Executive Remuneration

Chetan J. Parikhcapitalideasonline.com

Level 5 leaders channel their ego needs away from themselves and

into the larger goal of building a great company. It’s not that level 5

leaders have no ego or self-interest. Indeed, they are incredibly

ambitious – but their ambition is first and foremost for the institution, not

themselves – Jim Collins, Good to Great

Corporate Governance

• Executive pay has taken over as the top concern of corporate governance from last year’s biggest worry, the independence of auditors

Astronomical growth in CEO pay

• During the nineties, senior executive compensation in the US rose by 442% in 8 years

• By 2000, CEOs in America were getting more than 1000 times the wages of the average employee, up from 85 times from the beginning of the decade and 42 times 2 decades earlier

The external CEO market

• For neoclassical economists, the external CEO labor market is a market like any other

• Sociologists use a structural perspective which recognizes the centrality of social networks and relationships

Structural perspective• This recognition points away from economic

calculations and towards patterns of social relationships, reputation, information flow, constraints, opportunities and the determining roles of community and power

• The CEO labor market is a closed market where the distribution of opportunities is restricted to a narrow set of eligible individuals

Various forms of executive compensation

• Basic pay• Bonus• Stock options• Stock appreciation rights• Stock grants• Golden parachutes• Loans granted and forgiven• Pension packages

If we had to name a single father of the bubble, we would hardly need a

DNA test to do so. The father is executive compensation made

manifest in the fixed price stock option. – John Bogle

Are incentives aligned to shareholder value creation

• Typical stock option programs are not the right sort of incentives for the long run value creation of the firm

• Stock options mean that executive pay depends on stock prices in the short run where it is easier to improve the appearances of profits than to actually improve the profits

Are incentives aligned to shareholder value creation

• In bull markets all option holders stand to benefit and in bear markets all suffer without any clear distinction between companies that deliver superior performances and those that don’t

• Options can get repriced which makes a mockery of the concept

When executives are paid for raising the price of their company’s stock

rather than for increasing their company’s value, they don’t need to

be told what to do “achieve strong, steady earnings growth and tell Wall

Street about it. Set ‘guidance’ targets with public pronouncements of your expectations, and then meet your targets - and do it consistently,

without fail – John Bogle

First, do it the old fashioned way, by increasing volumes, cutting costs,

raising productivity, bringing in technology and developing new

products and services. When making it and doing it is not enough, meet your goals by counting it, pushing accounting principles to their very edge. And when that isn’t enough, cheat. As we now know too many

firms did exactly that – John Bogle

Options Accounting

• Stock options became almost like an off-the-books currency

• Accounting rule makers’ attempts to require recognition of the cost of these options met with wide spread opposition forcing them to back away from requiring recognition

• In response to the Enron and WorldCom scandals, accounting for stock options is being rethought

Options Accounting

• Current accounting rules provide that the value of an option is not required to be expensed on a company’s income statement

• A company is however required to report its earnings per share on the income statement on a basic and on a diluted basis, the latter taking into account the potential reduction in the ownership of the existing shareholders due to the grant in exercise of options

Options Accounting

• According to the New York Times, options were the source of more than half of most top executives compensation last year

• The International Accounting Standards Board issued a proposal in November 2002 and the FASB is working on a proposal expected to be issued shortly

Accounting for stock options in India

• A leading Indian software company’s annual report for 2002-03 stated – the excess of the market price of the underlying

equity shares as of the date of grant of the options over the exercise price of the option including up-front payments if any is to be recognized and amortized on a straight line basis over the vesting period. All options have been issued at fair market value. Hence there are no compensation costs

Mental Accounting

• Employees put stock options in a mental account that is separate from the cash income and don’t count on the stock for day to day budgeting and don’t consider it when they do their jobs

The answer lies not in inadequate laws … but rather in what I call

boardroom atmosphere. When the compensation committee armed as

always with support from a high paid consultant reports on a mega grant of options to the CEO, it will be like

belching at the dinner table for a director to suggest that the

committee reconsider – Warren Buffett

The bull market also meant that shares and share options granted by

boards to top executives often proved a lot more generous than

initially expected : some of the new wealth came simply as a windfall as share prices soared. So extravagant

pay was not entirely the board’s fault. But several other points should

be noted – The Economist, 28 June 2003, Survey on Capitalism and

Democracy

Targets set as triggers for incentive payments came to suffer from what central bankers know as Goodhart’s

law, after the academic who noted the phenomenon : any target that is

set quickly loses its meaning as it comes to be manipulated – The

Economist, 28 June 2003, Survey on Capitalism and Democracy

In any case, the setting of detailed performance targets, whether by

boards or shareholders is no easier in a private company than it used to be in the Soviet Union. The expertise required to fine-tune such targets in

the face o complex markets and organizations is unattainable – The

Economist, 28 June 2003, Survey on Capitalism and Democracy

However general or detailed the targets, the stock markets demand

for smooth raises and quarterly earnings, combined with the frequent link between those

earnings (or just the share price movement) and bonus payments, provided a powerful incentive for

manipulation – The Economist, 28 June 2003, Survey on Capitalism and

Democracy

The auditors supposed to be monitoring such accounting reports

were appointed by the management themselves, and dependent on them

not only for continued fees but also for even larger consulting business –

The Economist, 28 June 2003, Survey on Capitalism and

Democracy

Remuneration packages were set by board committees with little

influence from shareholders who left chairmen to chose supposedly

independent directors. Without any pressure to tie pay to long term

corporate performance, it was naturally linked to quite short term

measures or to none at all. The rapid rise in share prices paid its part by

making options exercisable increasingly quickly – The

Economist, 28 June 2003, Survey on Capitalism and Democracy

For all managers, knowing the costs of staying in business and treating

them as genuine costs is a basic responsibility. This implies, first, that

the financial figures of their institution be adjusted to inflation so

that managers know the true economic position of their

enterprise. It implies, secondly, that managers accept that they operate

at a loss unless the surplus of current revenues over costs of past

and present covers the cost of capital for all the money employed –

Peter Drucker

There is an urgent need to adjust executive compensation to reality.

As long as executives get extra compensation based on reported

‘profits’, they will resist changing the way they report their earnings. Extra

compensation based on profits should be never be paid until the costs of staying in business have

been covered by current earnings – Peter Drucker

Not to disclose that the genuine costs, the costs of staying in

business have not been earned is fraud. To pay oneself ‘bonuses’

based on a nonexistent profit is embezzlement – Peter Drucker

Questions to ask when designing executive compensation

• What business results must the organization deliver to be successful?

• How can top managers impact these results?

• What metrics have the greatest impact on shareholder value?

• How can pay be linked to these metrics?