In the post-Enron-WorldCom era, greed again turned rampant, repeating again after the credit meltdown: Executive salaries are again skyrocketing; the gap between executive and worker compensation is widening; outsourcing increases unemployment; and executives still focus narrowly on short-term quarterly earnings (to help maximize their personal net worth in merger deals and stock options), rather than enhancing long-term company values that benefit investors.
In spite of the disclosure requirements in the Sarbanes-Oxley law, executives are back to the pre-scandals business-as-usual games of manipulating earnings, analysts, accountants, regulatory agencies and the press. Worse, today’s CEOs and their executive compensation committees continue flaunting their excesses as the gap between the rich and the rest of America widens. Worse, in the wake of the subprime credit meltdown, as banks suffered huge losses and pocketed billions in taxpayer dollars, billions was passed as yearend bonuses, while incompetent executives at Citi, Bank of America, JPMorganChase and other “too-stupid-to-fail” banks were fired with billions in severance.
In Warren Buffett’s 2006 “Chairman’s Letter” to Berkshire-Hathaway he reminded shareholders of another axiom in his “Economics 101.” The most a stockholder can “earn between now and Judgment Day is what their businesses in the aggregate earn.” Business productivity is the key, not playing the stock market. Buffett took direct aim at one of his favorite targets, the raging out-of-control pay to the guys at the top. “Too often, executive compensation in the U.S. is ridiculously out of line with performance,” says Uncle Warren, “because the deck is stacked against investors when it comes to CEO pay. The upshot is that a mediocre-or-worse CEO—aided by his hand-picked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo—too often receives gobs of money from an ill-conceived compensation arrangement.
For example, CEO “Fred Futile” of “Stagnant, Inc” gets gobs of options from his buddies. The company goes stagnate. But good ol’ Fred cleans up no matter what, even when the investors lose bigtime. Seriously, even if he gets fired, says Buffett, Fred “can ‘earn’ more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these—let’s say enough to give him an option on 1% of the company—his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.”
Options distort the executive brain and shareholder values
Buffett’s goes into detail explaining CEO Fred’s con game: “Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 159% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.6 million by that time, and earnings per share would thereby increase to $25.90.”
So Fred is increasing his personal retirement nest egg at the expense of his company’s shareholder value: “Simply by withholding earnings from owners, Fred gets very rich, making a cool $159 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.” It gets worse.
The “iron law” in action—CEO’s win if their stockholders lose
Buffett continues: “Fred can also get a splendid result for himself by paying no dividends and deploying the earnings withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically—with Stagnant’s p/e ratio remaining unchanged at ten—Fred’s option will deliver him $68.9 million. Meanwhile, his shareholders will wonder what happened to the ‘alignment of interests’ that was supposed to occur when Fred was issued options.” They’re doing the exact opposite!
“A ‘normal’ dividend policy, of course—one-third of earnings paid out, for example—produces less extreme results but still can provide lush rewards for managers who achieve nothing. CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options,” says Buffett. “I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.”
Buffett warns: “It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But—surprise, surprise—options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation ‘experts,’ who are nevertheless encyclopedic about every management-friendly plan that exists.”
Amazing secrets of executive compensation magic
Whether it’s Lay and Skilling at Enron, or Fred Futile, CEO of Stagnant, and his friends, Ratchet, Ratchet and Bingo … or whether shareholders think they’re being protected by the SEC and Sarbanes-Oxley, and Wall Street’s bailed-out banks … none of that matters, forget it. Why? Because if it’s not options, it’ll be something else—Corporate America’s CEOs have made an art of creating huge compensation packages for themselves. They also know how to hide those $100 million-plus compensation packages we hear about in a Forbes “Special Report on CEO Compensation.”
As Forbes put it: “The key to hiding pay: Use as many words and as few numbers as possible.” They hide their golden gooses in six main ways: deferred compensation, perks, deferred options valuations, pensions and retirement benefits, merger agreements, dividends on restricted stocks, and other clever side documents that are extremely difficult to uncover, piece together and evaluate, thanks to lots of lawyers, accountants … and friends they pay off in Congress and the SEC.
As a result, USAToday now says that “during the past two decades, CEO pay has blasted off from the terrestrial world in which most workers toil to interplanetary levels where few salaried workers could ever hope to go.” The gap between CEO and workers was 40:1 in 1985 and grew to 600:1 in 2005. Now you know why guys like Uncle Warren gets hot under the collar when he tells his own shareholders stories like the one about Stagnant’s CEO, Fred Futile, who even if he gets fired, “can ‘earn’ more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets” … and why it will keep getting worse … and why, sadly, there’s virtually nothing the average Main Street investor can do about this masticizing cancer, nothing.
FirstPubDate: Mar’06