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?