“Hey, I’m a capitalist,” was the disclaimer of choice during the May 2006 House Financial Services hearing on executive compensation. Anyone arguing that there might be something wrong with the increasingly excessive compensation packages of top executives needed first to establish themselves as bonafide capitalists.
Today, the Senate Finance and Banking Committees will resume this conversation in hearings, this time hopefully with more room for advocates to focus on the facts rather than their own capitalist credentials.
Data shows that there are many reasons to be concerned about executive compensation practices. The May Financial Services hearing centered on the notion of “pay for performance.” This, just as it sounds, asserts that top executives should receive compensation based on their performance. Performance measures could include profitability, stock performance, and meeting predetermined goals and targets. In addition to restoring a sense of fairness to compensation, Pay for Performance should prevent gross misallocations of corporate resources and lessen the temptation to game the system or break the law.
The biggest issue on the table today will be the recent outbreak of stock options backdating, whereby compensation directors, or the executives themselves, retroactively pick the date of the options grant, often coinciding with dips in the stock price to maximize profits. When you set your own pay by fraudulently gaming the system, the operation of markets no longer determines your income.
Stock options have become one of the most favored Pay For Performance tools – the tax-exempt status wins over corporations; the built-in incentive appeals to investors; and the profit opportunity gives huge bonuses to executives. The corporation grants executives the opportunity to buy a certain amount of company shares at a set price — known as the “strike price,” or exercise price. These shares generally equal the market price on the day of the grant, and executives are usually required to wait a few years before exercising them. Executives see an immediate benefit when share prices increase, which directly ties his or her compensation to the market performance of the company. If an executive is granted options on a day when the share price is particularly low, the profit opportunity is that much greater.
Backdating is “playing fast and loose with the books,” in the words of Senate Finance Chairman Chuck Grassley. And according to The Wall Street Journal over 100 companies are currently under investigation for said fast and loose behavior as of August 31st. Aptly titled “The Perfect Payday,” an analysis conducted by The Wall Street Journal and published in March 2006, reveals that many of these executives have managed to profit against astounding odds. One in 300 billion for Jeffrey Rich, former Chief Executive of Affiliated Computer Services. One in 200 million for Dr. William McGuire, Chairman and Chief Executive for UnitedHealth Group. Dr. McGuire as it turns out had the distinct privilege of setting his own options dates – per the terms of his compensation package. Due to his “fortuitous” streak, he has already realized $200 million in the past four years, and had another $1.8 billion to look forward to in unrealized gains as of the end of 2005. UnitedHealth has delayed filing its second-quarter earnings report and may have to restate earnings for the past three years by as much as $286 million.
If the executive or the compensation committee can retroactively determine the grant date, they effectively strip the option grant of any and all performance incentives. No need to work harder or find creative solutions that better the business, the profit on the option is guaranteed.
The decoupling of pay and performance in any compensation scheme should be alarming to investors and business analysts alike. Yet this recent backdating scandal is by no means the only indicator that something is awry. Trends in executive compensation indicate an increasingly weak correlation with performance. A recent Center for American Progress report found that from 2001 to 2005, many companies increased the pay of their chief executive officers (CEOs) despite stocks that failed to outperform staid U.S. Treasury bonds. That’s right – T-bonds.
Executive compensation is an important issue both for fairness and for the health of the U.S. economy. Despite what some name-callers may say, those invested in the outcome and who show up to participate in these hearings recognize that corporations play a critical role in the Unites States economy and society as a whole. We must look for solutions that will steer corporate investments away from share repurchases and excessive compensation toward investments that would grow these companies in the long-term and will allow individual and institutional investors to start investing with confidence. From greater disclosure to changes in the tax code, there are countless options for addressing these issues. Let’s stop with the name-calling and begin to work towards change.
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