Tuesday, October 30, 2007

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)

Monday, October 29, 2007

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

Monday, October 15, 2007

Executive Pay: Complex or Complicated? (Redux)

Fred Whittlesey

Principal Consultant, Compensation Venture Group, 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