Perverse Incentives Are Endemic (TM)
Posted by Marc Hodak on February 8, 2008 under Executive compensation | 
3 Comments to Read
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
Posted by Marc Hodak on January 29, 2008 under Executive compensation | Comments are off for this article
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.
A sample of the level of detail they’re asking for:
[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.
Maybe this is closer to what they are looking for:
“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.
And, I wonder what the shareholders would do with all that information? Oh, yea. This has nothing to do with the shareholders.
Posted by Marc Hodak on December 30, 2007 under Executive compensation | Comments are off for this article
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.”
Posted by Marc Hodak on December 26, 2007 under Executive compensation | 2 Comments to Read
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.
Posted by Marc Hodak on December 10, 2007 under Executive compensation | Be the First to Comment
…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.
Posted by Marc Hodak on November 17, 2007 under Executive compensation | Comments are off for this article
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.)
Posted by Marc Hodak on October 22, 2007 under Executive compensation | Comments are off for this article
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.
Nocera is basically arguing his feeling against Kay’s experience. He goes on to admit as much: Nocera just doesn’t like the idea that CEOs make as much as they do, regardless of the reason. He doesn’t believe that their pay is the result of market forces, regardless of any evidence (amply provided by Kay). This is what passes for social commentary. Nocera finishes with one of the most disingenuous statements I’ve seen in a long time:
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.
Of course, it’s been a long time since I read the NY Times.
Posted by Marc Hodak on July 6, 2007 under Executive compensation | Comments are off for this article
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.
And what, exactly, is driving Mr. Moss’s bonus? According to Macquarie’s Remuneration Report, their executives’ bonus plan is based on “growing net profit after tax and sustaining a high return on equity.” ISS’s concern is accountability for future earnings, but Macquarie’s incentive plan has been relatively unchanged since 1985; their performance standard is highly likely to be net profit and ROE for the foreseeable future. Sounds pretty shareholder-friendly to me. In fact, such a results-focused plan is exactly what research shows yields the best results for shareholders. And Macquarie has done extremely well with their plan, better than Citigroup or any of it’s major peers.
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?
Posted by Marc Hodak on July 2, 2007 under Executive compensation | 2 Comments to Read
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.
Posted by Marc Hodak on July 1, 2007 under Executive compensation | Comments are off for this article
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.
I doubt my note would have been cited so often by the SEC in their final rules if I had included the term “business porn,” but I can see now how Larry Ribstein, who coined that term, got it right in characterizing the new rules.
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.
