CEOs Must Bring Investors Along for the Ride (WSJ)

This is one of my favorite subjects since the perverse short term incentives in public markets have disrupted the apple cart to such a degree - yet for 98% of companies, it just continues to be business as usual.

The completely broken Board of Directors system is another thorn in the side of any real resolutions and I have little confidence that it will ever change: every time we have a crisis, a lot of hen clucking goes on for a few quarters - then lobbyists begin to pull back on previous legislation that might be passed over the ensuing years... and we end up right where we started.

Defenders of the system send out the "sell your stock if you are unhappy" old line, knowing the vast majority of shares are held by institutional accounts who have zero advocacy. Rinse. Wash. Insert Crisis. Repeat. Already you can hear the sharp pencils of compensation consultants trying to find ways around any limitations that might be pursued.

I have to write an entry on the latest from Chesapeake's (CHK) Aubrey McClendon (some awesome new details have come out in SEC filings) [April 3, 2009: Chesapeake Energy CEO Aubrey McClendon with New Shady Compensation Deal], but it's systematic - not any one company or industry.

I know, I know - if chieftains are not paid 300x (more) what the peasants who work for them, they will leave to go to another country to work for.... 22x the median. And only a select few humans on earth could run two companies into the ground like Bob Nardelli (Home Depot (HD) / Chrysler) - or return on average -5% to -10%+ annually like many other companies have done this decade.

I get it, it's a select skill set and it's an outrage my socialist take of rational equitable outcomes even hits the internet.

I apologize in advance for the heresy - heads we win, tails we win [September 27, 2008: Heads We Win, Tails We Win] is indeed the correct course of action to put shareholders interests in line with the chiefs at the top.

Jeez, even the Wall Street Journal's Jason Zweig is talking heresy now. Don't worry Jason, the CEOs (and their top 3-4 confidants at the top of these reverse Robin Hood organizations) know they just have to keep their mouths zipped, stay low for the next 18 months and then when their stocks rebound to some degree, we can begin the "we are all in this together" chant - i.e. when your E*Trade account goes up $8,000 and my compensation goes back to $18 million (with perks) - we all win together.

Main Street = Wall Street... say it. Say it. Say it! :) Now where's my $87,000 rug so I can lounge Zenlike with legs crossed as I think this through further? [January 22, 2009: Merrill Lynch's John Thain Can Only Work on $87,000 Area Rugs]

• From 2006 through 2008 (3 years), the 10 largest financial companies in the U.S. awarded their chief executives a cumulative total of more than $560 million in cash, stock and options. Those firms -- some of which are no longer among the 10 biggest -- have lost a total of nearly $1 trillion in market value since the end of 2006. (Heads we win, tails we win - the shareholders interests are aligned with those at the top - long term value is being created - if we don't pay our CEOs this level they will leave and destroy other companies: keep repeating the dogma folks.)
• ... But it's hard to argue they deserved it all; something is dangerously wrong with a system that showers riches upon good and bad leaders alike. (I'm not sure how much longer Zweig will be keeping his post at WSJ with talk like this.)

Let's see how smaller companies, who still create very nice wealth for their top honchos but at least have some sense to their compensation structure do it...

• Now consider Alleghany Corp. (Y) The small, New York-based insurance holding company hasn't awarded stock options to managers in decades, doesn't measure its performance against a peer group when calculating incentive pay and reserves the right to claw back bonuses if results are later revised downward. (Shocking. How do they even keep a CEO with rules like that? Certainly they must have CEO turnover of immense proportion, since these rules are unfair.)
• Alleghany's proxy statement reports that the CEO, Weston Hicks, has earned (although not necessarily received) $28 million since 2005. That hardly puts him in the poorhouse. But his shareholders are unlikely to complain. From 2005 through 2008, Alleghany gained an annual average of 1.7%, while the Dow Jones U.S. Property & Casualty index lost 2.7% per year. (Notice the "not necessarily received" part - some is held in reserve until years later when they can see if indeed gains are legitimate and not transitory.)
• What Alleghany and a few other exemplars in the world of corporate compensation do right says a lot about what the rest of corporate America does wrong.

1. First, too many bosses get unconditional cash bonuses even when they push their firms to the brink of disaster. In 2006, Merrill Lynch's then-CEO, Stanley O'Neal, earned an $18.5 million cash bonus, and Charles Prince, then the CEO of Citigroup (C), got $13.2 million in cash. (Oh yes, Stanley O'Neal - our friend who exited the stage for a cool $160M for his wonderful work at Merrill - even better he does not have to face Congress when they walk up the villains for their showboat hearings; I mean why bring the people who were there when the seeds of destruction were being born? That would make too much sense. Great timing in "being fired" Stanley.) [October 30, 2007: You're Fired! Now Here is $160M to Help Ease the Pain]
2. Second, companies measure performance inconsistently, with a grab-bag of metrics that change over time. Lately, two measures have been popular: the stock's total return and the growth in earnings per share. Unfortunately, earnings in the hands of clever managers are like Silly Putty in the hands of an energetic second-grader. (Truer words never said - remember, just toss all the bad things you've done to the company under "restructuring"; claim it's a 1x thing even though it happens constantly and then wink at analysts on which set of earnings to use - pro forma - and we can all point to earnings excluding '1x charges' and talk about the money being printed by these companies; we all win here in the Casino.) Earnings per share can be stretched upward by stock buybacks, accounting changes, unrepeatable gains and a host of other ephemeral factors. (Booyah, just remember, stocks are "cheap" based on PE multiple - don't you dare use real earnings or how things used to be measured in the 70s or even 80s - notice a pattern here? Government and corporate America both skewing data measurement in an upward fashion to hide dirt? Sort of like a Ponzi scheme eh? If we did not resort to this we'd see the true growth measures across corporate America for the lowly 4-5-6% they are - can't have it; otherwise people would just sit in bonds.)
3. And instead of patiently measuring results, companies have ants in their pants. According to a survey by the National Association of Stock Plan Professionals and Deloitte Consulting LLP, 81% of companies tracked results over three years or less when granting stock incentives; 21% gave out "performance shares" based on a single good year. (Yes, for example look at all these quite excellent mergers such as AOL Time Warner (TWX) that massive payouts were thrown about for "excellent synergies" - it would be wrong and unjust to wait 4-5 years to see how those talking points actually worked out over time. Just do something! Anything! And give me a bonus for doing it.)

• Alleghany, by contrast, looks at the long term, using measures that are hard to game. The firm bases incentive pay for its managers on the four-year average growth rate in per-share book value -- simply put, the surplus of what the company owns over what it owes. Book value, as Warren Buffett once wrote, is a "conservative but reasonably accurate proxy for growth in intrinsic business value -- the measurement that really counts."
• Stock options? Forget it. "We don't want to be in the position of betting against the shareholders," says Mr. Hicks, Alleghany's chief. (Many CEOs who exercise options promptly sell.)
• Alleghany pays its long-term incentive awards as "performance shares" that go up or down with the market. Last year, when the stock fell 28%, "the value of my total compensation was negative," Mr. Hicks says, "as it should have been, since the shareholders didn't make anything." (Send this guy to continental Europe - pure socialist talk.)
• In the 1949 first edition of his book The Intelligent Investor, after which this column is named, Benjamin Graham said "there are just two basic questions" that investors should care about: "Is the management reasonably efficient?" and "Are the interests of the average outside shareholder receiving proper recognition?" Unless investors pressure more companies to adopt smarter incentive plans, the answer will remain "Probably not."

Related posts:

• October 4, 2008: Credit Crisis Sharpens Anger Over CEO Pay
• September 17, 2008: Thain's Aides May Get $200M for Weeks of Work

Comments

[Nort:]

How refreshing to see common sense (not socialism) being expressed regarding the disconnect of the arrogant people who run companies and the people who work for or invest in them. I started paying attention to this in the early 80's but was considered a trouble maker at the large company I worked for. The 2 main points that resonate most for me is the low to non-existent hurdles that the compensation is tied to and the idea that we need to retain these people or they'll leave. Let'em go. If these over inflated jobs dried up, I'd like to see them have to work and get paid a "normal" wage.

May 03 08:34 AM

[biomedlives:]

It amazes me that boards of directors are so concerned about paying CEOs well in order to motivate them but completely oblivious to the fact that cutting the salaries and benefits of people in R&D, sales, customer support, manufacturing will have a negative effect on the motivation and loyalty of the latter group. On the whole, the lower ranking people have a larger impact on the success of a company than its CEO does.

May 03 09:16 AM

[prudentinve...:]

The collapse in corporate governance is another reason to be sceptical about long-term exposure to US equities. It is one of the main factors that have motivated me to cash-in gains in the recent rally, rather than hold more stocks for their long-term dividend income.

I believe any board of directors that considers the interest of its long-term shareholders would not permit any raises, bonuses, or options to executives when dividends to shareholders are cut; and only to restore executive raises, bonuses, or option grants when dividends are restored to prior levels.

Any board of directors that considers the interest of its long-term shareholders would fire executives who bring about great damage to their shareholders' investment by poor management decisions (witness what happened to shareholders of DOW, GE, PFE, MRK, just to name a few, and not to even mention the banks).

However, the reality is that our entitled class of managements and their crony boards govern our public corporations as though they, and not the shareholders, are the owners; and this should be considered as a discounting factor when evaluating US equities as an asset class.

May 03 10:04 AM

[dcb:]

PONZI

May 03 10:07 AM

[sonearsofar:]

So why don't BoDs pay CEOs less? Because they are beholden to the CEO, who is usually also the BoD chair. The problem will persist until CEOs are excluded from the BoD and the directors are beholden to the shareholders. The largest shareholders should nominate the directors, and directors should receive no compensation from the company other than stock and dividends.

May 03 10:57 AM

[eieinli:]

Investors wake up! You are being taken for a ride. Only CEOs and their rubber stampers BoD are making money whether your company shows a profit or loss. What a system!
Sell your shares. Let the greedy CEOs play with their own money.
Remember the politicians that sold you out. Throw them out of office too!

May 03 12:31 PM

[Raymond Mic...:]

One note about Bob Nardelli: He actually didn't run Home Depot into the ground. Under his watch earnings increased dramatically (going from $1.11 the quarter before he became CEO to $2.63 in the quarter when he left, a 15% CAGR). The problem was that when he became CEO, Home Depot's stock was egregiously overvalued and over time it naturally drifted down to a more reasonable valuation despite the fact that earnings were increasing. Thus, shareholders of HD, if they bought the top during the Internet bubble, should really be upset with themselves for buying an overvalued stock, not with Bob Nardelli.

May 03 01:33 PM

[Bobco23:]

Having worked at senior levels of small and major corporations, I can tell you with complete confidence, there are dozens of highly qualified executives ready to take the helm in the event the current grossly overpaid CEO leaves in a huff over pay. There is no lack of top talent. Let the CEOs walk.

sonearsofar has the answer to the problem, seperate the CEO from the chairman of the BOD and change the way directors are nominated. Companies will not do this voluntarily. The current CEO/Chariman will not allow it. Sadly, the only hope is for the government (ugh) to change the rules for the election of directors. Until that happens, directors will be like minded as those who appoint them (the annual election is a Soviet style scam) and beholding to the CEO for their lucrative positions. Maybe the BAC fiasco will result in some of these needed changes. The government forced separation of the CEO and chairman are a good beginning.

May 03 04:36 PM

[rporter1@fu...:]

Amen to both the first two comments. Let 'em go. There are plenty of competent people to move into those positions, just like "lesser" automobile manufacturers will take up the slack left by Detroit.

May 03 05:30 PM

[TraderMark:]

Ah yes, because making decisions such as letting go of all the experienced, retiree types who actually knew what they were talking about - and replacing them with low wage college kids and early 20s set, was a bona fide strike of genius. Even though once they "booted" him they had to reserve that decision. And over that time Lowe's went from distant second to "first" in the mind of many.

Yes he did not run it into the ground - it would be nearly impossible (although Circuit City by doing a very similar policy suceeded) in destroying a duopoly in half a decade. But he took a good swing at it.

And you are falling into the trap of short term EPS growth - ANYONE can grow EPS in the near term by slashing compensation expense. I think the main thing he learned from Chainsaw Jack Welch is how to cut people to goose shorter term earnings.



On May 03 01:33 PM Raymond Micaletti wrote:

> One note about Bob Nardelli: He actually didn't run Home Depot into
> the ground. Under his watch earnings increased dramatically (going
> from $1.11 the quarter before he became CEO to $2.63 in the quarter
> when he left, a 15% CAGR). The problem was that when he became CEO,
> Home Depot's stock was egregiously overvalued and over time it naturally
> drifted down to a more reasonable valuation despite the fact that
> earnings were increasing. Thus, shareholders of HD, if they bought
> the top during the Internet bubble, should really be upset with themselves
> for buying an overvalued stock, not with Bob Nardelli.

May 03 08:35 PM

[TraderMark:]

You nailed it. Only the holier than thou few at the top think there is no one to replace them, and the defenders of corporate pay, generally are in the "back scratch" program (you sit on my board, I sit on your board) and we'll all walk about how we are irreplaceable to justify how we can get away with this. Have WSJ and CNBC trumpet the dogma and we all win here.


On May 03 04:36 PM Bobco23 wrote:

> Having worked at senior levels of small and major corporations, I
> can tell you with complete confidence, there are dozens of highly
> qualified executives ready to take the helm in the event the current
> grossly overpaid CEO leaves in a huff over pay. There is no lack
> of top talent. Let the CEOs walk.
>

May 03 08:36 PM

[smilingpilgrim:]

TraderMark - NOW you've nailed it - "you-sit-on-my-board-I... is THE problem. They mutually increase each other's pay in an inflationary super-spiral.

As a student of history I would say that we are in a neo-feudal phase. If you care about dry history see Medieval England, if not read Ken Follet's "Pillars of the Earth" and "World without End". Great bestsellers, and you will see that toady's CEOs are the Barons ofthe Middle Ages. This is most pronounced in the USA with the rest of the developed world being more balanced - although getting infected as well. If the American people do not revolt, their neo-feudal clique will soon be paid in the 1000's of multiples - not just 100's.

Apropos, am I the only person thinking that a CEO who is paid in the millions should be spending 24/7 at their job? Where do they find the time to worry about another company's problems? Unless they are Zeus on the Olympus, the time calculation just does not add up! As a non-US investor, I would not touch 99.99..% of US publicly traded companies with a ten-foot pole. My only US holding is JNJ.

Pilgrim


On May 03 08:36 PM TraderMark wrote:

> You nailed it. Only the holier than thou few at the top think there
> is no one to replace them, and the defenders of corporate pay, generally
> are in the "back scratch" program (you sit on my board, I sit on
> your board) and we'll all walk about how we are irreplaceable to
> justify how we can get away with this. Have WSJ and CNBC trumpet
> the dogma and we all win here.

May 03 11:07 PM

[Raymond Mic...:]

Fair points. Imagine, then, how much vitriol Nardelli would have received if he hadn't taken measures to goose EPS while the stock was falling from 50 to 20 in the first few years of his tenure (subsequently closing at 40 as he departed)....

Moreover, is replacing retiree types with college kids a horrible decision, if a) it does goose EPS and therefore increases shareholder value now and b) it's easily reversible if it turns out to be a horrible idea? Granted, you could lose market share in the interim, but is there really that much difference between HD and LOW (i.e., would LOW have always been a distant second even if Nardelli had been super-CEO)? Maybe there is, I don't know (or care), but if the college kids had turned out to be competent, Nardelli would have been hailed as a genius (I presume). That seems like it was a risk worth taking, no?

That being said, I'm not sure his $100mm+ pay package upon departure was justified (I suspect not--understatement, perhaps?), and you make a great point about the cronyism running rampant on corporate boards.


On May 03 08:35 PM TraderMark wrote:

> Ah yes, because making decisions such as letting go of all the experienced,
> retiree types who actually knew what they were talking about - and
> replacing them with low wage college kids and early 20s set, was
> a bona fide strike of genius. Even though once they "booted" him
> they had to reserve that decision. And over that time Lowe's went
> from distant second to "first" in the mind of many.
>
> Yes he did not run it into the ground - it would be nearly impossible
> (although Circuit City by doing a very similar policy suceeded) in
> destroying a duopoly in half a decade. But he took a good swing
> at it.
>
> And you are falling into the trap of short term EPS growth - ANYONE
> can grow EPS in the near term by slashing compensation expense.
> I think the main thing he learned from Chainsaw Jack Welch is how
> to cut people to goose shorter term earnings.
>

May 04 12:51 AM

[Mmarrkk:]

A reasonable question: if shareholders don't like the actions of the BOD, why aren't the BOD's voted out each year when the proxies come around?

I think the answer is that the majority of the shareholders like the job being done and thus, vote in approval. Hey, I hate the job the current POTUS is doing but there was an election! Each year, some of the BOD's of all of these companies go up for a vote. And each year, they receive a majority of the shareholders' votes. So, you see, the shareholders DID vote and they decided to keep the BOD's, the same ones you all are saying are doing a putrid job. Could it be that you are in the minority?

May 04 01:45 PM

[ValueInvestor:]

To be honest, I don't think individual shareholders even give a hoot. I personally throw out my proxies because I don't think voting on my .0001% holding is gonna do much, and how am I to tell which director to boot? Do I vote against all of them, one or none?

Most shareholders are there to make a buck off the stock price, not run the company like an owner should.


On May 04 01:45 PM Mmarrkk wrote:

> A reasonable question: if shareholders don't like the actions of
> the BOD, why aren't the BOD's voted out each year when the proxies
> come around?
>
> I think the answer is that the majority of the shareholders like
> the job being done and thus, vote in approval. Hey, I hate the job
> the current POTUS is doing but there was an election! Each year,
> some of the BOD's of all of these companies go up for a vote. And
> each year, they receive a majority of the shareholders' votes. So,
> you see, the shareholders DID vote and they decided to keep the BOD's,
> the same ones you all are saying are doing a putrid job. Could it
> be that you are in the minority?

May 04 04:42 PM