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Corporate Shenaninigans
Posted by: Dale Franks on Monday, November 20, 2006

The extraordinarily high rates of CEO pay cause a lot of grumbling, especially on the Left. They think it's intrinsically "unfair" for corporate execs to make so many multiples of what regular workers make. Conservatives, on the other hand, when confronted with figures like the multiple of executive salaries has jumped from 55 times the average worker's salary to well into the hundreds merely shrug it off as the market at work. Some of the numbers are actually quite impressive, such as IBM Chief Samuel Palmisano, who made 510 times the average salary, or United healthcare's William McGuire, who made 925x Unions, for instance, really hate that.

Salaries, of course, are effectively capped by the tax code, which disallows corporate write-offs of salaries above $1 million, unless it qualifies as substantially performance-based. So, enter stock options as a "incentive" for "performance".

So, when we talk about CEO pay, what we're really talking about is the value of stock options that CEOs are given.

Well, there's a problem with that, as it turns out, which has bloomed into a bit of a scandal.
The scandal has its roots in a 1992 SEC decree that companies list in their annual proxy statements the exact dates that they gave stock options to top executives. The dates had been disclosed before, but only in mailed-in filings that no one ever looked at.

To corporate America, the new rule was a minor hassle; to a first-year New York University finance professor named David Yermack, it was a new source of interesting data. Yermack began examining stock prices before and after options grants, and found the eerily consistent pattern displayed (in updated form) in the chart on this page: The average company's stock price dropped in the days before its CEO was given a bushel of options, and rose afterward.

Executive options are usually granted "at the money" - i.e., if the stock is at $10, the CEO gets options to buy it for $10 a share - so getting options on a bad day for the stock is good news for the recipient.

Yermack figured that this wasn't just luck, and theorized that companies were timing their grants to precede good-news announcements and follow negative ones. His findings began making the rounds in 1995, sparked a flurry of interest among finance and accounting scholars, and were published in The Journal of Finance in 1997.
So, some Biz-School finance professor took a look at it, but nothing really came of it. It seemed to be of no interest to the SEC, or stockholders, or anyone else for the next seven years.
Nobody off campus paid any attention - until 2004, when finance professor Erik Lie of the University of Iowa noted that many options grants were timed to exploit marketwide price movements that no CEO could predict. "At least some of the official grant dates must have been set retroactively," Lie suggested in a paper.

Fiddling with options grant dates retroactively and lying about it in corporate financial reports is clearly illegal. So Lie sent a copy of his paper to the SEC and the agency began sniffing around.

The resulting backdating scandal has so far led to criminal charges at two companies and a paroxysm of what Stanford law professor and former SEC commissioner Joseph Grundfest calls "Maoist-style self-criticism" at many others, with more than 40 high-level executives losing their jobs.
The trouble is, now that we know that, we have to wonder what other tricks are hiding up CEO's sleeves for fattening their own pockets. Tricks that may not be prosecutable:
"Bullet dodging," for example, is the term for delaying options grants until just after the release of bad news (or moving up the release of bad news to precede an already scheduled grant). Because the grant comes after the news is out in the open, such behavior is nearly impossible to prosecute on insider-trading grounds.
Corporate boards, however, can take a fairly simple action to reign in their CEO:
Grundfest has been advising companies to schedule their options grants three trading days after a quarterly earnings announcement. This minimizes the amount of inside information that executives could possibly take advantage of. It also has the interesting side effect of giving them an incentive to miss the quarterly earnings target set by Wall Street analysts (because that might depress the strike price of their options). Now that would be a shocking development.
Now, that wouldn't just be shocking, it could also be quite interesting. Meeting the quarterly earning projections has become something like a religion for US businesses. The standard critique of this practice has always been that it sacrifices long-term, strategic goals for short-term financial performance. In my view, there is much merit in that argument.

Conversely, others argue that shareholder value is a prime consideration for any company, and companies that miss earnings targets, tend to see lower stock prices. That, along with smaller earnings, makes the stock less attractive, making it harder to increase capitalization through new stock issues, and reducing the company's current capitalization. They argue that isn't fair to the shareholders, who are, after all, investing in order to receive a decent return. In my view, there is much merit in that argument.

But, I think both sides would agree that no useful purpose is gained by having CEOs bilk the shareholders—which is exactly what is happening—through the...uh...auspicious timing of option grants. Eventually, that type of behavior tends to get regulated. If they don't want the SEC to start digging around even deeper, then perhaps companies should examine their options granting policies, and regulate themselves, before it gets regulated for them.

Especially with a Democratic Congress already grumbling about CEO pay, and a Republican president of few firm economic predilections when it comes to regulation.

Also, as an aside, the whole problem of CEO pay was supposed to have been fixed by Bill Clinton in 1993, when he signed the tax reform legislation that capped CEO salaries at $1 million. The whole market in CEO options—and mushrooming CEO pay—came about in no small measure as a direct result of that regulation. The unintended consequence was to exacerbate the very problem it was supposed to fix.

I really have to question whether CEO pay would've risen to such stratospheric levels over the past 13 years, if corporations had been able to directly compensate CEOs at an adequate level, rather than offering such large option packages.
 
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Comments
Once again the feds mess about "with good intentions" and lo! such actions have unintended consequences. Surprise, surprise. It’s so tricky, trying overcome thousands of years of human behavior with just some tax regulations.
 
Written By: Linus
URL: http://
If you think the amount that a company is paying their CEO is excessive enough that it is impairing your returns, sells the stock or don’t buy it in the first place. If you are not a shareholder of a company then what they pay their CEO is literally of no concern to you.

 
Written By: DS
URL: http://
Yeah, DS, because one couldn’t possibly have an interest in the efficient, legal, and fair operation of companies in the US economy without owning stock in each particular company.
 
Written By: Mithras
URL: http://mithrastheprophet.blogspot.com
Mithras,

efficiency, as it relates to economics, is a term to describe the wasteful allocation of resources. With regard to executive pay, efficiency is hampered by ill-conceived regulations in a populist attempt to restrain corporate pay, which thanks to a strong market since those regulations went into place, had the effect of raising pay because the options that were granted ended up being worth more than they would have been expected to be worth. This is a matter for the Board - which is supposed to represent shareholders, and DS is correct to say that if efficiency is your concern, unless you own shares you’ve got no dog in this fight.

legal is what’s being investigated now with regard to backdating - though I’d note that as I understand it, as long as the in the money options were charged through GAAP earnings, backdating was and remains legal. Spring-loading (issuing options just before good news) and bullet-dodging (issuing options just after bad news) are both completely legal. We’ve seen a raft of executives resign over backdating, and I suspect there will be fines and perhaps even some criminal sentences. This is a matter for the DOJ and SEC, and thus the will of the governed and all the pros and cons with that - so call your representatives and ask them to change the laws.

fairness is in the eye of the beholder and it’s the shareholders’ representative (the Board) that determines "fair" executive salary, as with the economically efficient executive salary. Again, I’d refer you back to DS.




 
Written By: m.jed
URL: http://
Do CEOs fall under different rules than employees? I worked for a start up internet security firm and received options after we went public. The window for selling the options was very restrictive. It was closed for about two months leading up to the quarterly announcements and then for another two weeks or so after the announcement. By the time we were able to sell, the stock had usually made it’s move.

Just curious.
 
Written By: meagain
URL: http://
Do CEOs fall under different rules than employees?
Typically the rules for executives disposing stock are significantly more restrictive than for non-executive employees. Most of the (non-Enron-related) press articles about executive compensation, options, back-dating, etc. relate to paper gains not realized gains.
 
Written By: m.jed
URL: http://
So how do we find out when the CEO is going to be getting his options? Presuming that they are no longer retroactive it should be possible to make some gains.
 
Written By: unaha-closp
URL: http://warisforwinning.blogspot.com/
Mutual funds have historically been unwilling to take an active roll in the management of firms. As a larger and larger share of corporate equity has been transferred to the mutual funds (much of it held by our 401Ks) CEOs have been left free to pad their boards with patsies who give the big raises. You acknowledge that CEO compensation has skyrocketed. Is it because the supply of people willing and able to do the job has fallen? I think not. Is it because the performance of these firms is so good? In the case of United Airlines the CEO led the firm into bankruptcy and still got a big raise. According to Warren Buffet the governance of corporations has grown lax. The CEOs have exploited this for their own good. This has had nothing to do with government regulation except perhaps in a very few cases.
 
Written By: cindyb
URL: http://
I hate any government mandated "solutions", they almost never work. But there is a real problem in Corporate America, and it is a problem with the closed and incestuous world of the corporate board room.

Do you know that it is quite common for single individuals to sit on the boards of several corporations at once, even when they stock they own is not any greater than thousands of other stockholders?

The shortsightedness of many Corps is amazing. One thing corporate America is in the process of doing is destroying the work ethic of the American worker. When the bottom line is constantly only the next quarter, and when takeovers are ubiquitous, and always go along with restructuring, it is the rare American worker who does not find themselves working for a strange corporation, taking pay cuts, or being layed off, several times in their life.

This engenders a selfish attitude from the worker, after all, going the extra mile, working harder than the next guy, putting in extra hours, all of those things are no longer rewarded as before, and instead of making you more valuable, they make you the chump.
 
Written By: kyle N
URL: http://impudent.blognation.us/blog

This engenders a selfish attitude from the worker, after all, going the extra mile, working harder than the next guy, putting in extra hours, all of those things are no longer rewarded as before, and instead of making you more valuable, they make you the chump.
Can you cite any research into this?

My sense is that the way corporations are compensating people, it’s exactly the opposite. I’ve read newspaper articles quoting compensation experts about "A-players" getting raises significantly above the average for an organization, whereas B and C players are inline to below the average for an organization and the rest are getting zero raises to pink slips. Use of incentive compensation by companies is on the rise, which would also run counter to the sentiment you profess. Similarly, there have been studies where the market is becoming more meritocracy-based and one of the reasons CEO pay has exploded is that CEO tenure has declined fairly dramatically - thus to incentivize a sub-"C-level" executive out of their comfort zone and presumably area of extreme competence and into the corner office, the pay package has to be substantial enough to compensate for the shorter-expected tenure.

 
Written By: m.jed
URL: http://
m.jed

You ask Kyle to offer research supporting his opinion but offer no research to support your own. It implies that your own opinion has been pullout out of somewhere that you are embarrassed to share.
 
Written By: cindyb
URL: http://
Cindy,

Maybe that’s because I know what I’m talking about - so you can take your attitude and shove it up the place where you’re apparently are not embarrased to bare.
I’ve read newspaper articles quoting compensation experts about "A-players" getting raises significantly above the average for an organization, whereas B and C players are inline to below the average for an organization and the rest are getting zero raises to pink slips.
A small minority of very skilled workers will get raises as high as 50 percent this year, while most California employees will receive minimal or no pay increases, according to Mercer analysts. ``When you take that 4 percent average and divvy it up, you’re looking at companies giving most of their employees small increases or no increases in order to give more to their high performers,’’ said Charles King, a senior compensation consultant with Mercer’s San Francisco office. . .To keep labor costs down, a growing number of companies are adopting one-time rewards like bonuses that don’t become a built-in part of employees’ wage base. Companies are also increasingly trying to link workers’ pay to their performance. Eighty-four percent of companies said they see merit and performance as ``very important’’ factors in raises, while only 5 percent see the cost of living as very important.
http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/1998/08/28/BU20649.DTL

Compensation experts urge companies to take this opportunity to move farther from a system that relies heavily on across-the-board merit increases to one that focuses on rewarding top performers substantially more than the rest of the field. Companies need a compensation system that catches a top performer’s attention and sends a signal to a poor performing employee. . . Rewarding “top-performing employees” does not mean rewarding solely high-level employees. Organizations are using performance pay for middle managers, professionals and hourly workers, determined not to let the depressed business climate lead to a depressed workforce.
http://www.shrm.org/hrmagazine/articles/0103/0103covstory.asp
Use of incentive compensation by companies is on the rise, which would also run counter to the sentiment you profess.
Employers Increasingly Favor
Bonuses to Raises
Companies Aim to Motivate
Workers, Lower Fixed Costs;
Losing ’Entitlement’ Notion
By ERIN WHITE
August 28, 2006; Page B3

http://online.wsj.com/article/SB115673064517347005.html?emailf=yes
Similarly, there have been studies where the market is becoming more meritocracy-based and one of the reasons CEO pay has exploded is that CEO tenure has declined fairly dramatically - thus to incentivize a sub-"C-level" executive out of their comfort zone and presumably area of extreme competence and into the corner office, the pay package has to be substantial enough to compensate for the shorter-expected tenure.
The Increasingly Short-Term CEO: Last month, 80 CEOs with an average tenure of 4.2 years left their jobs
By: D.C. Denison
November 06, 2001, National Post

http://www.kellogg.northwestern.edu/news/hits/011106np.htm

OCTOBER 30, 2006
EXECUTIVE SUITE
The Great CEO Exodus
An impatient Street and stepped-up oversight have CEO turnover in overdrive. Will business suffer?

http://www.businessweek.com/magazine/content/06_44/b4007086.htm

According to Burson-Marsteller, the average tenure of a U.S. CEO has shrunk to about five years. The average was nearly 10 years in 1995, according to Booz Allen Hamilton.
http://www.line56.com/articles/default.asp?ArticleID=7976

How has CEO Turnover Changed? Increasingly Performance Sensitive Boards and Increasingly Uneasy CEOs

Steven N. Kaplan, Bernadette Minton

NBER Working Paper No. 12465
Issued in August 2006
NBER Program(s): CF

http://www.nber.org/papers/w12465
 
Written By: m.jed
URL: http://
Dale, a very thoughtful article.
Also, as an aside, the whole problem of CEO pay was supposed to have been fixed by Bill Clinton in 1993, when he signed the tax reform legislation that capped CEO salaries at $1 million. The whole market in CEO options—and mushrooming CEO pay—came about in no small measure as a direct result of that regulation. The unintended consequence was to exacerbate the very problem it was supposed to fix.

I really have to question whether CEO pay would’ve risen to such stratospheric levels over the past 13 years, if corporations had been able to directly compensate CEOs at an adequate level, rather than offering such large option packages.
I find it hard to believe that this really happened, but the chain of consequences you project from it, if it had/did happen, is plausible.

The real problem leading to CEO pay inflation is the potential for implicit and indirect collusion in the market for CEO pay. As a CEO looking to create cost savings and impact the earnings line, when you have the choice of a) cutting the salaries of people under you and b) cutting your own salary, human nature dictates B, even if equivalent competitive and efficiency gains would come from cutting top executive salary as from starving the grunts.

Mutliply that decision-making process by every firm in the industry and you have a natural collusion where CEO salaries absolutely refuse to sink and indeed keep climbing regardless of firm and industry performance. When every CEO is getting paid in nine figures regardless of performance, it is much harder to be the first board to cut salaries, because of the talent loss you may suffer. Whereas the simultaneous *willingness* of firms to cut pay and jobs for the entry-level people means that all firms are together protected from the adverse consequences of lowering labor rewards that would otherwise accrue - i.e. being stuck with less-talented employees.

In this way the aggregate decision making of individuals leads to a broken market for CEO pay that ignores performance and genuine value-added. That’s why we have a countervailing institution- government - to break the deadlock.



 
Written By: glasnost
URL: http://
I find it hard to believe that this really happened, but the chain of consequences you project from it, if it had/did happen, is plausible.
Businessweek reached the same conclusion in an article this week. . .

NOVEMBER 27, 2006
How Bill Clinton Helped Boost CEO Pay
A law he championed to curb compensation has backfired — and pay packages have exploded

http://www.businessweek.com/magazine/content/06_48/b4011079.htm?chan=top+news_top+news+index_careers

Glasnost, assuming your collusion theory is the predominant underlying factor in escalating CEO pay, what would you posit the reason that it’s accelerated over the past decade or so?

Are Boards cozier now than they have been historically? I don’t know the answer, but with the examples of Hewlett-Packard spying on Directors’ leaks and the AIG board ousting Hank Greenberg, along with forced regulation to have predominantly independent boards, limited availability of and expensive Directors’ liability insurance, greater scrutiny of the Board audit and compensation committees by auditors and regulators, it would seem (and I believe I’ve read some articles about this as well) that the dynamic between Boards and CEOs is becoming more adversarial, not less.
 
Written By: m.jed
URL: http://

 
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