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American Pastime: OverPaying CEOs

Posted By Barry Ritholtz On April 5, 2010 @ 7:15 am In Really, really bad calls,Wages & Income | Comments Disabled

There is a longish Sunday NYT article [1] on CEO pay that I plan on reading. But before I get to it, I wanted to share some longstanding thoughts of my own on exec compensation.

While there was a temporary drop in exec comp caused by the market crash, we still have structural compensation issues that need to be addressed. For too long, we have been vastly overpaying CEOs of public firms for mediocre performance . Even worse, we have institutionalized this trend in recent decades. The result has been a massive transfer of wealth from shareholders to corporate execs.

In Europe, pay scales have been increasing modestly — but nowhere near the level of shameless theft here in the States.

Some 50 years ago, the highest paid executive (usually the CEO) made 30 times what the firm’s lowest paid employee did. This has changed over time, shifting upward in the 1980s. It has radically shifted the hi/lo pay ratio at American companies. Since 1999, as the average US paycheck has remained flat, C-level execs compensation has exploded. Just before the credit crisis crushed stock prices, the highest to lowest ratio was near 400 to 1.

Executives of public companies  have been making a killing. Even worse, its for mediocre performance.

Roger Lowenstein details a rogues gallery of over paid execs in 2004′s Origins of the Crash [2]. Back in 1991, Tony O’Reilly, CEO of Heinz, got a package worth the then astounding sum of $71 million dollars. Ed Nardelli of Home Depot grabbed a $210 million severance package for essentially losing market share to Lowes. More recently, others — especially in the financial sector — got paid $100s of millions of dollars for essentially destroying their own firms.

Huge stock option grants create perverse incentives. GE’s Jack Welch pocketed over $400 million dollars in salary, bonuses, and options. Lowenstein argued in his book that Welch essentially managed the earnings with very creative accounting and the help of GE Capital’s impenetrable financial black box. The credit crisis caused the collapse of GE’s earnings management, confirming Lowenstein’s thesis of earnings management. Its hard to avoid his conclusion that the greatest industrial CEO in recent American history was little more than a clever accounting cheat.

How does this happen? How are shareholders hoodwinked so thoroughly? I can describe the legal corporate theft by insiders in 5 simple steps. The scam goes something like this:

Five Steps to Shareholder Wealth Transfer

1. The Board of Directors, usually cronies of the CEO (often hand picked by him) forms a compensation committee. To appear “objective,” the committee hires an outside compensation consultant.

2. The compensation consultants are themselves well paid whores, who rather than turning tricks outside the Holland tunnel, offer up absurdly generous comp package. They deliver what they are paid to: They provide cover for the boards to make an otherwise indefensible giveaway of shareholder monies in the form of cash and stock options. It is typically called “Pay for Performance,” but that is a horrific misnomer, as we see in step #3.¬† The comp committee approves the consultants’ nonsense, forwards it to the Board, who rubber stamps it.

3. Here’s where things get interesting: If the stock price rallies, the exec can exercise and cash out, risk free. If the stock price falls, the exec requests a new round of options — or even easier, asks for a repricing of the old ones.

4. After the options are repriced, the exec simply waits. Whether the market rallies or falls . . . you simply go back to step three. Repeat until stock options are in the money. There is no risk or outlay of cash on the part of execs.

5. True “performance” is not a factor. Stock prices can rally for a vast range of reasons having nothing whatsoever to do with management or CEO performance. The market can rally, a sector can come into favor, or even when the Fed can cut rates.

This is not pay for performance, it is pay for stock price volatility.

Actual performance would look at factors such as peer profitability, sector performance, SPX index gains. Bonus payments and stock option exercise should be for gains OVER AND ABOVE these factors — but sadly, rarely if ever are.

There are numerous enablers of this terrible comp system: Crony boards rubber stamp what turns out to be outsized — and oft guaranteed — pay packages for under-performance. An entire class of consultants somehow blesses these absurdities, giving the boards cover for their theft of shareholders. Third, large mutual funds remain mute, failing to fulfill their obligations as stewards of their investors’ stock shares. Instead, their silence is bought with 401k business and syndicate shares (IPOs, secondaries).

Solutions are as simple as they are unlikely: Require shareholder approval of exec comp plans, mandate public disclosure of consultant comp plans (they are embarrassingly ridiculous), and last, cleave the mutual fund asset management business from the rest of the companies. Impose a fiduciary obligation on mutual funds to investigate all Board nominees and vote their shares on behalf of S/Hs.

Just don’t hold your breath waiting for credible compensation reform to take place . . .

>

See also:
Bargain Rates for a C.E.O.? [1]
DEVIN LEONARD
NYT, April 2, 2010
http://www.nytimes.com/2010/04/04/business/04comp.html

Few Fled Companies Constrained by Pay Limits [3]
ERIC DASH
NYT, March 22, 2010
http://www.nytimes.com/2010/03/23/business/23pay.html


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2010/04/american-pastime-overpaying-ceos/

URLs in this post:

[1] NYT article: http://www.nytimes.com/2010/04/04/business/04comp.html

[2] Origins of the Crash: http://www.amazon.com/exec/obidos/ASIN/1594200033/thebigpictu09-20

[3] Few Fled Companies Constrained by Pay Limits: http://www.nytimes.com/2010/03/23/business/23pay.html

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