Executive Compensation – Fair Wages or Abuse of Shareholder Trust?

Executive Compensation – Fair Wages or Abuse of Shareholder Trust?

“My fair wages for that work I will openly take”.

The above quote is part of an oath that Professional Engineers in Canada take as part of the “Iron Ring Ceremony”. By taking that oath I have sworn to work to bring honour to my profession and honourably guard my reputation. But the oath also indicates that I should be paid fair wages.

“I work hard, I get paid”

Some years ago when I had made an offer on a house the seller asked my real estate agent to take a cut on his commission. My agent’s quick reply was no and he said; “I work hard, I get paid”. Those six words succinctly express how a fair employment contract should work. You work hard, you should get paid. You employ someone, you should pay a fair wage.

I firmly believe that no one should apologise for taking fair wages for their work.
Now, the hard part. What exactly is a fair wage? This article is not about the working man’s wages. Most groups of workers arguably won that battle a long time ago. This article is about executive compensation.

Presidents and executives of large corporations deserve to be paid fair wages too. Most of them work very long hours and many of them are very effective and instrumental in creating shareholder value. But I think it’s plain to see that there has been an accelerating trend towards lavish salary and bonus packages and particularly a trend towards breathtakingly rich stock option grants.

This is important to shareholders because it is getting to the point where the compensation of the executives is, in many cases, a material percentage of the net income. Also extremely rich executive pay packages may be a signal that management and the Board are more interested in helping themselves to corporate funds than they are in working to grow shareholder value. Boards and Management are in a position of trust and stewardship in regard to the corporation’s funds, which ultimately belong to shareholders. It could be argued that if executive pay becomes too lavish, that constitutes a breach of trust. Even if the amount is not material as a percent of profit, I am not entirely comfortable trusting the control of my corporations to persons who seem to possibly be abusing my trust.

When the President of Quebecor receives $2.5 million is salary and bonus plus 350,000 options, it seems like quite a rich pay package; when the President of Nortel receives a salary and bonus of $6.7 million plus 750,000 options, it seems more than rich and might well be called obscene; but when the President of JDS Uniphase receives a salary and bonus of $890,000 (admittedly smallish by CEO standards) but with 9.6 million options (that’s right 9.6 million options), we have gone well beyond obscene and into a realm of offensive and completely unjustifiable excess (in my opinion). Stock option grants at JDS are so staggeringly rich that the former CEO of JDS Uniphase had unexercised, in-the-money options worth $2 billion Canadian dollars at their last fiscal year end. When compensation reaches this kind of excess it’s time for share holders to take notice and take action. (P.S., you can guess that I shed no tears when the value of this fellow’s options plummeted with the recent collapse in the JDS stock price).

When the only way you can possibly justify executive compensation is to note that all the companies seem to be doing it and anyway don’t they deserve as least as much as star sports figures?, you know something is wrong and that it’s time for shareholders to take action.

When the President of Nortel when criticized for his total compensation (mostly through exercising stock options he was given in previous years) of $135 million U.S. defends himself by noting that the CEO of Cisco realized $345 million in stock option gains, its clear that a time of mindless excess has arrived and it’s time for shareholders to take action.

It is, of course, very difficult to say what would be a fair amount for a successful president of a large corporation. But I offer the following thoughts.

  • A one time payment of about $5 to $10 million (even after taxes) would be more than enough for a man or woman to immediately retire on and to keep the person and family in relative luxury for the rest of their days.
  • It does not seem logical to me to pay someone an annual sum that is so large that within a year or three the executive is completely financially independent. That could certainly take the edge off of a person’s hunger and drive to succeed.
  • Good executives are generally driven to succeed by their inner drive and sense of accomplishment, so why are we paying them ungodly sums?
  • If you can’t get a good executive for under a million (or five million) per year, then how do we explain the fact that Prime Ministers, Premiers, and even the President of the U.S. is paid far less than that, with no shortage of highly qualified applicants?
  • A million dollars is roughly 20 times the wage of an average worker. Do people really need to earn more 20 times higher than an average industrial worker? If 20 times is acceptable is 200 times ($10 million) acceptable. Where does this end?
  • Money represents a claim on goods and services in our society. If an executive receives a claim (money) that can be redeemed for $5 million worth of goods and services, then all else being equal, an awful lot of other people have to take a bit less in goods and services in order to make way for the claims of the executive.
  • I believe in free enterprise, but at some point if those at the top end of the salary scale begin to completely abuse their position in society then the masses will eventually take action.
  • I’m not sure exactly how much is fair, but I do know that amounts over $2 million per year are excessive. After all, these guys are the hired help, not the owners of the business. As the great investor Ben Graham once said, you don’t have to know how much someone weighs to know that they are fat. If money were fat, there would certainly be a large number of obscenely obese executives waddling around.

In fact it’s clear that there has been a bubble in places other than “tech stocks”. There is a bubble in executive compensation, and it needs to be burst. And, I think that the board members who approved some of the more scandalous compensation packages might just have a bubble or two in their brains.

Accountability to Shareholders

It’s important to understand that in most cases there is no majority shareholder. Quite often this means that management themselves control the company. Many of the Board members may have been nominated for their memberships by the President of the company (who often doubles as the Chair of the Board). In this situation we have a nice clubby clique of individuals running the show. It’s really no wonder that President’s tend to take advantage of this situation and that pay packages get fatter and fatter.
In the past, executives were paid quite handsomely but arguably not obscenely. Even if the pay package seemed fairly outrageous, it was probably not a large enough amount for share holders to get concerned about.
However, the recent trend is getting out of hand. The pay packages are getting large enough to be a significant drain on profits. Excessive stock options dilute ownership and are especially dangerous.
It is very difficult for shareholders to organize and hold management accountable to keep executives salaries within reason. But in some cases we have reached the point where shareholders do need to organize and take action.

Stock Options

Stock Option grants can constitute excessive wages by stealth. When the typical 10 year life stock options are granted with an exercise price equal to the current share price, they are not then “in-the-money”. They cannot be exercised for an immediate gain. But they are not worthless. In fact stock option pricing formulas would indicate that in may cases they are worth (very roughly) one third or more of the actual share price. This is because over a ten year period a share price of an average company is almost bound to rise. The shares of a mediocre company that is earning just 7% return on equity can be expected to double in ten years if the company simply retains all of its earnings (no dividend).

So, when an executive is granted 100,000 options on a share trading at $50.00. Those options are worth perhaps (very roughly) 100,000 x $50 / 3 = $1.67 million. Amazingly, in Canada, companies are not required to disclose the estimated value of the options that they grant. With companies granting options by the hundred thousand it seems to me that Boards of directors may not even understand the value that they are giving away. Option valuation is a complex subject. It seems to me that some Boards may be allowing that complexity to mask some very lavish compensation packages not only obscuring the amount from investors but perhaps from themselves as well. If Boards don’t disclose the estimated value of the options that they grant, I can have no confidence that they understand the value of the options and the cost of those options to shareholders.

Many shareholders may think that granting stock options is always good and is not costing the company anything. They are good…to a point. But too much of a good thing can turn it bad. Stock options probably do motivate executives. But they most assuredly have a cost to shareholders. Stock options obligate the company to sell shares at less than full value at some future time. Stock options dilute earnings per share.

The accounting profession also lets us down when it comes to stock options. Warren Buffet has noted that stock options are most assuredly compensation and that they should (like other compensation expenses) be shown as an expense on the income statement. It would have to be an estimated expense. But that is no excuse. The Accounting rules should require an expense to be shown and a reserve could be set up on the balance sheet to charge against the amount that shareholders , as a group, lose, through dilution, when the options are eventually exercised at less than market value. This treatment would make it clear to investors that stock options are an expense.

Stock options should always be granted at an exercise price that is well above the current market price of the shares. Or the exercise price could rise each year. The reason for this is that we want to use stock options to reward better than average growth. When options are issued at today’s market price, an executive will receive a large gain by the end of ten years even if earnings per share grow slower than your average money market fund. That serves to reward mediocre performance.

The Great Pension Bonanza

Pensions are another component of compensation that has gotten out of hand. Most pension funds pay out based on the highest 5 year’s average earnings and the total number of years employed. That formula was derived perhaps 40 years ago and seems designed to adjust the pension for inflation in wages over the years. A more accurate formula would be to use a percentage of all years of employment but to adjust prior years salaries for actual inflation. The 5 year formula works okay if wages have in fact risen at about the rate of inflation or where everyone in the pension fund has had roughly similar inflation in wages over the years. But that formula produces ridiculous results when we have a situation where executive pay is increasing at phenomenal rates. It simply defies common sense to pay an executive say an additional 2% of say $3 million ($60,000) for every year the person was employed. The early years of employment were likely at less than say $60,000 (adjusted for inflation) and it makes no sense at all for those early years to now be generating an additional $60,000 per year in pensions. It is becoming common now to see pension pay-outs approaching or surpassing $1 million per year for life. This is ridiculous and is going to add up to a significant profit drain for companies as executives retire at today’s fat wages. Of course companies can argue that this is the normal pension formula that most companies follow. Well, yes it is normal and yes it is completely ridiculous and unacceptable.

Shareholder Action

As shareholders it is difficult to take action. We can hope that institutional investors will take action for us to prevent the worse abuses. But shareholders can at least voice their concerns. At the very least companies should be required to disclose the estimated value of the options that they grant. As well, accounting rules should be changed to require that the estimated value of the options be charged as an expense on the income statement. If enough shareholders take action by voicing their concerns then changes will be made.

As an investor I get nervous of management’s that have obscene pay packages. It makes me wonder about the character of these individuals and whether they are looking out for all shareholders or just looking out for number 1. These people may be fine characters but I find outlandish pay packages to be a negative indicator and would tend to avoid investing in those companies, all else being equal.

Executives, like engineers, should indeed openly take their fair wages. We as shareholders and their ultimate bosses should insure that those wages are indeed fair and that there is open disclosure. And after all I would not want to pay an executive so much that he or she would be embarrassed to openly take his or her wages.

Shawn Allen, May 19, 2001