The pay packages for Wall Street’s highest executives is coming under a new sort of scrutiny. This time what seems to have attracted attention is not so much the huge amounts of money the chief executives received by chief executives of investments banks—but the strange similarity in the pay packages. We noticed this a couple of days ago when Bloomberg’s otherwise measured reporting on the compensation of Bear Stearns chief executive James Cayne—who was reportedly paid $40 million for last year—was interrupted by a not-so-subtle implication that there was something odd about the fact that so many of the guys running Wall Street’s banking firms took in similarly sized pay packages despite the variety in the size of the firms. Why does the head of Bear Stearns get paid as much as the head of, say, Lehman Brothers?
Today Bloomberg columnist Graef Crystal drops the “subtle” and “implication” part and comes right out and says that he thinks there is something fishy going on. “Is Goldman, Lehman Pay Set in Smoke-Filled Room?” his column asks.
So why, when there is so much disparity in sales and net Income, is there so little difference in pay?
Is it just coincidence? Possibly. Although total pay packages have become more and more similar, there is still some healthy variation in different forms of pay, such as base salaries and annual bonuses, as well as free stock and option awards.
I have an alternative theory that takes its page from the Old West: circle the wagons. If you’re going to pay more than any other industry and by a substantial margin, it helps if you can justify your compensation by holding up the numbers of your industry peers.
So is it a smoke-filled room? Circled wagons? Is the fix in? Or is there perhaps less than meets the eye? More on this later today. It’s way too early in the morning to start talking about wage curves and positive correlations. Is Goldman, Lehman Pay Set in Smoke-Filled Room? [Bloomberg]
Even when it comes the chief executives.
From today’s Wall Street Journal editorial page:
Watson Wyatt Worldwide has been tracking trends in executive pay for years. What it has found is that a CEO’s pay tracks a company’s three-year performance pretty closely.
Thus, a company that offered its CEO a pay package in the middle of its peer group and had middling performance over the next three years ended up putting an average amount of money in its CEO’s pocket. Companies that outperformed over those three years ended up with richer CEOs than comparable companies that underperformed, regardless of whether the pay package at the outset was low, medium or high relative to its peers.
Some companies do overpay. And Watson Wyatt’s Ira Kay acknowledges that the Lake Wobegon Syndrome is present in some board rooms: Few directors want an “average” CEO, so they pay above the average for their group. While overpaying may not be optimal for shareholders, even “overpaid” CEOs, according to Watson Wyatt’s research, do better when their companies do better. Which we thought was the idea.
Unfortunately, the editorial page goes on to warn, you won’t see any of this in the upcoming disclosures under the new SEC rules for executive compensation. And so we should all get ready for the outrage of the business columnists, which will of course be backed by graphs, charts and human interest stories about folks who cannot retire because they invested their life savings in an underperforming company whose CEO smokes cigars wrapped in thousand dollar bills on the thighs of America’s Next Top Model.
CEOs and Their Millions [Wall Street Journal]
Is it too early to start talking about bonuses for 2007? Bear Stearns doesn’t think so. It has already set up a bonus pool for its top executives, according to a recent SEC filing.
A maximum bonus pool of $165 million has been established for a group of five senior executives that includes Bear Stearns Chief Executive James Cayne, the company said. Payout will be pegged to the company’s return on equity. No executive can get more than 30 percent of the total pool, which can be as little as zero.
Bear Stearns’ compensation committee also approved the performance goals for a second bonus pool for seven other top executives. The maximum amount will be $140 million, with awards based on pretax return on equity, departmental income and expense controls.
That Wall Street Journal story we mentioned earlier opens with this tantalizing lede. Too bad it is so misleading.
On Jan. 4, 2002, the chief financial officer of Broadcom Corp. tapped out an email about stock options to his chief executive and others.
“I VERY strongly recommend that these options be priced as of December 24,” he wrote.
They were, and that was fortunate for recipients. Broadcom’s share price rose 23% between the two dates. The pretense that the options had been granted on the earlier date made them extra valuable.
It also violated the rationale of stock options. They give recipients a right to buy stock in the future at the price when the options are granted, so that recipients can profit only if the price of their company’s stock goes up. Setting a lower “exercise price” for the options gives recipients a head start on profiting.
That last paragraph bears re-reading because it is, at the very least, quite contentious for a front-page news story. Remember, this isn’t a Ben Stein rant or a Gretchen Morgenson screed. So it unfortunate that the reporters make the mistake of stating the pro-criminalization, anti-backdating case as a matter of fact.
Backdating does not necessarily “violate the rational of stock options.” This is a point we made a long, long time ago. First of all, even the reporters statement of “the rationale” is questionable. There are many rationales for granting stock options. In addition to tying employee compensation to stock performance, stock options also allow a company to provide compensation to valuable employees without diminishing their immediate cash position. What’s more, some employees prefer stock options to immediate cash payments because they want to participate in the potential upside growth of their companies. There are also powerful tax-incentives for accepting stock-options, since they are usually not taxed until a gain is realized.
More importantly, none of these rationales (save, perhaps, for the tax-deferment) is violated by granting backdated stock options. This should even be obvious for the rationale preferred by the Journal reporters. Holders of backdated stock options may have a “head start” on their options—the options are actually in the money when granted—but they still must usually hold the options for years before they can be cashed in, and their profits still increase with the rise of the share price. Their incentives are thus aligned exactly with those of other shareholders.
Backdating involved violations of some very complex accounting rules. And reporters, investigators and shareholders certainly have every right to expect companies not to play fast and loose with these rules. But it doesn’t help the public understanding of this mess to paint backdating as some sort of corporate looting or embezzling or to pretend that backdating stock options destroys the very rationales for granting them in the first place. Probes of Backdating Move to Faster Track [$$] [Wall Street Journal]
Consider what this exodus of talented public company executives to private equity-funded companies means. These executives can certainly get hired as CEOs of public companies. If they were so overpaid, they would not leave the public companies. The fact is that many of them are leaving to run private equity-funded companies.
This also suggests that CEOs do not control their boards and get the boards to overpay them. On the contrary, the fact that CEOs are leaving suggests that public company boards may not be paying their good CEOs enough. I am encouraged because it may finally have become apparent, even to the New York Times, that U.S. CEOs, boards, and corporate governance are subject to market forces. In addition to the fact that public-company CEOs can earn more as private-equity company CEOs, here are a few additional observations that suggest that the criticism of CEOs and boards may have gone too far.
While it seems almost no-one is willing to defend ex-Home Depot CEO Bob Nardelli’s pay package, the criticisms of the pay package and his performance as CEO have certainly excited the business end of the internet. The latest is from Ken Lacroix, the D&O Diarist:
One question that needs to be asked is how much of what happened to Home Depot’s share price had to do with Nardelli and how much it had to do with where the share price was when Nardelli took over. As PointofLaw.com points out (here), Home Depot’s share price was already at stratospheric levels when Nardelli arrived.
But the more troublesome aspect of the criticisms about Home Depot’s share price is the clear implication that Nardelli would still have a job (although he would be $210 million poorer) if he had managed to get the share price to go up. It used to be the conventional wisdom that the market determined a company’s share price, not the CEO. Moreover, it has not been that long since corporate America faced a series of crises and scandals because too many CEOs seemed to think it was their job to engineer their company’s share price rather than to run their company. Corporate activists may be congratulating themselves for their “victory” at Home Depot, but they should be very careful about the lesson here. The danger, as pointed out on the ContrarianEdge blog (here) is that “the ousting of Bob Nardelli sent a wrong message to America’s CEOs : it taught them an incorrect lesson – manage the stock, not the company.”
We’re not going to beat you over the head with defenses of gigantic CEO pay packages. Okay, we probably are. But not right now. We’ve done enough of it in the last couple of days. And we’re pretty sure you get the point by now that the populist outrage of CEO pay at public companies—combined with outsized criminal penalties for white collar criminal convictions, increasingly burdensome regulation and gigantic risks being shifted from the markets to chief executives and financial officers—is in all likelihood leading to a brain drain away from public markets toward private equity. And that this move itself leads to a shift in wealth away from private shareholders and the broader public to the wealthy few who can invest in private equity funds. You totally get all that already, right? Good.
So now we’ll bring you the other side. Greg Easterbrook does the math that shows exactly why people are so outraged at pay packages like ex-Home Depot chief Bob Nardelli’s.
Combining regular income, stock options, pension and a golden parachute, Nardelli received $274 million for six years of work. That’s $34,250 an hour. That’s about 3,000 times the hourly wage of a Home Depot worker. That’s $275,000 per day – five times as much per day as the typical American family earns in a year. Good management is of value to a company’s shareholders: skilled corporate officers should be well paid. But there’s a difference between “well paid” and something akin to looting. Why isn’t Nardelli’s $274 million, taken from the shareholders, simply viewed as embezzlement? Home Depot stock fell from $43 to $41 under his Nardelli’s tenure, a 21 percent drop when calculated for inflation. The CEO cannot control a company’s stock price, and excessive emphasis on stock price creates a temptation to cook the books. But it’s absurd to think that shareholders can get hosed under a CEO’s watch, and for that the CEO deserves $274 million. The Home Depot board offered Nardelli the terms that led to the $274 million. Boards of directors have a self-interest in overpaying CEOs, because many board members are themselves CEOs who know their own pay will rise if other CEOs’ pay rises. With Nardelli’s $274 million, CEO overpay has reached runaway levels. What the Home Depot board did was perfectly legal, and that in itself is a scandal. What the Home Depot board did was perfectly legal, and that in itself is a scandal. The word for what many public-company CEOs and their boards are up to should be: embezzlement.