moose an option, sometimes apparently there isn’t enough earning potential in those and he wants a discounted price to go with it. Maybe he’ll want to be reimbursed for the liabilities created from that option. And if you reimburse the moose he might want a tax gross-up to go with it because when he's eaten all your muffins, he'll want to go to the store to get some more muffin mix. Maybe that’s what drove these companies to take such huge risks to deliver additional pay through backdated or suspiciously-timed option grants.

These mooses are definitely in a jam.

The Myth of the Average Worker Pay Ratio

Fred Whittlesey
Compensation Venture Group, Inc.

Are CEOs overpaid? Many people think so. If so, many potential causes have been identified: CEOs with too much power, inattentive boards of directors, conflicts of interest by compensation consultants, the use of stock options – the list goes on. Depending on the source, the average CEO in 2005 was paid $10 million to $15 million dollars. This calculation usually includes base salary, annual bonus, payouts from multi-year bonus plans, cash-outs of stock options that were granted as much as ten years ago, and new grants of unvested stock and stock options that have only theoretical value today.

Are rank-and-file workers underpaid? Everyone, I suppose, feels a little underpaid. Depending on the source, the average American worker was paid about $40,000 in 2005. This figure includes base salary or wage and typically excludes overtime, tips, bonuses, and gains from stock-based compensation. The potential causes of this are deemed related to CEO pay – greedy executives, putting profit over people, etc.

Are CEOs overpaid compared to rank-and-file workers? If you read the media stories this year, and in previous years, you might conclude that they are. Many interest groups have determined that the ratio of CEO pay to the “average worker” is an appropriate measure of this problem. Some websites allow you to calculate exactly how underpaid you are compared to your CEO. According to these sources, CEOs are paid between 250 and 500 times that of the average worker, whoever that is.

Before we assess how much pay an executive receives relative to other workers, however, we need to ensure we have measured the pay level of each properly. Then we need to decide whether that is a relevant comparison.

Measuring executive pay

Who are these average CEOs that are purportedly paid hundreds of times more than the average worker? In most analyses, they are CEOs managing the largest public companies in America – usually the top 250, 350, or 500. These are the largest of the 10,000 or so public companies - the largest 3% to 5% of corporations in the country. Given that most managerial jobs pay more for managing larger operations and all other things being equal, we might expect these individuals to be among the top 3% to 5% in pay and we should not expect that they are paid at the average rate for CEOs managing any of the other 10,000 companies, some of which are only a few million dollars in revenue per year.

These large companies, being publicly-traded, all exist for the purpose of generating profit and value for shareholders. There are no private companies, government agencies, or non-profit organizations in the sample. Public companies generally pay their managers more than organizations in these other sectors and have types of pay available, such as stock options, that the others do not.

While this data indicates we might expect these CEOs to be among the highest paid people in the country it’s more difficult to arrive at a factor regarding the relative value of the individuals in the job. Most CEOs I’ve dealt with are highly intelligent, have advanced degrees - often from one of the top universities in the country, or the world - and have worked 70 or more hours per week for most of their career. Even if they weren’t CEO of a public company, people with a resume like that get paid much more than the average person.

The biggest issue in this, however, is the double-counting that goes on. I’ve never understood how one can justify adding together the gain on a stock option granted in 1996 and the theoretical value of an option just granted in 2005, plus the value of theoretical value unvested restricted stock granted in 2005, and include those in “pay” for 2005. There are related issues such as the notion that the “value” of a stock option (and thus the amount included in the pay calculation) is the amount the individual will have to pay the company to exercise that option someday, once it is vested. This is absolutely misleading and absurd. Yet leading business periodicals use the data from well-known data sources to report executive pay this way year after year.

Measuring worker pay

If we want to understand the pay level of the average worker in America, we would have to ensure this included a representative sample of workers of all kinds from companies in all industries, all education and experience levels, and so forth. We would have to ensure we included all forms of their pay – wage or salary, shift differential, overtime pay, bonuses, tips, commission, and stock-based compensation. Without digressing into which sources do and do not do this (hint: none do) it would in theory provide a good portrayal of how much the average worker is paid for his work. We would assume that these are average performers with average levels of education, and so forth.

And, we would want to be confident, too, that, those numbers represent pay for just one year, as no sensible analyst would add together pay numbers from the past 10 years with those from last year and call that “pay” for last year, would they?

Comparing workers

I can’t recall seeing a comparison of how much software engineers are paid versus postal workers, or how much superior court judges are paid versus bank tellers. I think this might mean that no one believes these would be relevant comparisons because different jobs with different educational requirements and different levels of responsibility should be paid differently. We don’t always know or agree how differently, but differently.

Because we’re comparing the average American worker’s pay to CEO pay, we would have to ensure that we’re including all non-CEO positions in that data – software engineers, postal workers, superior court judges, and bank tellers because they are part of the American workforce. We also would include CFOs and Executive VPs and Managing Directors as well as entry-level counter staff at fast-food restaurants. I think we all agree it wouldn’t be fair to exclude other non-CEO executives from that calculation, correct?

Now that we have constructed a fully representative sample of American workers, we’ll have to limit it to those that work for the 250 or 350 or 500 largest American public corporations just for it to be a fair comparison. We should probably only compare to the top 5% performers among all the non-CEO workers, particularly since this is America and we believe in pay for performance so if we’re looking at a group of top CEOs we should compare that to a group of top non-CEO employees. We then we could calculate a more accurate ratio between CEOs and all other workers.

And it would still be completely meaningless. If that’s how you like to spend your time to push your particular political agenda, however, I now feel that I’ve done everything I can to ensure an apples-to-apples comparison.

Having said that…

I am in no way trying to serve as an apologist for high executive pay levels. After more than 20 years in the field of executive compensation I have seen numerous examples of inappropriate pay for executives – not only in amount, but in reason and in form. Billions of dollars have been paid to thousands of executives who have ruined companies and workers’ lives. I have seen executives join a company shortly before a takeover and get millions in “change in control” payments. (Those payments, too, often appear in the executive pay calculations but not in average worker calculations and tend to inflate the ratio a bit.)

I also have seen numerous examples of inappropriate pay for nonexecutives – sales representatives that made far too much pay due to a flawed incentive plan; a receptionist earning more than double the market rate because she had been with the company for decades and there was no pay cap for any position; software engineers that joined a company at just the right time and cashed out their stock options just before the stock price crashed and the company went out of business due to a poorly developed software product. I have a friend who has a knack for joining companies shortly before they do major restructurings and layoffs; she’s made hundreds of thousands of dollars in retention bonuses and severance pay yet always found her next job right away…or contracted back to the company that just laid her off at double her previous pay rate, on top of the severance pay. (If that kind of data was captured in the “average worker pay” calculation, which it is not and never will be, the ratio might look a little different.)

If there is an excessive CEO pay problem, we won’t fix the problem by measuring the wrong things and then misinterpreting already flawed calculations. That only will encourage misguided legislation and we’ve had plenty of that. It also might encourage big shareholders and their advisors to begin bullying companies into change using arbitrary standards, and we’ve had plenty of that. Disclosure and publicity of pay allows us to identify the egregious situations and apply pressure to fix them but only when the data seem accurate to reasonable people.

I just read that U2 made $236 million on their 2005 tour - $3 million per show (about $1 million per hour) - which was far above Motley Crue’s $33 million for a similar number of shows (a paltry $400,000 per show, well under $200,000 per hour). I don’t think most Americans want to impose an arbitrary cap on CEO pay any more than we want to impose a cap on U2’s concert tour receipts because we know U2 would stop touring, and good CEOs would stop CEO-ing, and neither of those are to our benefit.

So let’s start focusing on the real problem and not on concocted metrics rooted in socio-political sentiments. There is a lot of fixing needed in executive pay practices and these average worker pay ratios have the potential to send us in the wrong direction.

Global Equity Hot Topics

For those of you that find some of my blogs somewhat technical at times, you should attend the Global Equity Organization Annual Conference and experience the world I live in. Just this morning’s sessions were enough to demonstrate how complex it can be to pay employees around the world with equity. If you’re really paying attention, your head will hurt at the end of each day, but it’s a good kind of hurt.

I wish I could summarize every session but until I pick others’ brains at tonight’s GEO Awards ceremony I’ll have to limit my comments to the sessions I attended.

Beyond the Great Wall – Case Studies
John Bagdonas and Warren Miles (Computershare) plus Cheryl Spielman (Ernst & Young) discussed the complexities of equity compensation in China. If you thought learning the language was the most challenging aspect of venturing to this nation, you haven’t designed and implemented an equity compensation plan there. For many years employers have faced uncertainties due to the lack of regulation there, and recent introduction of some rules hasn’t made things much better.

Ironically, PRC - with its communist worker-oriented philosophy - somehow overlooked in its recent legislation the need for accommodating all-employee share plans. Recognizing the critical role that equity-based compensation can play in encouraging growth and profitability of enterprises, the government is (finally) addressing the topic in its securities and tax laws to help companies understand the rules but their clarification is thus far limited to executives and “key” employees. Of course, many global equity professionals would argue that all employees are key employees, thus the basis for all-employee equity plans. There is still the challenge that PRC prohibits Chinese nationals from owning shares of foreign companies but one cannot find a law stating such restriction, which is somewhat funny until you have to deal with it.

Key points learned: What I also found humorous is that the PRC treats the Hong Kong Stock Exchange as a foreign exchange. Go figure.

Key terms you’ll need to know to converse on this topic: CSRC, Circular 35, SOE, Red Chips, SASAC.

The Impact of Section 409A on Global Equity Plans
This panel - Bill Dunn (PriceWaterhouseCoopers) and Frederic Singerman and David Weiner of Seyfarth Shaw - discussed how the American Jobs Creation Act of 2004 and resulting US tax code Section 409A (the experts pronounce this “Four Oh Nine Cap A) continue to create jobs for lawyers, tax specialists, and consultants. Companies and their advisors are grappling with the complexity of a law intended to stem the abuse in nonqualified deferred compensation arrangements but resulted in unintended effects on equity compensation programs here and around the world. As difficult as this new set of rules has been for companies based and operating in the US, the implications for global firms are truly overwhelming. Mr. Dunn gave the example that a US citizen working in France and subject to taxation in the US who receives a non-discounted stock option there may receive what, under 409A, is a discounted option and have that option taxed at vesting (rather than at the time of exercise) as a result of the employer’s compliance with French law stating how options must be priced. Whew.

Key point learned: Continued uncertainty over the details of 409A creates an amazing minefield for companies pursuing even the simplest global equity plan designs. It’s ironic that many US firms failed in their attempt to export US-based equity plan designs to other countries, and now we are inadvertently exporting our tax rules, creating failures of otherwise successful plans.

Key terms you’ll need to know to converse on this topic: Four Oh Nine Cap A, transition rules, service recipient stock, permitted distribution, offshore funding.

Pleasing Institutional Investors – A Worldwide View
Damian Carnell and James Matthews of Towers Perrin (UK and US, respectively) presented a global perspective on a topic we read about every day in the US media: corporate governance - which is often manifested in stories about excessive executive pay. They point out, however, that the corporate governance movement had its roots decades ago in corporate scandals and actions unrelated to pay. In the US we are now accustomed to dealing with the influence of ISS and various institutional shareholders when seeking shareholder approval of equity plans. As one crosses international borders, the governance framework changes with varying reliance on legislation, regulation, stock exchange rules, and investor pressure, and disclosure. Also, I really liked their term “executive comp rehab” - not that any of my clients would ever need such intervention…

Key point learned: Interestingly, while many countries have incorporated their governance requirements into a single set of rules, the US has not, relying on a combination of stock exchange listing requirements, investors and proxy advisory firms’ guidelines, and various “blue ribbon” panels making it more difficult to understand just what the “rules” are particularly since many of them are in conflict with one another. You have to love the US’s free market approach to this!

Key terms you’ll need to know to converse on this topic: In the UK, ISS/RREV, Cadbury Code, Greenbury Code, Hampel Code, Combined Code, ABI, NAPF. There’s another set for each country and the list goes on.

Keynote: The Medici Effect: Groundbreaking Innovation
Frans Johansson (US)
I often miss the keynote general sessions but how could one not attend a session for which the introduction includes the teaser: “What do termites and architecture have in common? Music records and airlines? And what does any of this have to do with health-care, card-games or cooking? Most of us would assume nothing. But out of each of these seemingly random combinations have come groundbreaking ideas that have created whole new fields.” I thought I knew the unfortunate answer to the termites-architecture piece but found there was another angle I missed.

Mr. Johansson’s topic is particularly well-suited for a group of global equity professionals who come from a variety of technical backgrounds – accounting, tax, law, administration, human resources - and often stay siloed in their area as they think through equity compensation issues. We saw this over the past couple of years with the introduction of new accounting requirements for share-based payments (often labeled “option expensing”) that unfortunately have had a disproportionate impact on some companies’ equity plan designs to the exclusion of other financial considerations, strategic factors, and behavioral drivers. (Why, that’s exactly what I’m covering here in my presentation tomorrow at 2pm!) Diverse teams are the solution (Diversity Drives Innovation was a slide shown several times) says Mr. Johansson so I think that means that the accountants, lawyers, administrators, and even we consultants. need to step out of our siloes if we are going to provide innovative solutions for our clients and employers.

Key point learned: (1) All new ideas are combinations of existing ideas (2) People and teams that break new ground innovate and execute more ideas – the relationship between quantity and quantity of innovation.

Key terms you’ll need to know to converse on this topic: I think Mr. Johansson would prefer that you purchase his book to find this out (which you get for free if you attended this Conference). I already gave away his two key points and shouldn’t tell you his five key ideas for innovation.

Cops, Robbers, and Priests: Stock Plan Fraud and Ethics
Well didn’t these two - Carine Schneider (Smith Barney) and Emily Cervino (Certified Equity Professional Institute) - get lucky; one must choose one’s speaking topic many months in advance of the Conference and while stock plan fraud and ethics were already hot topics a few months ago, the recent scandals on stock option timing and backdating must have boosted interest in this session. Hopefully people didn’t misinterpret the fraud part of the title and think this was a “how-to” session as so many of the other Conference sessions are.

It actually was an excellent how-to session on the steps for avoiding becoming another poster child for stock plan fraud, a group which included in their session Cisco Systems, US Wireless, Mercury Interactive and HMT Technologies. I came away thinking that there is going to be a lot of blogging to do on this topic in the not-so-distant future.

Key Points Learned: I may be a bit sensitive on this point but the highest-fraud age group is 41-50 yet we, I mean they, are only third in the median value of frauds committed. The older the perpetrator the higher the median fraud amount – the over-60 group are the high performers here.

Key terms you’ll need to know to converse on this topic: Ends-based, acts-based, and duty-based principles; Section 302, Section 404, and – of course – SOX.

Someone will undoubtedly complain that while I listed the “key terms” I didn’t spell out the acronyms or define the terms. This is a blog, and if you were at the Conference today you’d already know!

Blog you tomorrow.

Global Equity Update

In the spirit of this week's Annual Conference of Global Equity Organization, I thought I would share something I became aware of thanks to Google Alerts. This is a blog from China about an article discussing Google and Intel's use of equity-based compensation and my quote on the issue.


矽谷工資水平大增 英特爾準備跟進加薪
矽谷工資水平大增 英特爾準備跟進加薪陳穎柔/綜合外電報導
全球第一大半導體廠商英特爾追隨矽谷加薪潮，擬進行調薪，以便吸引並留住人才。
英特爾日前表示，該公司員工薪水與紅利往後數年期間都會獲調高，該公司並計畫增加限制性股票的發行，以防範股權遭稀釋。網際網路泡沫破滅，一度使矽谷科技業的薪資水準成長減緩，不過現今在經濟回穩下，當地薪資節節高升，科技業也因而承受愈來愈大的加薪壓力。矽谷工資水平大增有部分原因源自網搜公司Google提供優渥薪資，英特爾薪資主管湯普森女士（Gaby Thompson）表示，Google一心想成為薪資為全美前三名的科技公司。
PayScale公司對外提供薪水資訊，該公司薪資長魏透希（Fred Whittlesey）表示，企業要招攬最佳人才，就得對薪資和機會加碼，Google所做就如過去一些公司的做法，該公司的確正朝著薪資第一名邁進。
根據經營工作登錄網站的Dice公司的統計，今年截至十月十日，矽谷科技專業人士的薪水平均增長二．一％，比名列第二的紐約市科技業平均工資增幅高出七個百分點，較西雅圖市多出將近二十八個百分點，亦即受調查地區整體而言僅矽谷調漲工資。
與此同時，英特爾已經開始擴大僱用更多海外員工，並以他們在其它科技公司的薪水做為給薪參考。截至目前，英特爾海外員工規模約為九萬九千人，比去年底多出一萬四千人。

Lots of Zeroes

It’s shareholder meeting season, and hundreds of companies released their information in proxy statements on executive pay. Many executives made tens, even hundreds, of millions of dollars last year, as the media like to count it, leading to continued concerns about excessive executive pay.

Remember the caveat in my recent blog about how the media counts these numbers. A lot of the pay attributed to last year is the result of executives exercising options that are up to 10 years old and in many cases had to be exercised last year before they expired. These gains represent years of hard work, managing through the bubble and the bust, and are often reflective of significant long-term shareholder value creation. Case in point is the article in which I was quoted (misquoted actually, but that frequently happens) regarding Boeing. Even where that was not a factor, the continued adding of apples, oranges, and bananas gives us mixed fruit, not an accurate apple count. Many of the media stories that compare these pay numbers to last year’s share price performance are not only absurd but intentionally misleading because the writers and their consultants know better. Admittedly, there are overpaid executives in some companies, especially when company performance is considered (which requires matching the time period of pay with the time period of performance, not a simple calculation). In the past week, however, I have encountered some pay and performance issues myself, such as the cook at the restaurant that burned my little boy’s grilled cheese sandwich not once but twice (how hard can that be?). I’m a big fan of pay for performance and conclude that overpaid and underperforming employees are distributed throughout our economy, at all levels of companies, and often seem to be clustered in the businesses I deal with. They don’t have their pay and performance published in the paper but I’m happy to help spread the word.

These executives made a whole lot more than just about anyone reading (and certainly anyone writing) this blog. Some organizations are obsessed with calculating exactly how much more these executives earn than the so-called “average worker”. I am encouraged if some of those executives are reading my blog because I think they could learn a lot about some of the fascinating technical aspects of compensation, not to mention the added bonus of hearing my opinion, which is that comparing executive pay to that of the average worker is meaningless, distorted, and incites unwarranted anger.

Many executives are good negotiators, some have professional negotiators working for them, and others might be good buddies with those on their Board of Directors who have a voice in determining their pay. (We can gripe about that last point all day and won’t change the fact that business is often done among friends and always will be.) Many others were in the right place at the right time. But others are brilliant strategists and managers who have managed a complex multi-billion dollar multinational corporation in a manner that has created enormous value for shareholders, employees, customers, and our economy. Yes, CEOs make hundreds of times more than we average folks do. There’s a complex set of reasons for that and continually complaining about it will not get anyone a 20,000% pay increase – they could, however, start a company that ends up being worth $10 billion and then they might earn $10 million a year, too. That would require enormous effort which is what many of these executives have expended and they’re being paid for the results.

These stories dominate the business section this time of year which limits the number of interesting topics to write about, but this next item is keeping things interesting. At least a few of the individuals mentioned in the news items above may have received additional compensation, beyond what was intended by the formal compensation program, due to a questionable practice in how their options were granted. It appears some companies may have granted options on days when the share price hit a low, ensuring the options produced gains much higher than they might otherwise have. When they missed that opportunity, they may have simply backdated the options when they were granted later. The most recently accused include UnitedHealth Group (whose CEO has about $1.6 billion in option value – no I did not misspell “million”) and Vitesse Semiconductor. “Yeah, these options were really granted a few months ago before that big price run-up that I just made a lot of money on. Yeah, that’s right, that’s the ticket.” (If you weren’t watching SNL in 1985 you might not get the reference to the Pathological Liar character but it seems fitting.)

I blogged about this earlier this week. We thought that after Enron, Sarbanes-Oxley, and a number of CEO perp walks that these kinds of things wouldn’t happen any more. Oh well, let’s roll out some additional legislation shall we? No, let’s just jail the crooks, if in fact a crime was committed, and not blame the problem on stock options. It’s costing Americans too much money to continue having these scandals eroding the confidence of US companies in the world’s capital markets.

Some companies reacted to these disclosures by either putting the individuals suspected of the behavior on “administrative leave” or by promising not to do it any more. I’m not sure but I think that if I had done something similarly unethical and illegal my leave might be much more than merely “administrative” – probably more along the lines of “incarcerative” and “refund-ative” (c’mon, that’s no worse than calling it ‘option-gate’ which some journalist inevitably will do.)

Pardon my tongue-in-cheek tone today, but reading a week of these kinds of headlines, for one who is dedicated to the field of compensation – and dedicated to professional integrity – requires maintaining a sense of humor about it at times. Too much time is spent on superficial numbers and analyses and not enough time on the real issues. Sometime soon I’ll write about the various “golden parachute” and severance deals that have produced some very excessive compensation for some very inadequate performers so that we can understand the real problems that need solving. Here’s a previous blog describing one example.

I be posting next week from NYC at the Global Equity Organization (GEO) Annual Conference where I will have to be very brief because I must spend less time blogging and more time attending critical events like the evening receptions. As everyone knows, that is where the real work gets done and I have a job to do. Maybe I’ll add a gossip section to the blog - though I wonder how compelling gossip among global equity professionals could really be: “I can’t believe what they did with their option term! This won’t help them a bit with their FAS123R expense and there were better ways to deal with ISS’s concerns on their plan.” This might set me up to say something like “you had to be there.”

What's New in Global Equity Plans?

To answer that question, I'll be spending the better part of next week at the Annual Conference of the Global Equity Organization (GEO). There will be over 350 global equity professionals from 14 countries meeting in NYC for this event. I'll be blogging daily from there for those of you who are unable to attend the event but need to know what is happening on such topics as the EU Prospectus Directive, cross-border tax withholding, global ESPPs, stock plan fraud, RSUs, SIPs, CSOPs, and more.

Shameless plug: My presentation is Friday afternoon, titled "After the Fall (of 2005): What Really Happened with Option Expensing in the US." The slides from that presentation will be posted on my website. This session presents our research, updated daily, on what companies have really done - and not done - in response to new equity compensation accounting requirements (fondly known as FAS123R).

You can visit this blog or go to the GEO site to access the daily news I'll be reporting. For other breaking news on HR-related issues you can visit the HR MegaBlog, which posts all new entries from this blog, or see my column on HR.com in the Areas of Interest: Compensation section.

Creative Compensation

As I discussed in my Compensation Integrity blog on April 19, the latest compensation scandal over the timing of stock option grants has created shock and awe. Would corporate executives and members of boards of directors really time the granting of options to catch stock price lows and ensure additional gain from those options? Or worse, would a company backdate an option grant? Would a company then try to make amends when record-setting option gains are suspected of being a result of such practices? Or would that just be too darn obvious?

Yesterday's news included the story that UnitedHealth Group is suspected of this behavior and the CEO has called for a halt to all equity grants to executives plus capping some other noncash perks and supplemental executive retirement benefits. I would just love to be the person who gets to do the calculation to see if these "givebacks" are comparable in value to the alleged ill-gotten gains from the purported option granting practices.

Other companies have recently been caught doing something similar, including Vitesse Semiconductor, and I can tell you there are many, many more. What is most surprising to me is that so many companies have been doing this for so many years, and so many company employees were aware of the practice, yet it took investigative journalism years later to uncover it.

My clients often ask about "creative" compensation plans or how to do something "innovative" with their compensation programs. I tell them my view is that "creativity" is applying an existing solution to a new problem (like using a paperweight for a doorstop), while innovation is developing a new solution to an old problem (inventing a device that holds paper to your desk and keeps your door open at the same time). If the accusations are true, I think these companies were not creative but were quite innovative in finding a way to prevent underwater stock options and ensure the maximum "bang for the buck" for each option granted. But like developing an innovative way to rob money from a bank, or even creatively robbing a bank, it's illegal and it's wrong.

So please, let's not again conclude as many did after the Enron debacle that stock options are the source of the problem. That would be like closing all banks to prevent bank robberies. Let's instead make sure that the penalty for bank robbers is not just that they have to promise not to rob any more banks and offer give back some of the money they stole from robbing amored cars. Our jails might be overcrowded but there's always room for one more billionaire.

The solution to these recurring instances of abuse of otherwise sound compensation practices is well-documented and accepted by many organizations: an active, informed Compensation Committee of the Board of Directors that resists "one-off" deals and "exceptions" and has a formal calendar of meetings and actions prepared in advance of the year. With those things in place, the alleged UnitedHealth situation could never happen and if it looked like it did there would be ample documentation to the contrary. Absent such practices and policies, however, it might look like someone got a little too creative, or innovative, or maybe just greedy.

April 1: Compensation This Weak

What an incredible couple of weeks it has been in the world of compensation. I intended to blog much earlier but the deluge of media stories kept me reading instead of writing. Here’s a recap:

Job Bank for the Jobless
General Motors has a program, known as the Job Bank, that provides full pay and benefits for workers when there is no work for them to do, if they continue to report to the workplace or an alternative facility. Following innovator GM’s lead, Silicon Valley firms have established a Job Bank for software developers displaced by offshoring of their jobs. There will be a facility where the unemployed will be able to solve theoretical math problems that have no practical application, write poorly functioning code, and send email to each other. “This is just like working at that big software company” said one unemployed programmer “except we’re required to actually show up for work, there’s no telecommute option.” Plans are underway for a similar facility on Sand Hill Road for venture capitalists displaced by the movement of VC activity to India. This program will allow the unemployed to spend their day playing Monopoly and sitting in conference rooms listening to presentations of untenable business plans.

Living Wage Legislation
Outraged by the soaring cost of jet fuel, illegal domestic staff, and defense attorneys, an influential group of CEOs has proposed “living wage” legislation in Congress. “I don’t know how anyone is supposed to live on $10 million per year” said one CEO. “And now that there’s an expectation of performance in return for the money, it’s just gotten ridiculous. What’s wrong with America?”

SEC Disclosure Rules Struck Down
The SEC’s proposed rules for increasing disclosure of executive pay have been struck down by the Supreme Court citing the community standard for obscenity. Justice Potter Stewart’s quote “I know it when I see it” was cited in the unanimous opinion. Several Court Justices were reportedly unexpectedly aroused by reading about executive pay levels in US companies. “We can’t have our nation’s youth seeing this sort of information” said one Justice who requested anonymity.

Option Expensing Rule Reversed by the FASB
In a surprise move by the Financial Accounting Standards Board, the requirement to report stock options as an expense has been deleted from the US accounting standards. “We had no idea this was going to reduce company profitability” said the head of the FASB. The rule change is expected to immediately improve profitability of all US companies, with the exception of airlines.

Airline Industry Lobbies for Accounting Rule Change
The US airline industry has urged the FASB to adopt a new accounting rule that would exclude the cost of labor and jet fuel from the calculation of profit. “This change is long overdue” said one airline CEO. “If we had changed this rule 20 years ago think of the number of airlines that could have avoided bankruptcy.” The proposed change was applauded by airline executives participating in profit-based bonus plans.

NASDAQ to Restate Stock Prices
Citing a series of calculation errors, and following in the footsteps of companies having to restate their financials, the NASDAQ will be restating stock prices for all listed companies for the years 1998 through 2001. “It turns out there wasn’t a bubble after all” said the head of NASDAQ. Stock prices have actually only moderately increased since 1998. We apologize for the error.” Class action lawsuits are expected by shareholders seeking to obtain refunds from employees who became wealthy from stock options, and executives whose bonuses were tied to stock price who now seem to have been overpaid.

Google Adopts Severance Plan
Google, continuing the streak of innovation reflected in its Dutch Auction IPO, AdWords, and Google Maps, is implementing a unique severance plan for employees. Employees who are terminated will be required to repay to Google an amount based on the formula of $1 million for every year of service. A Google spokesman said “they make way too much money anyway and this is an opportunity for them to really serve the Google shareholders.” In addition, following the lead of General Motors under the new Google Buyout Plan employees who elect to retire early will repay Google a flat amount ranging from $5 million to $10 million. This program is aimed at the lower-paid workers in the company, prompting claims of discrimination from administrative assistants and software testers who argue that it would be burdensome to write a single check to the company covering one month’s pay. For the record, a Google spokesperson denied that it has any poor performers, pointing out that it has only hired the smartest people but the Company got even smarter rendering some employees relatively dumb.

Happy Aprils Fools Day to our Blog Readers. Let’s all hope that this time next year I have much less material to work with as I try to point out the absurdity of some compensation practices.

Stock Option Grants Smaller? Or Not?

If you saw the article in the Mercury News Thursday morning, “Stock Option Flow Slows” you might think that (a) this is news , (b) companies are giving out fewer stock options to employees, and (c) this has something to do with new accounting rules. I think (a) no, (b) somewhat and (c) no.

I suppose it is news that Bear Stearns issued a report with data indicating that this is the case. Their report says that companies in 2005, compared to 2000, are issuing (a) fewer options and (b) less total “value”. I think (a) yes and (b) no. But that has been occurring for the past four or five years and it is old news.

If I was really drunk right now, but much less drunk than the time I was the drunkest I’ve ever been, the news might be that I’m not really all that drunk. In 2000, US companies were drunk on stock options. There was no accounting expense required for employee stock options and shareholders were giddy about the bull market (widely misinterpreted as their investing savvy) so they didn’t mind that they were being diluted. Employees in the US got lots of options. Employees outside the US in those same companies, where pay is a fraction of US pay, often got the same number of options. New hires got big option grants (even though we hardly knew those people) and continuing employees got grants every year - even the poor performers (we can’t give them zero, they might complain or leave). Today, companies are granting fewer options than they were in a time when many granted an absurdly high number of options. But that is not news.

Remember that then the market crashed and shareholders got mad. But a lot of those employee options got “repriced” or exchanged so that the employees weren’t penalized for the stock price decline, even though others may have gotten rich during the bubble. That irritated some investors. Since then, many of the companies that were granting an absurdly high number of options cut back to above average levels - less drunk now. Shareholders of some companies refused to approve more shares for employee stock plans. No more for you, sir, I’ll call you a taxi. Some companies didn’t even bother asking shareholders to approve more shares even though they had run out. Closing time, indeed. It’s important to note that several companies gave smaller grants, or no grants, because they ran out of shares and it wasn’t good timing to ask for more. But they’ll get more this year, and may have to do extra-large grants to make up for last year. I personally know a couple of companies that are doing this. So when is a zero not really a zero?

Reports like those issued by Bear Stearns are based on data from hundreds of companies and it takes a lot of work to pull all that data together. But those of us who study each company in detail know there is much more to the story. Microsoft, instead of granting stock options, now grants restricted stock units in a number about one-third of the number of options it used to grant. So, did they “reduce” their grants by two-thirds? Or did they reduce their “option grants” to zero? A few other companies like Amazon made a similar change. I have seen, and continue to see, these types of errors in reports issued by reputable firms. (This article, by the way, notes that restricted stock is now “popular” but I have no idea what the criterion for being popular is. I do know, however, that granting restricted stock is still a minority practice, like popular orange shoes, and is very unpopular with a lot of investors.)

What about the company that didn’t issue options last year because they allowed employees to exchange worthless underwater options for newly-priced options? Is that a zero too? And what about the company that moved its annual option grant date from December to January, and went 13 months between grants with none in calendar year 2005. Zero? As the mathematicians in the audience know, zeroes can bring down an average quite a bit.

Here’s a really deceiving part of the story. You might remember that stock prices were quite a bit higher in 2000 than in 2005. The NASDAQ was roughly double where it is now. Due to a bizarre but widely accepted belief that an option granted when a share of stock is at $100 is twice as valuable as an option granted when that same stock is at $50, we conclude that we are giving less value because stock prices are lower. In other words, those $100 options we gave you are worth much more compensation even though our stock price is now at $50. For those of you who understand stock options you probably noted the absurdity of that last sentence. That’s the “duh” part. Options granted when stock prices are a fraction of what they were in 2000 are of lower “value” because the Black-Scholes option pricing model says so. Not.

But wait, there’s more! Companies definitely took action in response to the new accounting rules for stock options. Few people know that US companies spent millions of dollars of shareholders’ money over the past two years on consultants who helped them to develop “better” estimates of the value of stock options granted to employees. (Did you miss the news story on that?) This became a compelling activity because of the need to start reporting that value as an expense reducing reported profit. In virtually every case, that “better” estimate was a lower one (surprise!). Don’t take my word for it, just read their 10-Ks. Thus the reported “value” of employee stock options went down because companies got “better” at low-balling the number. Did that reduce employee pay? Of course not. And of course there are those companies that accelerated vesting to avoid recognizing any expense at all, so those options will now require an accounting expense of zero and must therefore be worthless. Hmmm. How did you calculate those, Bear Stearns? Seems to me that those options just got a lot more valuable.

Amidst all of the smoke and mirrors, many companies have indeed started issuing stock-based compensation to employees on a more reasonable and thoughtful basis (I do not include the vesting accelerators in that group). But let’s not think that a massive reduction in option grants has occurred because some will take that as further evidence that the US worker has experienced a massive pay cut while executives have not and then introduce federal legislation to fix the problem. The real news is that companies are radically changing how they pay employees which is the big positive outcome of the new accounting rules and shareholder pressures. Many companies are taking the first fresh look at pay practices since a time before many business journalists had started learning their cursive. That is the really big news but the data won’t show up in reports issued by accounting analysts at investment banks who I happen to think should leave the compensation business to people who actually know something about compensation and go focus on investing.

How Did You Do?

Every year I read Parade magazine’s article on what people earn. Actually, now that I think about it, I don’t think I’ve ever actually read the article but rather scan every picture and job title and salary. As a compensation specialist I can’t resist. Usually I just see surveys or spreadsheets of what people earn - job titles and salaries; here I get to see their faces. It’s a little voyeuristic as is the whole notion of the topic of pay.

This year, however, the article appeared on the one Sunday that I didn’t make it to the corner to buy the newspaper and today a colleague advised me via email of the article online. So I didn’t get to peruse the facebook (well, there were 12 shown) - but when one shifts from print to web there are tradeoffs. I got to read the reader comments posted on the site. And I actually read the article.

As easy as it would be to launch into a political commentary, I’ll just say that the most striking comment by the writer was: “Workers need perseverance, stamina, flexibility, and patience to succeed in this difficult environment.” I always thought those are the requirements to succeed in any environment but maybe that’s because my father was born during the Depression and was thrilled to work later in life, after fighting in World War II, as a mailman (we call them “postal workers” now.) So I’m probably biased.

The comments posted, most of them ranging from irritated to outraged, blame the magazine, the President, the American economic system, our court system, the stock market, company politics, Howard Stern, Democrats, Republicans, the entertainment industry, sports teams, and others for the purportedly sorry state of American pay. It seems that Americans are getting a raw deal and it’s not their fault.

What’s interesting to me is the entitlement mentality that we Americans seem to have developed. We are entitled to real pay increases, darn it. What the heck is wrong here? Some of the quotes in the article include:

“Wages haven’t kept up with inflation.”
“Salaries just don’t seem to be keeping up with the average person’s cost to live.”
“My income will probably increase…but I doubt the increase will cover the higher cost of insurance and gas.”

I can’t think of a single source that would provide assurance that any of those expectations would or should have been met.

What really amazes me is the fourth sentence in the article: “'While the economy has been growing since 2001, all the benefits of that growth have gone into corporate profits' says Mark Zandi, chief economist at Moody’s Economy.com." I would point out to Mr. Zandi, without sounding like an apologist for corporations, that corporate profits turn into more jobs, higher stock prices, dividends, capital investments, and tax revenue. I think you and I get the benefit from at least one, if not all, of those. Granted, some of those jobs may not be in the US, but read on.

Yes, the US economy is booming, and many people are benefiting from the boom, but American employees – on average – are overpaid compared with the rest of the world. An outcome of globalization is to fix that. We are seeing capitalistic US values spread around the world, and some aren’t liking it when others are better than us at the game we invented. For every disgruntled employee in America there are two or five or twenty people in other countries that are ecstatic. But Americans still have choices. Depending on your particular skill set and area of expertise you can move almost anywhere else in the world; you can find a place where the ratio of your salary to cost of living is more favorable and you can be a beneficiary of the new equilibrium. I recently read about a mid-career software manager who moved from Seattle to Shanghai for just that reason. Go online and find out what your job pays in Shanghai or Rio de Janeiro or Amsterdam.

And, yes, on average, the real pay of Americans is declining. There is a bit of the 80/20 rule occurring: the top 20% see their pay soaring while the other 80% are experiencing erosion. Of course, the government numbers miss a lot of pay elements, but the crux of the statement is true: Americans are earning less. People in other countries are able and willing to do the same, or better, work for less pay. Step back, and it’s hard to be angry about that.

No one is going to insulate American workers from pay erosion because they complain about it. What Americans can do is what we’ve always done best – work hard, innovate, and take responsibility. We can get paid for that. But blame and resentment have never been high-paying skills. Good survey data shows that what increases pay of an individual is education, skills, experience, level of responsibility, and related factors. Accumulating those require - in the words of the writer - perseverance, stamina, flexibility, and patience.

I wonder when Parade will shift their annual story to show worker pay around the world and not just in the US. I can’t wait to see the reader comments then.

A Blog about a Blog

In addition to my consulting work with Compensation Venture Group, teaching for WorldatWork, speaking at conferences, and founding role with The Integrity Institute, I serve as an advisor and occasional blogger for PayScale, Inc. Check out the PayScale Blog where this week I discuss the burgeoning chaos in executive pay reporting by the media:

Take This Executive Compensation Quiz

Compensation This Week

Why Your Compensation Survey Data is Wrong

Most compensation professionals realize that the data in compensation surveys has always been flawed. Over the past two years, however, it has become not only meaningless but dangerously misleading. Having always been skeptical of the data, my concerns were highlighted by a two-year stint as a consultant affiliated with the self-described "leading provider" of surveys for a particular industry. As I work with Boards of Directors to assess and design programs, these surveys have become not only of lessened importance, but a laughing stock. OK, this is a blog, so I can say it: the data is garbage.

What's the solution? For top executive pay, current disclosure requirements provide a wealth of information. While some still think that reading the annual proxy statement is sufficient, those who have been paying attention know that 8-Ks are a rich source of data, and 10-Qs are required reading for understanding equity compensation practices. The data changes daily! Online services are now available to facilitate the gathering of that data rather than requiring direct examination on the SEC's EDGAR site. But outside of those top five positions no such data is easily available.

Those following the recent surge in internet-based services (whether you like the term "Web 2.0" or not) have seen a wave of new data become available in many fields but, as usual, HR is the lagging field. As Chief Compensation Officer of PayScale, Inc. I love to promote our service as a solution to this; in fact, I love to promote my blog on that site and have just done both.

Compensation has become exceedingly complex, not just for executives, but for all levels of employees. The talent market has become global. Individuals have an expectation of immediate access to information online without the interference of intermediaries (like HR departments). People know that they have value based on their unique combination of skills, experience, and work histories that may or may not fit into a job description box. All of these factors are real, not speculative and explain why that survey binder you have on your shelf - or that online data service that is a mere automation of your survey binder - is causing more harm than good.

As we enter the annual "executive compensation season" with daily (hourly, actually) news stories about executive pay, we will see the real-time nature of pay information like never before due to the new environment of disclosure. This will trigger a wave of scrutiny, and dissatisfaction, with published survey data coming from executives and boards of directors. And then HR, and their consultants, will have a real problem. Actually, they already do.

Maytag CEO Ralph Hake: The Poster Child for What’s Wrong with CEO Pay

Rarely in this blog will you see me directly criticize an individual’s compensation arrangements but this example epitomizes why shareholders are angry about the state of CEO compensation today. It is these types of incidents that lead to generalizations about executive pay and the resulting activism, legislation, and misguided reactions. We cannot conclude that all CEO pay is wrong, or that most CEO pay is wrong, but I can conclude that Ralph Hake’s compensation arrangement, in light of his destruction of Maytag and its treatment of its customers, is unacceptable. The members of the Compensation Committee of the Board of Directors should be held accountable for this. Here's why.

The CEO joins the company in June 2001, proceeds to destroy two-thirds of the company’s market value over the next 4 years costing the shareholders $1.6 billion. In return, he gets compensation of $9.4 million by having the company taken over by Whirlpool Corp. This describes the situation with Maytag's CEO Ralph Hake. By driving the company into the ground, Maytag became an easy takeover target, triggering Mr. Hake’s golden parachute payments. This, of course, is on top of his multi-million dollar annual pay package.

I can see one source of the problem: the Charter of the Compensation Committee, dated 11-11-04 and posted on Maytag’s website, says:

“The Committee’s basic responsibility, on behalf of the Board, is to assure that the Chief Executive Officer and senior executives of Maytag and its wholly owned affiliates are compensated effectively in a manner consistent with the stated compensation strategy of Maytag, internal equity considerations, competitive practice, and the requirements of the appropriate regulatory bodies.”

What’s missing? How about the obvious: that the Committee’s primary job is to ensure executive compensation supports shareholder value creation. The Committee members seem to have satisfied their Charter. Unfortunately, it’s the wrong Charter.

Not only did the shareholders pay dearly, but during this time Maytag’s product quality plummeted, costing customers millions of dollars. I don’t see any mention of “customer” in their Charter either.

That Maytag repairman is really going to be the "lonliest man in town" now because he'll be out of a job while Ralph enjoys his newfound millions. This is why people are angry about executive pay.

Pay for What Performance?

"$400 awarded to each Alaska Airlines employee."
http://seattletimes.nwsource.com/html/businesstechnology
/2002748080_bizbriefs19.html

This headline could have just as easily read “Alaska Airlines Pays $4 million in bonuses for providing subpar customer satisfaction 1/3 of the time.” At the schools I attended, missing 1/3 of the answers was a score of 67% -- a “D” -- and I don’t remember any bonuses being paid for that.

The other interesting tidbit in this article is that Alaska missed its on-time goals 100% of the time in 2005 when compared to other airlines. But the company has nipped this problem in the bud. Rather than comparing itself to airlines with whom it competes in the marketplace, the company will now pay bonuses based on the percentage of flights it “expects to arrive on time each month” in 2006.

Incentive compensation design is a fascinating topic and pay-for-performance is one of the key issues in executive pay right now. I wonder how this message will play to Alaska Airlines shareholders: "We paid our employees an additional $4 million for failing 1/3 of the time on one measure; we failed 100% of the time on another measure and rather than fail 100% of the time again this year, we are lowering the goal so that we have a better chance of paying ourselves a bonus in 2006.” That is the sort of thing that shareholders at other companies are mad about.

I do not own shares of Alaska Airlines but do own shares of Southwest Airlines where customer satisfaction and on-time performance are not a basis for extra pay but a daily expectation and requirement. I'm unable to paste the stock price comparison chart of ALK vs. LUV into this blog but if you are interested you should take a look at it on Yahoo! Finance. A picture truly is worth a thousand words which is much too long for a blog, so I'll just say that some ALK shareholders may be asking for their $4 million back.

When Nobody Likes Your Pay Plan

Imagine submitting a compensation proposal and having the following groups express vehement opposition to it: The United Auto Workers, United Steel Workers, a U.S. Government agency (The Pension Benefit Guaranty Corp.), bondholder Wilmington Trust, pension funds in the states of Mississippi and Oklahoma, another pension fund in The Netherlands, and an investment fund manager in Austria.

This is what Delphi Corp. accomplished with their executive compensation proposal. Apparently the rank-and-file employees at Delphi are terribly overpaid, so they will need to take a reduction from a current average wage of $26 to about $12.50 per hour. The executives and managers at Delphi, as the CEO describes the situation, are terribly underpaid and need approximately $500 million, including 10% of the equity in the post-bankruptcy company, to be retained and motivated.

I forgot to mention that aspect of the story. Delphi filed for bankruptcy, and the executive and management team that presided over that failure - including accounting fraud and a $400 million underfunding of the employee pension plan - is the team that needs to be retained and motivated.

On 5 January, a U.S. Bankruptcy Court Judge will hear the proposal.

The New Share Plan Metrics

Until recently, the ubiquitous use of stock options made competitive comparisons a relatively easy process. Now, significant changes in plan design - triggered by new accounting rules, the corporate governance climate, and emerging "standards" from a variety of constituencies –render the old metrics inadequate. Overhang, run rate, Black-Scholes values, and other measures give an inaccurate view of pay levels and value transfer, leading to misguided decisions.

As companies assess alternative forms of share-based awards – performance-based options, stock-settled SARs, restricted stock and RSUs, performance shares – as well as changes in the mix between equity and cash, the decision process requires assumptions about the "value" and "cost" of each type of award. Firms attempting to understand their competitive position using survey data and their compliance with investor requirements face new challenges given the outdated methodologies being used. This session explains the emerging metrics and techniques being used by leading companies in understanding the value and cost of share-based payments in this new environment and presents a model for navigating through the complex decision process. The presentation includes a preview of new standards in 2006 from organizations including the SEC, ISS, S&P, ABI and others.

Attend a Web seminar on this topic, presented by Global Equity Organization, on 11 January 2006. http://www.globalequity.org/events/webseminar/index.html#Register

How are Companies Responding to FAS123(R) and Option Expensing?

Over the next few months, Compensation Committees, CFOs, compensation professionals, consultants, accountants, and others will be preoccupied with the imminent adoption date (for most companies) of 1/1/06. The most common phone inquiry I receive these days is "what are other companies doing?" to which the response is "calling me to ask what other companies are doing."

Seriously, there is an obsession with the notion that someone, somewhere has figured out "the answer" to equity-based compensation under FAS123(R), and that consultants know the answer and just won't tell. The truth is, however, that there will not be a single solution along the lines of the simplistic 1990s "options for everyone, 4 year vesting, and an ESPP" approach. Companies relying on survey data to guide their strategy are going to be disappointed, misguided, and at a competitive disadvantage.

Are companies moving toward restricted stock and restricted stock units (RSUs)? Not to the extent the headlines would lead you to believe. Some companies have added restricted stock grants to annual option grants, but mostly at the executive level. Some have made a single restricted stock grant to a single executive, usually in a new hire situation, landing them in the category of "companies abandoning options for restricted stock."

In my presentation at the NASPP conference in November (www.naspp.com/Conference2005/) I will make the point that the media and those feeding the media frenzy (consultants and others) are erring on three points:

1. Causality - the assumption that adoption of FAS123 and the granting of restricted stock proves that the FAS123 adoption was the reason for the restricted stock grant. There are few companies where these two actions are even remotely connected.

2. Attribution - the inference that a company's adoption of a long-term incentive plan that allows for the granting of restricted stock counts as a company now using restricted stock. Much of the survey data being bandied about today is measuring the wrong thing and reporting data submitted by individuals who don't really know the difference.

3. Single Variable - most of all, the conclusion that changes in long-term incentive plan design and grants are the result of accounting rule changes, rather than a confluence of factors including flat stock prices, companies that are not creating any value for shareholders, corporate governance pressures, and the interesting interactions of these three.

A quick look at the 2-year, 3-year, and 5-year stock price charts for the companies that pioneered the aggressive use of stock options tells the real story. When stock prices were rising during a bull market with technology stock glamour, stock options were guaranteed to deliver pay in most of those companies. But when these glamour companies have matured, lost their growth potential, and spent time and money fighting accounting rules rather than innovating technology solutions, stock options become impotent - a bonus plan with an unrealistic target.

Growth companies will continue to pursue growth company strategies which will include a central role for stock options but not to the exclusion of other pay tools, such as restricted stock, which have always made sense in certain situations. Mature and declining companies will make use of the corresponding strategies which will include more cash, more restricted stock, and other forms of pay that compensate people for working at a company that is not delivering returns that exceed the cost of capital and thus have flat stock prices. Smart companies will end up, after this next FAS123 frenzy, with compensation programs that rely on sound strategy, rigorous analysis, and effective execution rather than mimicry of questionable survey data.

That is what "other" companies are doing.

Will Cox Delay Option Expensing?

(originally published as a Practice Alert at www.naspp.com prior to his confirmation)

The resignation of William Donaldson as Chairman of the Securities and Exchange Commission (effective June 30) and the timely nomination of Christopher Cox as his replacement has caused speculation about the fate of FAS 123(R). Congressman Cox is on record as being a staunch opponent to option expensing.

The 6-month delay decreed earlier this year by Chairman Donaldson was viewed by most merely as additional planning time to address the inevitable change. Yet some companies interpreted this as a harbinger of a defeat of the new rule, and the change in leadership at the SEC has added another reason for those firms to extend their "wait-and-see" thinking regarding compensation planning priorities.

Chairman Donaldson and some of his predecessors have observed, however, that opinions and viewpoints held prior to taking the helm of the SEC often change after assuming that role. In time we will see whether Congressman Cox’s opposition to option expensing will find a fast track or will be rethought. Regardless of the outcome, we believe it would be unwise to table current equity compensation planning efforts for several reasons:

• Hundreds of companies, representing the majority of U.S. equity market capitalization, have adopted FAS 123 and many of those have significantly altered their compensation plan design. The resulting impact on market compensation practices could not be unwound for many years.
  
• If FAS 123(R) was nullified, there would be significant technical accounting issues required to achieve consistent reporting among companies. The timeline for this likely would be in years rather than months during which time companies that have adopted FAS 123 will continue to operate under the "level playing field" it creates for alternative long-term incentives.
  
• If option expensing was eliminated we still might find that a change in perspectives has occurred over the past few years regarding the impact of non-cash compensation expense. The FAS 123 era may have permanently softened resistance to forms of equity-based compensation that create expense – restricted stock and restricted stock units, performance shares, and similar instruments may be deemed less "costly" after the past 10 years of analysis and reconsideration.
  
• The FASB and SEC cannot avoid addressing global pressures for fair value accounting for share-based payments. With the International Accounting Standard Board’s (IASB) International Financial Reporting Standard governing companies across the globe, an American about-face on this issue would be contrary to Congressman Cox’s stated concerns about the status of US capital markets in the world economy.
  
• Finally, FAS 123(R) is only one, and arguably a less significant, influence on current compensation re-design efforts. If APB 25 returned as the law of the land tomorrow, investor pressure, corporate governance trends, the movement toward pay-for-performance and other factors would continue to keep companies focused on alternatives to stock options.
  

Whether FAS 123 continues on its current timetable; or option costs get moved from the income statement to the balance sheet as the Chairman-appointee has previously proposed; or stock options again become "free" under APB25, the changes in compensation strategy and design that have occurred over the past few years have a momentum fueled by diverse forces and are unlikely to be reversed. Companies should not discontinue the assessment of total compensation strategy based on a multi-disciplinary approach in light of all financial perspectives – financial reporting, taxation, cash flow, value creation, dilution, corporate governance, and marketplace practices.

Valuation of Full-Value Long-Term Incentive Awards

(originally published on www.CompensationStandards.com)

The recent interest in alternatives to stock options – fueled by corporate governance concerns, imminent changes in accounting rules, and changes in equity markets – has led to the discussion of the appropriate "conversion rate": how many units of the new form of award should be given in lieu of a stock option.

Because options have been the "currency" of long-term incentives for decades now, most survey data, grant guidelines, and measures of usage (overhang and run rate) assume that all grants are option grants. As companies consider restricted stock, restricted stock units, performance shares, and long-term cash incentive plans, many look to the few companies that have completely (for now) abandoned options. Microsoft, Amazon, Expedia and others become the new reference point.

The one-for-three number currently is making its rounds as the "right" ratio. This has its roots in several places including the rumored average conversion rate in Microsoft’s restricted stock unit program and the average fortune 500 Black-Scholes value of 33%.

An issue that has not been addressed is the assumption that a full-value grant is equal to its face value. This is because forcing the Black-Scholes valuation (by treating a restricted share as an option with a strike price of $0.00, or $0.000001 to make most models return a value) yields a number equal to face value. But option pricing models, which have an implicit stock price growth assumption, were never intended to value employee stock grants (let alone employee option grants) and their use further distorts the data needed for compensation decisions.

For example, a company with a Black-Scholes value of 60% of face value (the average in the technology sector) might give a 25% "haircut" and thus grant a number of restricted shares equal to 60% x (1-25%) = 45% -- 450 restricted shares in lieu of 1,000 options. But a Black-Scholes value of 60% has an implicit growth rate (over a four-year vesting period) of 12.5% per year. A restricted share will thus grow to 160% of face value at that rate. So, in lieu of an option granted at $10.00 that provides a gain of $6.00, the company is granting .45 restricted shares that grow to a value of $7.20 (.45 * $16.00), a 20% premium over the option gain value. . .with no downside risk. Without the haircut, the premium is even greater.

The FASB Exposure Draft and its endorsement of the binomial model (and implicit avenue for reducing reported option value) is highlighting the inappropriateness of these models for compensation planning. While growth-based models require assumptions as well, the availability of analysts’ growth targets and investors total return expectations provide a more rational basis for assumptions than required by option pricing models.

Responsible compensation planning requires abandoning theoretical option pricing models as a basis for compensation allocation among alternative vehicles under the newly emerging "portfolio" approach to long-term incentives. Not only does the gain model provide a more reliable basis for these decisions, it is a method with greater face validity among Board members, employees, and investors.