Wednesday, May 31, 2006

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.

Friday, May 19, 2006

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).

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.

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.

Monday, May 01, 2006

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.