Hodak Value

For many governance critics, the level and growth of CEO pay suggests something is broken with the way boards oversee their companies. The idea that there is a problem, of course, attracts the idea that we need a political solution. Thus, a bill to allow shareholders a direct vote on executive compensation has been introduced by Barney Frank (D-MA). The proposal sounds sensible. The shareholders, after all, own the firm. In a perfect world, shareholders should decide exactly how their companies are run, including compensation policies.

In the real world, shareholder involvement in corporate operations, including human resource decisions, is simply infeasible. That���s why we have boards. Boards can study the issues in depth, consult with relevant experts, and bring their often-considerable operational experience and judgment to bear on key decisions affecting the value of the firm. Increased shareholder involvement would do little to address the underlying drivers of executive compensation. It would, however, create new agency costs of unpredictable magnitude regarding board oversight.

The W$J gave front-page prominence to executive compensation, again. Today's article highlighted five "players" and the groups they represent. Jesse Brill, "The Networker." urged a tally sheet for directors. Lucian Bebchuk, "The Professor," is known as the main academic proponent of the "managerial power" thesis of why pay has grown. "The Bureaucrat" is Meredith Miller, assistant treasurer of the state of Connecticut. "Mutual Fund Trustee" John Hill, from Putnam Funds represents institutional investors. Finally, "The Union Leader," Edward Durkin, helps oversee the giant pension fund of the United Brotherhood of Carpenters and Joiners.

Other than having nicknames strongly reminiscent of a 70s heist flick, these "players" share an interest in what the authors call shareholder activism on executive compensation. But what interest, exactly, does each player have? What type of activism does each player promote? When you get into the article, it turns out that their interests and methods only partly overlap. The point of overlap, of course, is reducing the perceived abuses of CEO pay. But they define the scope and nature of thoses abuses differently, and pursue correspondingly different policies to rectify them.

Boy, the WSJ went to town on CEO pay today. Like most news stories, the writing suffers from a disturbing conflation of description and prescription. Descriptively, the rules on disclosure have changed and many companies are reacting to those changes in various ways. That's interesting stuff for someone like me into executive compensation for professional reasons.

The prescriptive part was what you'd expect of journalists trying to rope in the non-professionals with a sensational story while pretending to offer simple answers to complex issues: a list of "Ten Things," compiled from suggestions of various activists, experts and "daring" directors. Drum roll, please:

1. Don't allow the board's pay consultants to do other work for management
2. Don't let outside CEO recruits monopolize the pay setting process
3. Don't offer severance for anyone with a lot of equity or deferred pay
4. Make it easier to fire for cause
5. Be skeptical of "peer group" comparisons
6. Kill unjustifiable perquisites
7. Link long-term incentives with performance goals
8. Divulge precise measures for performance-based payouts
9. Conduct regular check-ups about pay practices
10. Give investors a voice in executive pay

Now, how hard could that be?

Well, the Democrats have fulfilled on their populist promise to "do something" about CEO pay with the new "Say on Pay" bill passed yesterday. It's difficult for me to add anything beyond what I already wrote when this bill was first proposed a few weeks ago, or the able commentaries of Professors Ribstein, Bainbridge, and Smith. But this is an economics, as opposed to a legal, blog, so I will make it really simple:

This bill, if passed into law, will politicize decision-making on executive compensation at public companies. Politicized decisions are rarely better decisions, so investors will suffer.

If Congress had any integrity about this proposal, the most they would do is to require all public companies to give actual shareholders the choice about adopting a "Say on pay" policy at the company level, which many companies are already doing. This measure is supposed to be for the benefit of the shareholders, right? The fact that the Democrats are choosing, instead, to end-run shareholders perfectly able to vote for themselves with a top-down, Federal law gives you a clue as to who the real intended beneficiaries are.

Anyone who believes that investor-run public companies are better than board-run public companies should invest in North Dakota firms, or in firms that have adopted their own shareholder-vote proposals, and leave the rest of us investors to choose which governance models work for us.

Yesterday's WSJ had an article on what boards are doing about compensation consultants. The concern among governance critics is that a major HR firm���s executive compensation practice, which might earn $200K to $300K in a year, might be influenced by that firm's much larger, other HR practices, which could easily earn ten times that amount. Directors should be concerned, the theory goes, that the executive comp advice they get from a consultant may be colored by his colleague���s desire to sell much larger projects, and the need to keep the top guy ���happy.��� So, what board experiments are currently keeping the governance critics happy?

I guess it makes sense for a retailer to be the first to experiment with a bargain CEO. Sharper Image took a step advocated by many governance mavens to improve their bargaining position in negotiating for an outside CEO. They avoided identifying a single "gotta have" person, then trying to negotiate pay from a position of potentially failing to get him or her. As Pearl Meyer noted, this creates a situation where if "they find the person they think will make a difference, the cost is immaterial." Instead, Sharper Image decided to take the pressure off themselves by identifying back-up candidates in case their first choice got too demanding. Fine so far, but then they looked at the sticker and got all Jack Benny.

Their compensation consultant conducted a peer analysis to determine that the board needed to be prepared to pay a target salary plus bonus of $1.5 million plus 150,000 options per year to attract current or past CEOs identified by the board's search firm. Even though this was not much less than the current CEO was making, all things considered:

The potential price tag dismayed board members. "Everybody raised their eyebrows," remembers Morton E. David, chairman of the nominating committee and former CEO of Franklin Electronic Publishers Inc. "Nobody was happy with the numbers" amid Sharper Image's declining revenue, he explains. "Money was an issue. For some people, it was the prime issue."

Directors decided to seek alternative candidates who had not run public concerns, and likely would cost less. Mr. David says they gave Mr. Levin [the interim CEO] authority to offer such a candidate "materially less" than a seasoned public-company chief would have demanded.

Now, I'm not one to automatically exclude the less obvious candidates for any position, but to do so for the CEO position based on price? To save $700,000 per year? Sharper Image has a $170 million enterprise value. A CEO that could bring their return on capital up to the industry median, where they were just a few years ago, would generate over $50 million per year in extra EBITDA, easily tripling the company's market value. A merely "very good" CEO, one able to return the company to profitability, might generate a 50 or 100 percent return--not bad, but not 200 percent. In other words, the potential difference between the best and next best CEO could easily be hundreds of millions of dollars. And they're concerned about $0.7 million per year?

Admittedly, no one can predict which candidate in the field would turn out to be the best. There is no guarantee that the guy who costs the most would actually be the best. There are many qualitative characteristics a board should consider before paying top dollar for someone who might not be a good fit, regardless of their track record. But to eliminate contender because of a cost that could easily be a fraction of value added does not seem like good governance to me.

No one can predict how this will all turn out, of course, but for what it's worth, Sharper Image's stock dropped 1.5 percent upon the release of this story (the market was flat), shedding about $2.5 million in market value. That would be net of the cost savings on the CEO.

The day I get back from vacation, I see this article about how much Stephen Schwarzman is worth--$7.5 billion.

Most people would think, "Wow. That's a lot of golf balls" (or whatever). I thought, "Wow. Congress is going to see red on this one. They won't be able to resist that bale of cash just sitting out there." I figured that within a month, the other shoe would drop.

Well, as usual, I'm off on my timing. It took one day for Congress to react. It looks like the tax on carry is going to be amended for public PE firms. This won't affect public partnerships of any other sort, just investment firms--the ones whose fabulously rich partners have been in the news. Yea, this measure has been considered for a while, long enough for Schwarzman to lobby for preferential treatment via a transition rule, but I can't help but think that the pols who announced this might have taken a measure of the public mood in their timing.

For those of us who study executive compensation, you'd think that the new disclosure rules would have been a boon. It's not. In fact, I am becoming convinced that the only beneficiaries of the the new disclosure rules are the story writers of our so-called business press.

As I predicted in my note to the SEC (pdf file), the new rules provide very little for the serious analyst that wasn't already provided under the old disclosure rules. I was particularly skeptical of the need to disclose specific perks down to $10,000 when the total value all perks was already required to be disclosed. At the time I wrote that:

greater detail in the disclosure of perks would serve little purpose beyond the voyeuristic interests of those opposed to executive “privileges” of any sort.

Yesterday's front page story in the WSJ, for example, notes that the CEO of Occidental Petroleum "received compensation last year valued at $416.3 million." It makes no mention about what the shareholders got for this pay (in other words, the business story). No, this front page story is about $0.06 million of that amount for his wife's flights on the corporate jet.

The critics ask, couldn't someone who makes $416.3 million pay for his wife's use of the jet? Of course he could. But that would mean taking the time to perform an actual administrative process that wouldn't normally be necessary when simply using an existing corporate asset, like paying to use the bathroom on your floor. Of course, administrative costs are borne by pulling together all this tedium for corporate disclosure. It's hard to see how the shareholders benefit from any of this, until one accepts that the shareholders were never intended to be the real beneficiaries of such disclosures.

I think a more interesting story is how Journal author JoAnn Lublin arrived at the $416.3 million she says the CEO got "last year." The new disclosure rules properly distinguish "granted" versus "realized" compensation. Equity granted in prior years would not be counted as "last year's" pay. Prior year grants that were realized last year would merely be a reflection of company performance under the CEO over the period from grant to realization. If that number is large, it's a reflection of the terrific job done under that CEO.

Someone like Lublin who has covered business and compensation issues over the years--she is, in fact, the Journal's main writer on compensation issues--would, one might think, avoid the error of counting realized income as "last year's" pay. And under no circumstances, one might think, would she count both realized (i.e., historical) and unvested (i.e., future) compensation as "last year's" pay--a double counting flaw intended to be corrected by the new compensation disclosure rules. Alas, one would be bitterly disappointed. Lublin counts all of it as "last year's" pay. Why? Because that makes the number as BIG as possible, which happens to serve the interests of story writers.

Fortunately, there are no disclosure rules for journalists.

Instead, I'm concerned.

The adversary is Towers Perrin, the embodiment of everything that is wrong with compensation governance. Towers' outmoded, feel-good HR model places too much emphasis on "competitive" pay and too little on aligning managers and owners. They're responsible for entire HR bureaucracies focused on rewarding strategies instead of results. They don't offer shareholder-friendly incentives.

The government suspects this failure is the result of the corrupting influence of managers who resist the accountability of such incentives, but I believe that suspicion is misplaced. No, Towers fails to offer useful incentives because their clients, including the most conscientious boards of directors in America, don't want them. Useful incentives require innovation, and boards are not in the mood. Instead, HR firm clients rely on their consultants' experience to give them an incentive plan just like everyone else's. No one will pay Towers, or Mercer, or Hewitt, or Watson Wyatt--what you might call Big HR--for any incentive plan that will differentiate their company, so Big HR doesn't develop them.

Consequently, Big HR is intellectually stunted with regards to leading edge, value-focused incentives. Their consultants are uninformed in modern financial economics--the main vein of research relating incentives to shareholder value. Their analysis is schlock, based on reticent hypotheses, yielding conclusions of questionable validity. To the extent they keep up with developments in incentive compensation at all, it's by stealing the ideas of people who bridge the gap between research and practice. Some of us have a foot in academia and a hand on the pulse of actual clients. Firms like Towers Perrin have both arms around their clients, and legs, furiously shaking to loosen up some more dollars to meet their shareholders' quarterly expectations.

So, I should be happy that Towers is feeling the heat of a congressional committee seeking all of their sensitive client information. But, I'm not. Perhaps it's my sense of history. Perhaps it's because, for all their faults, Towers Perrin doesn't scare me.

First Chanos, the short-seller made famous by his Enron call, and now ISS. Chanos is concerned that Macquarie might be creating a false impression of high and growing earnings which may not be sustainable. ISS's complaint is that Macquarie's executives don't have the right incentives to sustain those earnings. I can't evaluate Chano's concern, but I can shed some light on ISS's:

Should the gains prove fleeting, an executive would have little exposure to that future downside risk...

ISS also criticizes the company for giving executives 74.2% of their total pay as cash. ISS argues that corporate executives should receive a bigger chunk of [it] in company stock that can't be sold right away -- an incentive for them to keep earnings growth brisk.

Of the US$25.6 million that Macquarie Chief Executive Allan Moss was paid in the fiscal year that ended on March 31, 87% was in his bonus check and 4.2% in Macquarie stock. By contrast, of Citigroup Chief Executive Charles Prince's $25.98 million, nearly 44% was in Citigroup stock.

Macquarie's bonus plan stands in stark contrast to Citigroup's. Prince's bonuses are based on multiple financial and non-financial criteria, subjectively assessed by the board. The criteria and performance thresholds get reviewed each year and are subject to change. This is the type of unfocused, discretionary, shifting plan that the same research shows to be of least value to the shareholders. Furthermore, unlike Mr. Prince's bonus, a good portion of Macquarie's is deferred and forfeitable. Mr. Prince may elect to defer some of his cash, but he can't lose any of it, even if he leaves involuntarily.

Perhaps ISS's qualm is that Macquarie's executives should have more equity. So how much equity does a CEO need? Macquarie's chief has nearly one million shares and options. Is that enough? A five percent gain or loss in Macquarie's stock price would swing his personal wealth by about $4 million. Citibank's Prince has 2.6 million shares. So, how much difference does it make to his alignment that he got another 0.2 million last year?

By the way, most of Prince's equity grant was not performance-based. The board awarded it to "increase retention." I suppose that means they needed to give him that award to keep him at the helm versus, say, jumping over to JP Morgan, or retiring. As if. And, unlike Citibank, Macquarie's guidelines prohibit hedging of executive's shares.

So what exactly does ISS have against Macquarie's incentive compensation that they might want it to look more like Citigroup's?

Instead, I'm disgusted.

Since I'm an expert on executive compensation, I guess I ought to comment on this stuff. However, I'm a little late to this story, in part because I no longer subscribe to the NY Times. Frankly, I can get rags for free from the worn out clothing generated by my growing kids. Nocera's column on CEO pay is typical of the reason for my dropped subscription. (Please don't encourage them; here is an ungated version.)

Nocera is pretending to debate Watson Wyatt's Ira Kay about the social value of CEO pay, as if they are on the same intellectual plane.

I've heard Kay make this point before - and even debated him on it. He really does seem to believe that all of the great economic benefits enjoyed in the United States during the past two decades or so can be traced back, in no small part, to the way chief executives are paid.

I, on the other hand, believe he's got the cause and effect exactly backward: that it was the rising market that made the lucky fellas running America's corporations look like geniuses - and made them richer than they'd ever imagined, thanks to the shift to stock options as the primary way to reward executives.

If it turned out that in a real market for CEO pay, their compensation remained in the stratosphere? I might not like it, but I could live with it.

For those of you who may not have taken my class on compensation and corporate governance, how much did each these recently departed CEOs get in severance pay?

Stan O'Neal:

1) As much as $250 million
2) $160 million
3) $159 million
4) $0

Chuck Prince

1) $95 million
2) $40 million
3) $29.5 million
4) $0

(If you took my class and didn't ace this, you'll need to return your course credit.)

...but I somehow doubt that the Congress wouldn't just end up gumming it up for all of us.

The House of Representatives Committee on Oversight and Government Reform just published a document on executive pay that claims that "corporate consultants can have a financial conflict of interest if they provide both executive compensation advice and other services to the same company." The committee is considering additional disclosure rules to remedy this problem.

Henry Waxman, the congressman who requested this report, is apparently concerned that compensation consultants and corporate executives are conspiring to disregard their professional responsibilities to each other and the shareholders. This seems like a reasonable concern, if you consider the board of directors nominally overseeing this transaction as lazy or corrupt. In that case, more disclosure about the arrangements between consultants and management would make sense, if you consider the investors to be alert enough to do something positive about it. As it turns out, all of these assumptions are highly debatable. Investors with competent directors don't need additional disclosure; investors with incompetent directors can't be helped by it.

Congressman Waxman should know a thing or two about conflicts of interest, and how much difference disclosure really makes. Waxman gets the lions share of his campaign funding from unions. He has 93% rating from the AFL-CIO based on how he voted on issues of concern to union leaders. Do those facts suggest a conflict of interest? And how many of the citizens in West Hollywood, Santa Monica and Beverly Hills, that hotbed of the working class that Waxman represents, know those particulars? All of it is out there, if you know where to look. The fact is that the link between Waxman's congressional cash flow and his congressional work won't penetrate the sunglasses of his constituents any more than the details of corporate HR policy will be taken in by shareholders, despite mounds of disclosure already available to them.

Some problems are simply not big enough for the ham-handed machinery of Congress to fix. Some problems cannot be fixed even by unconflicted lawmakers, and most problems are made worse by their attempts to fix them.

I came across this survey showing that most employees, including senior executives, consider CEOs "overpaid." Nevermind this survey's schlock statistical methods; the question that immediately came to mind for me was whether the question itself made any epistemological sense. Consider this definition:

Overpaid: Any person receiving a wage in civilized society.

Consider the perspective of people making far less than American employees. To someone struggling in the third world, anyone living an American middle class lifestyle by doing, say, electronic filing from their cushioned chair might be considered overpaid. We can't ask our dead great-grandparents who tried to pull survival from the ground what they would think, but is it far-fetched to consider that they might regard their progeny pushing paper in cubicles, or Big Macs out of a drive-thru windows, as "overpaid?"

Yet innumerable articles continue to be based on the premise that CEOs are "overpaid." Sure, one might argue that certain individuals are "overpaid" based on how they get their pay, e.g., cheating or stealing. But that's not what this question is asking, nor is it the premise behind so much jaw-boning about the subject of CEO pay. No, this survey was simply pulling a subjective response from an uninformed audience, and the press was simply reflecting this response back to them in the guise of informing them. This study's authors and the media, then, become a critically passive route by which useless information gets processed--kind of like intestines that push along the crap with the nutrients, failing to sort them for the nourishment of the body.

I took Larry Ribstein to lunch a couple weeks ago as a meager thank you for his guest lecture in my "Scandal" class this Fall. Eating with Larry, one expects to partake of his keen insights on corporate law, business, and the media. The bonus of this particular lunch was Larry's hearty recommendation of oPtion$ by Fake Steve Jobs (aka, Daniel Lyons of Forbes).

Despite being an FSJ fan since before Thanksgiving, I didn't think I'd have time to add another book to my Christmas list. I decided to chalk it up to "research" on my own options idea I would be developing during my iLess break on the farm.

My wife, wrapping last-minute presents in the kitchen and hearing me laughing from the living room, was wondering what could be so funny about modeling a complex financial product. I disclosed the nature of my preliminary 'research', and tried to read a passage to her.

Friends, I simply couldn't get it out coherently. I ended up needing a paper bag to catch my breath from laughing so hard. No spoilers, here, but the passages with Apple's Chairman, who hilariously hates Jobs, and FSJ's run-in with the attorneys investigating him as well as the one hopelessly trying to defend him are priceless. Various celebrities get skewered in cameo appearances, any one of which is worth the price of the book.

Having sampled the FSJ site over several weeks, I was initially concerned that oPtion$ would read like a collection of blog entries forced into a book just to cash in on the site's popularity. Folks, it didn't read that way at all. Each funny chapter hewed to a story line that was faithfully maintained to nearly the very end. At that point, some hints of character development emerge, only to be gratefully suppressed in a suitably goofy denouement.

When I was done with it, I thought, "God, I wish I could write like that."

The SEC asked for more information, more details about that extra information, and in plain English, in its major revamp of disclosure laws last year. Oh yea, and with civil and criminal penalties for false or misleading statements. No, this wasn't called the Compensation Attorney's Full Employment Act, but it could have been.

So far, the SEC is unhappy with what it's gotten. Last year it sent out letters to 350 companies complaining that they weren't providing what the regulators wanted.

A majority of the companies have now received second letters, according to an SEC official, and of 26 companies whose cases were closed, 21 were chided for not giving enough information about the role of individual performance in their pay decisions.

[Boston Scientific] said it gave CEO James Tobin a 3% raise after reviewing "whether the company had met or exceeded quarterly sales and earnings targets, the performance of our Taxus stent system, our product-development initiatives and business integrations, as well as other matters."

The SEC wasn't satisfied and asked for "substantive analysis and insight" into how the board's compensation committee determined specific pay, according to its Sept. 26 letter.

"The board, in deliberating Mr. Tobin's salary increase reviewed their quarterly sales targets of $2,055 million, $2,064 million, $2,074 million, and $2,083 million, respectively. The company, in fact, achieved $2,065 million, $2,086 million, $2,070 million, and $2,047 million, respectively. Despite two quarterly shortfalls, the Board felt it needed to give Mr. Tobin a five percent increase anyway, to remain competitive. When one director questioned the retention risk associated with giving Mr. Tobin less than five percent, one of the directors replied that he bumped into Mr. Tobin at O'Hare just a few weeks earlier, where Mr. Tobin looked uncomfortable and mumbled something about visiting his widowed sister-in-law in Skokie. It was noted by this director that Mr. Tobin was wearing his Ermenegildo Zegna suit as he walked away.

"Another director loudly noted, 'That's his closer suit,' referring to Mr. Tobin's sartorial preferences in prior negotiations. There was then a brief discussion around why Mr. Tobin would take a commercial flight to O'Hare at this time of year when he apparently had plenty of time left on the corporate jet. One director pointedly commented, 'Sister-in-law, my ass. Skokie is on the way to Deerfield. I'll bet those bastards at Baxter called him up again for a friendly chat.'

"By now, the board was agitated at the prospect of their CEO negotiating a competing offer with a peer company behind their back. This agitation was followed by a motion to rescind the proposed five percent raise, and replace it with a proposal to dock him five percent the next year. Cooler heads quickly prevailed, noting that Mr. Tobin was probably well worth keeping around, despite the current downturn. The chairman of the Compensation Committee noted that some kind of raise was likely necessary to keep Mr. Tobin from 'looking,' if not 'walking.' The Board was split among two factions on this point. One faction was in favor of at least five or six percent while another wanted to give Mr. Tobin nothing or, in the case of one director, an amount indicated by a finger gesture understood by the other members to mean less than nothing. After some more back-and-forth, they compromised on a three percent figure, considering that an anticipated 12 and 18 percent increases, respectively, in the Blazer TM and Ultra ICE TM catheter lines could justify a little extra bonus to make up for the potentially competitive shortfall in salary.

Even Megan McCardle laments:

I wish someone had a better answer to the question of why large institutional investors aren’t more active in corporate governance.

Here's two reasons:

1) Rational apathy
2) Lack of comparative advantage in doing so

The Comcast board has decided to cut founder Ralph Roberts's salary to $1 per year, make him ineligible for bonuses, annual equity grants, as well as certain death benefits that would have accrued to his wife or estate. These changes follow a loss of about a third of the value of the company's shares in the last year. As a result of that slide, Comcast has been under severe criticism from major shareholders. Besides concern about the founder's pay, certain large shareholders have generally been critical of management's apparent lack of focus on value creation, and have asked for more of the cash being returned to shareholders. So, along with the cuts in pay, the company responded yesterday with 25 cent per share dividend, and a commitment to buy back $7 billion of shares by 2009.

All this is evidence that, while the happiness of shareholders is proportional to a rise in share price, the power of outside shareholders increases with a decline in value. In other words, major shareholders seem to live with a balance of happiness or power, depending on the company's fortunes. When performance falters, just about any board can put enough pressure on a controlling family to make significant strategic changes, and even rein in their compensation. Unfortunately, when things are going well, it's easy for a controlling family to layer on additional compensation, and the Roberts family took advantage of that. No one I know has found a way around this dynamic.

So, when the company was riding high in prior years, the Roberts family accumulated beneficial ownership of millions of additional shares, including those that were part of about $50 million in compensation for 2006. The family now owns or controls nearly 40 million shares, not counting a couple million more unvested, underwater options. What that means now, however, is that the $1.50 increase that followed yesterday's changes were worth about $60 million to them. So, in 24 hours the Roberts were able to increase their wealth with some shareholder-friendly moves by more than their total compensation from the firm for all of last year. Now, if they can recover what they had lost from their peak last year, they could make an additional half billion dollars.

For now, this family is completely on the shareholder's side. The time to watch them again will be when the company makes a spectacular recovery, and management again becomes untouchable.

Toll Brothers has somehow flushed a perfectly good bonus plan down the toilet.

Their old bonus plan gave the CEO a fixed 2.9 share of his company's profit gains. There was no cap on the bonus, which presumably meant no cap on their performance. And their performance was good. In the good years, their CEO made big bucks. So did the shareholders, including the largest shareholder, the CEO.

The new bonus plan is based on undisclosed "varied" criteria. In my experience, this is pretty close to saying "discretionary." Mr. Toll also continues to get 2 percent of the profit, so there is now marginally less emphasis on profitability, and more on other "varied" stuff. And his new plan is capped at $25 million. Two things puzzle me about this cap: it's arbitrarily high, so it won't likely be a practical limit, and it still manages to convey that we will cap performance when the wind is really to our back. This is almost the perfect way to convey the message that we will provide a token sop to our investors that doesn't really help them.

What I don't get is why Mr. Toll would go to the trouble of undermining a perfectly good bonus system for a few million more dollars. The man owns 29 million shares. It's not like this extra $6 million he would have earned under the new plan would make up for the nearly $300 million he lost as a shareholder from the decline in his stock price. He can make this bonus amount with a one percent increase in his stock price.

Then, KB Homes, with the same, nearly flawless bonus plan, objective and profit-based, decides to override the market's short-term verdict with a "discretionary" bonus of $6 million (coincidence?). Their explanation?

Otherwise he wouldn't have received KB's standard "annual incentive" for the top job, which is tied to profits under the builder's current plan.

"This is the kind of stuff that makes us crazy," says Richard Metcalf, director of public affairs at the Laborers International Union of North America, whose pension funds own stakes in both Toll and KB. "What kind of board of directors gives a $6 million bonus when the company's stock falls 60%?"

Henry Waxman, Chairman of the House Oversight and Government Reform Committee, held hearings yesterday on executive compensation. The Wall Street Journal predicted:

It should make for good political theater. For added effect, Mr. Waxman has invited testimony from corporate-governance experts and Brenda Lawrence, the mayor of Southfield, Mich., a middle-class community that has been affected by the housing crisis.

Here are my qualms about Congress trying to substitute their judgment for that of directors on this issue:

1) Their analysis is post-hoc. The competition for talent in the executive suite is fierce--something Henry Waxman doesn't really believe. The competition for returns in the corporate market is extremely fierce, something Henry Waxman doesn't have a clue about. About ten percent of executives that were thought highly competent when they were hired will end up in the bottom ten percent of corporate returns, even on a sector-by-sector basis. "Why did the board pay these people so much money when they plainly were such poor CEOs?"

2) Even post-hoc, Congress is incapable of distinguishing perverse incentives from decent ones. It's not that they're stupid. I have quizzed institutional shareholders, securities analysts, corporate officers, even other compensation consultants on the incentive effects of certain compensation structures, and they often come to the wrong conclusion. "You mean that regular grants of restricted stock actually create an incentive to tank the stock price?" Could happen. I'm skeptical that our national Chamber of Unintended Consequences will come to the right conclusions.

3) I pity Compensation Committee members. Yea, there are a few who are careless, maybe even negligent. I've read about them, and can jump to conclusions as fast as any reader. And Nell is right that most compensation committee members don't quite know what they're doing in structuring packages, but that's not their fault. We don't generally hire incentive experts to the board, and their fiduciary responsibility demands that they apply incentive mechanisms to their packages, and incentives are tricky (see 2). Nevertheless, the directors I've personally worked with, to a man (or woman), have been highly conscientious and, if anything, wary of overpaying their CEO to the point of occasionally hurting their chances of retaining a very good person.

Personally, I believe that the answers to the 'problem' to exec comp are far more subtle than a congress-critter can manage.

Link here on "where does this committee the authority to investigate stuff like this?"

Many CEOs over the years have reportedly turned down bonuses or otherwise requested that they get less cash than the Board approved in their pay packages. This act generally invites praise or cynicism of the CEO. As far as I'm concerned, once the board has awarded the money to the CEO, he or she can do whatever they want with it, including return it to the company, pass it along to their colleagues, or donate it to my kid's education. However, I'm always left wondering about the governance of companies that have somehow accidentally paid their CEO too much.

Generally, the refusal to accept the full board-approved pay is associated with poor company performance. Foregoing pay is generally intended to be a sign that the CEO wishes to "share the pain" of cutbacks being felt by the workforce or declines suffered by the shareholders. This sacrifice is generally well received by the employees when it's donated to a pool to be divided by employees. It's often well-received by the shareholders when the CEO simply allows his bonus to revert to the corporate coffers. Sometimes, the CEO gives back cash, but gets more in equity, something the unions refer to as "bait and switch," and what we at the HV Mechanism Design Center refer to as a poorly implemented incentive plan.

In fact, my problem with CEOs turning down pay has nothing to do with their motivations around what they or others feel they deserve. My reservations are about their boards' competence in incentive design. A well designed bonus plan should never result in a situation where the CEO doesn't feel his or her pay is undeserved. A well-functioning board should not find itself in a position to have its incentives ignored and returned. What impact did the incentives have if the CEO didn't even take it?

A CEO dictating to the board to give them less than the board approved does not inspire confidence in me that the board is in control over one of the few things they should totally control. Whether the CEO does this out of a sense of guilt or showmanship or political correctness does little to salve that concern.

Whenever I'm debating the merits of "Say on Pay" with an earnest advocate, they invariably contend that they are not against CEOs making a lot of money per se, they are only concerned that CEOs make it fairly. They contend that the current system unfairly rewards CEOs due to the laxity or corruption of directors who set their pay, and that giving investors some say over executive compensation will remedy that problem.

One can dispute both of those premises without attacking the motives of those in favor of "Say on Pay," and I have done so here and here. But I have not been above attacking their true motives, too, here and here. Alas, nothing makes it easier to attack their motives than simply listening to the political supporters of "Say on Pay" on the campaign trail.

Obama, gunning for blue collar votes in Pennsylvania, has been highlighting his support for this regulation, saying that "CEOs make more in one day than their workers make in one year." Politically speaking, it certainly makes more sense to attack the rich with a subtle conspiracy theory than to expect voters in middle America to digest the subtle governance issues actually being debated in this bill. Obama can conclude that if well-regarded Harvard academics are in favor of it, it's safe to exploit his support for the bill by any means necessary.

"Say on Pay" proponents may contend that just because most of its supporters are appealing to envy, out of more concern with social issues than governance issues, it doesn't mean that advocacy on the governance issues is inappropriate or insincere. True enough. But these same advocates generally hold the trump card of politics over rationality: even if there is no evidence that "Say on Pay" will actually help the shareholders, they will tell you, "If we don't pass this, Congress will come up with something worse"--a veiled threat of substantive regulation of pay. Which is just saying that one should accept a poisoned slice instead of a poisoned loaf.

Thanks.

That sounds like a silly argument, but it's basically what the State of New York is telling a couple of HMOs. Here's the line of argument:

Two of the largest HMOs are seeking approval for a merger, which would make them the largest HMO in the state. Each of CEOs had performance-based incentive plans last year--plans that put a significant amount of their pay at risk. It worked. Their firms performed well, and they doubled what they took home the year before.

“We are very concerned about HIP’s announcement that it has doubled the salaries of its top 10 executives at a time when the company has not been performing well,” a spokesman for the department, David Neustadt, wrote in an e-mail message. “As we consider its pending merger with GHI and conversion to a stock company, we will be asking the executives tough questions about this decision.”

Fact #1, their salaries didn't budge over the two years; what increased were their bonuses, which was pay they had at risk. Fact #2, against what standard had this HMO not performed well? Apparently against some standard that doesn't account for revenue and profit, the two metrics upon which the bonus plans were based. In fact, the state offers no argument whatsoever that the incentive plans were not reasonably designed. (I personally don't like rewarding managers for buying revenue, but I wouldn't call that unreasonable.) They only object that these plans actually paid out more money to the top executives, and call it a "salary" increase.

Logically what does performance-based pay for the executives have to do with any rationale for approving or disapproving a merger? I'll admit my eyesight isn't as good as it used to be, but I don't remember seeing "CEO pay" as a criterion in the antitrust statutes. In fact, the state offers no logic; they only promise to "ask tough questions," once the cameras are in place.

It's a shame that we can't ask these tough questions of the State Inquisitors...er, state officials.

That was the headline of a WSJ article primarily about holders who don't want more say. In fact, the three skeptics it cited are surprising to anyone who plays in the corporate governance world.

Charles Elson, chairman of the Weinberg Center for Corporate Governance at the University of Delaware, has rarely seen a governance reform he didn't like. But in this case, he says that it isn't the job of shareholders to tweak compensation plans; if you have a problem with the board's work, go after the board, not their work. This attitude is similar to the attitude held by most people (including Elson) regarding the line of demarcation between the board and management; if the board doesn't like what management is doing, it should reconsider the management, not get involved in the particulars of management policy.

Edward Durkin is Director of Corporate Affairs United Brotherhood of Carpenters. It's not often that a union man is against anything that would make management's job more uncomfortable, but Durkin says:

a simple "yes" or "no" vote on pay plans would lead to a "hollow" dialogue between investors and directors. The union manages 95 pension funds with around $40 billion invested in thousands of companies. Reviews of each of those proxies would necessarily be cursory, he says. In response, he would expect directors to standardize compensation packages, which could lead to less flexible and poorer pay plans.

Finally, Peter Clapman questions the wisdom of "Say on Pay." Nobody would accuse Clapman of being a tool of management; he is former governance chief at the giant fund manager TIAA-CREF, and a partner in U.K.-based investors' group, Governance for Owners LLP.

The quality of a proposal is not, of course, to be judged by who lines up for or against it; it should be judged on the merits. It's just nice to see some of the corporate governance mavens espousing a more thoughtful approach than the press headlines.

David Chun made a great find among an early filer this proxy season.

Many companies are under increasing pressure by the SEC to disclose specific metrics and targets. Issuers (companies) are resisting, claiming that their metrics and targets are confidential information, which disclosure might compromise their competitive position. This is often (but not always) a difficult proposition to defend, especially if your company is allegedly paying bonuses based on EPS targets and is already providing earnings guidance to the investor community.

Well, Equilar, David's firm, turned up the proxy of AEP, where they provide an explicit EPS guidance range, and disclose how their senior executive bonuses are tied to that very same range. That seems pretty straightforward.

Unfortunately, when the SEC asked for more disclosure, they were thinking that all comp plans would be as simple as AEP's. But tying senior executive bonuses only to EPS, while simple, is not necessarily optimal. Many companies have more involved bonus plans. Some of this complexity is functional and value-enhancing, some of it is simply obscurantism. Who is going to decide which is which? The SEC's enforcement division? Developing.

Should CEOs make a lot when their workers wages are rising only modestly, if at all?

Let's say that you're CEO of an electronics company. You have always gotten those electrical components from a domestic supplier that is a government-protected monopoly. One day, you cleverly figure out how to sidestep that monopoly by sourcing from abroad. Your company saves a lot of money, and profits go up. The shareholders would like to reward, not punish this behavior. That's how markets work.

Now, as certain compensation critics would have it, you have injured the earnings of the domestic producer. Your pay should be proportionately lower, to reflect their reduced earnings. Make sense? I didn't think so. But if you replace "government-protected monopoly supplier of materials" with "government-protected monopoly supplier of labor," then you arrive at the same illogical endpoint; the wages of managers linked with the cost of inputs. That, of course, is a recipe for bleeding the firm with a managerial bias toward uncompetitively high labor costs.

Insisting on a linkage between CEO pay and the wages of their employees is what I'm calling the Wage Link fallacy. It's based on a primciple that is central to communism: An Individual's wages should be unconnected to their productivity. Most purveyors of the Wage Link Fallacy, besides outright communists, are unions and their fellow-traveling politicians, most recently including EU officials from yesterday's FT.

Excessive pay awards for company executives came under fire yesterday from the European Union's senior economic policymakers, who condemned them as "scandalous" at a time when ordinary employees are under pressure to accept modest wage deals.

Those pressing the Wage Link Fallacy invariably are pushing for government to trump the verdict of the market in assigning a small portion of productivity gains to those who create them. They wish, instead, to punish the managers who create those gains, the domestic consumers who benefit from them, and the employees outside of the unions' sphere of influence who help make them possible.

In the latest issue of Directorship, Amy Borrus of the Council for Institutional Investors says,

Additional sunlight is chasing some perks away at some companies. That's a good thing--perks are the polar opposite of pay-for-performance.

So is salary. Is CII advocating that CEOs be paid purely on variable compensation? That kind of runs counter to the oft-stated desire to bring down overall CEO pay. Surely, institutional investors can't expect CEOs going all-variable to forego extra compensation for the extra risk they must bear. Their investment clients certainly would accept such a trade-off. Who would? The "it's-not-pay-for-performance" critique of perks is too simplistic for an organization like CII.

There is only one good reason to cut perks: They look bad. It looks bad that a CEO who is making millions of dollars per year has the company paying $20,000 for a country club membership, or $15,000 for tax planning. It makes the CEO look grasping, when in fact these perks long preceded their accession from a time when they made perfect sense. It looks bad for the board because it makes them look like a bunch of stooges who can't say "no" to the smallest thing.

The fact is that most boards can say no. They're really not all incompetent or corrupt. They have been saying no for years. The fact is that these perks were generally good for the shareholders. They came about, admittedly in a more innocent age, because they represented tax-efficient ways to compensate their executives. If a board takes away $100,000 worth of perks that can legitimately be offered for business reasons, such as country club memberships (for business development), tax planning (to avoid personal financial issues, or fraud), or car and driver (for security), then the executive paying for those items with their own after-tax dollars would have to have their pay increased by about $200,000 to make them whole, especially if the board expected the CEO to retain many of these services.

But, since perks look bad, boards take them away, executives largely replace them at their own expense, and shareholders pick up the tab anyway, except twice over.

Well, that was the headline, anyway. Actually, he is simply backing the "Say on Pay" bill, which will require a shareholder vote on CEO pay and severance. Because, you know, democracy works so well in producing optimal outcomes. Like McCain.

After years of being the poster boy for greed, the whipping boy of the New York media and political establishment, for having the temerity to accept what he was paid by his bosses, Dick Grasso can finally smile. The New York Court of Appeals basically affirmed the business judgment rule by affirming the dismissal of four of the six charges against him originally brought by then-AG Elliott Spitzer. It's highly unlikely that the new AG, left to clean up his predecessor's mess, will be able to prevail on the remaining counts.

While some will no doubt grouse about fair pay, I will be wondering about the headlines that weren't written about this story on C1:

"Grasso Gets to Keep What He Was Paid"

"Court Dismisses Spitzer's 'Attempt to Circumvent Law'"

"We're Sorry For Sullying Grasso's Good Name"

Larry Ribstein, predicting this outcome, wrote:

It likely will be recognized as the bald-faced political gambit that it was.

A state's attorney can get away with "attempting to circumvent the law" with impunity. In fact, he can be rewarded for leading a crusade supported by shameless, moralistic enablers.

When Spitzer got tossed out of the Governor's mansion, it wasn't for doing something that should be illegal, but isn't; it was for something that shouldn't be illegal, but is.

Alas, most people are more bothered by the idea of sleaze in making a buck, even if that turns out not to be true, than they are about sleaze in winning high office, even when that turns out to be true.

Update: Now it's game, set, and match.