Executive Privileges - TomPaine.com

http://www.tompaine.com/articles/2006/08/11/executive_privileges.php

Executive Privileges

Lee Drutman

August 11, 2006

Lee Drutman is the co-author of The People’s Business: Controlling Corporations and Restoring Democracy.

This week, federal prosecutors charged three executives at Comverse Technology Inc. with reaping millions of dollars in illegal profits through fraudulent “backdating” of stock options. The little-known voicemail technology company is now the second to be charged in the rapidly expanding stock options backdating scandal that is starting to garner national attention. If you haven’t heard about it yet, you will soon.

As the scandal continues to unfold, the basic plot line is starting to look achingly familiar. Something to do with companies stacking the deck so that top executives somehow keep drawing all the aces. Something to do with CEOs whose personal greed knows no bounds. Something to do with auditors and lawyers who surely should have known better. Something to do with boards of directors whose inattention (willful or otherwise) knows no sense. Something to do with shareholders who knew nothing and were, once again, easily victimized. And unless something dramatic changes, it’s something that is going to keep happening.

The depressing part of this particular executive compensation card-trick is that actually turns out to be ingeniously simple.

Consider: Say you are the CEO of GloboMegaCorp, and you get 100,000 stock options granted on January 1, when the stock was worth $50. You cash them in six months later, when the stock is now worth $60, and you’ve just made $10 per share (the difference between the $60 on the sell date and the $50 on the grant date). With 100,000 options, that’s $1 million—not bad.

But say you “backdate”—that is, change the grant date—to the previous November, when the company stock hit a low of $40. Now, when you sell your options at $60 a share, you make $2,000,000 instead. Even better.

At last count, 80 companies were facing backdating investigations , though one academic study estimates that the practice may be far more widespread. By the count of Erik Lie at the University of Iowa, 29.2 percent of companies have engaged in some questionable timing of options grants and 13.6 percent of options granted to top executives between 1996 and 2005 were of questionable timing.

But while the stock options backdating fiasco is troubling indeed, most of the cases under investigation happened before Sarbanes-Oxley improved reporting requirements and other recent changes to accounting rules that require companies to count their stock options as expenses. So it’s not that likely to happen again.

Still, what’s important to note is the way these scandals provide yet another example of just how ingenious top executives have become in working the system—and just how helpless we seem to be to stop them.

Between 1993 and 2003, the percentage of company profits going to the top five executives more than doubled, growing from 4.8 percent to 10.3 percent. In 2004, the median Fortune 500 CEO received compensation worth $15 million. At last count, average CEO was earning more than 400 times average worker pay, and more than 800 times the minimum wage. It is worth noting that in almost all other industrialized nations, the average ratio of CEO-to-worker pay is rarely more than 25 to 1.

So, what’s to be done?

First, what’s been done already: Recently, the Securities and Exchange Commission issued new rules on executive compensation. Given that the new rules—the first in 14 years to address executive compensation—attracted 20,000 comments, you might expect that the SEC was proposing something radical. Hardly.

The new rules basically require companies to be more up front about how they are compensating their top executives. So instead of wrapping the details of outrageous retirement packages, use of the corporate jet and country club memberships in a cocoon of dense legalese and scattering throughout corporate financial statements, companies will now be required to provide a “Compensation Discussion and Analysis”—wherein they will explain and justify their executive compensation decisions, including its stock option granting practices. However—in a potentially gaping loophole—companies can beg out of this requirement if they can prove that such disclosure would reveal competitive information.

Problem is, we already know top executives are getting compensated at outrageous levels. We’ve known this for years. And somehow, despite widespread condemnation of this fact by just about everyone—it’s pretty hard to find an apologist these days—executive compensation still somehow continues to rise. Shame is clearly not an issue here! So, now that we have some new rules, maybe we’ll know a little more. But what exactly will that do to curb runaway CEO pay?

In theory, shareholders—armed with this new information—could punish companies that reward their executives too much by selling the stock. But given that numerous studies have conclusively shown absolutely no link between share price performance and CEO pay—plenty of CEOs do quite well during times of declining stock prices—it’s not clear whether even a massive sell-off would have much impact.

And, well, that’s about it. Shareholders could register their displeasure at annual shareholder meetings, but the problem is that the board of directors is almost always selected with the blessing of management. Not to mention that at 75 percent of U.S. companies, the CEO is also the chairman of the board of directors. So such displeasure by mere shareholders will inevitably be met with displeasure that somebody would express such displeasure in the first place.

Shareholders could threaten to vote sycophantic outrageous-pay-approving directors off the board, but the threat would ring hollow for a simple reason. Since management controls access to corporate proxy statements, almost all director elections are run Soviet-style: Managers appoint one slate of candidates, and shareholders can either approve or disapprove. The slate of candidates with the most votes wins.

For years shareholder groups have been arguing that the SEC should require companies to open up their proxy statements to minority shareholder groups, but pro-management groups like the Business Roundtable and the Chamber of Commerce have been able to convince the SEC that this is a bad idea. Unfortunately, until shareholders can somehow hold directors accountable—or vote directly on executive compensation—there will be very little they can do to restrain executive pay.

Barring direct shareholder involvement, the only other possibility is the moral argument against the outrageous excesses of CEO compensation made most recently by Berkshire Hathaway Vice Chairman Charles Munger. A month ago he delivered a blistering rebuke of excessive CEO pay at a keynote speech at the Stanford Law School Directors’ College.

Munger told an audience that included some CEOs that "Corporate compensation in America is offending a lot of people needlessly and it should be fixed. It is really dangerous to have a lot of envy taking sway in the world.”
He added that CEOs "have a duty to the larger civilization to dampen some of this envy and resentment by behaving way more noble than other people and more generous…The CEO has an absolute duty to be an exemplar for the civilization."

Munger’s argument may fall on deaf ears, but ultimately, it may be that the only way for CEO pay to be brought under control is for CEOs themselves to finally say enough—to realize that they do have a moral responsibility as leaders, and to understand that when their pay is such an issue, it breeds resentment among an increasingly harried and squeezed working class, undermining a sense of shared gain and fairness in the economy—a sense that can’t be good for worker productivity. After all, it’s pretty disheartening to know that as an average worker, you would have to work for 400 years (about 10 working lifetimes) to make what the average CEO makes in one year.

As troubling as the stock options backdating scandal seems to be, it is merely one more chapter in an epic tale that shows no sign of ending. While regulators focus on new rules to prevent options backdating, executives are surely coming up with fresh new ways to outdo themselves. Disclosure may provide fodder for anecdotes, but it will change little.

As it stands, there seem to be two ways to bring CEO pay under control—either empower shareholders to hold directors and executives accountable, or somehow convince CEOs they have a moral responsibility to demonstration moderation. Unfortunately, neither seems particularly realistic at this point. It’s starting to seem like things are going to have to get worse before they get better. Problem is, it’s hard to imagine them getting much worse.