Clearly Incomprehensible: Disclosure Of Executive Compensation Is Inadequate

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Clearly Incomprehensible: Disclosure of Executive

Compensation is Inadequate

Loren D. Miller

Albright College

Reading PA

There is a conflict raging in corporate American today. It is not a clash widely

recognized but it and its participants range far and wide across the corporate landscape,

passionately engaging in discussion on many levels. From boardrooms to political

forums, from small investors’ living rooms to the main offices of large institutional

concerns, from editorial columns to Internet blogs, the discussion of executive

compensation and its disclosure (or lack of disclosure) consistently arouses the strongest

of emotions in many of those involved.

This focus of the discussion, the lack of disclosure of NEO’s (named executive

officers such as the CEO, CFO, COO, etc) compensation and the way it is presented, is

blanketed in an apparent shroud of mystery and legalese. Companies routinely minimize

any discussion or focus on clear explanations of the compensation and often backdate

stock options (in which options are retroactively issued to coincide with low points in a a

company’s share.) This practice of backdating allows the recipients to fatten their profits

when they sell the options at market prices but is not an altogether legal one. The

Security and Exchange Commission (SEC) is now taking steps to address this issue and

ultimately the issue of how disclosure of executive compensation is inadequate.

Before examining whether or not executive compensation is adequately disclosed,

it must first be defined. Typically the average executive is compensated with a mixture

of cash salary, cash bonus, and shares of the company. These shares are almost always

subject to vesting restrictions (based on a set time limit or performance or both.) Forbes

Magazine uses four categories to define executive compensation: (1) salary (cash) (2)

bonus (cash) (3) other (market value of restricted stock received) and (4) stock gains from

option exercise (the gains being the difference between the price paid for the stock when

the option was exercised and that day’s market price of the stock.)

In reality, though, executive compensation is awarded via a multitude of other

ways and by using various vehicles. General Electric, for example, pays between 9.5 and

14% interest on deferred compensation (compensation that has been guaranteed but can

only be received in the future.) Many companies allow their CEO’s and other executives

to use corporate aircraft for personal travel. These additional costs incurred by the

company on behalf of their executives can easily and does regularly run into hundreds of

thousands of dollars per year. Citigroup, in 2003, paid over $304,000 for personal flights

taken by its committee chairperson (whose other pay was just over 16 million USD.)

Companies also pay the taxes for the personal travel of executives, which appreciably

increases the benefit to the executive.

Other ways of giving compensation include the forgiveness of personal loans to

executives. Though this is no longer legal, earlier loans that were made prior to the law

being changed can be carried indefinitely. For example, in 2000, Home Deport made a

10 million USD loan to its then-new CEO and forgave 20% of it each year, plus the

interest due and the taxes on both the loan and the interest. The reasoning? The loan and

its forgiveness would represent an incentive for him to remain with the company.

Providing amenities to executives is another avenue to compensate them outside the

normal salary structure. These amenities can include private boxes at sporting events,

entertainment, luxury apartments, country club dues, home security systems, etc.

Another well-known compensation trick is to make payments to terminated executives.

When the Walt Disney executive management team fired Michael Ovitz, he was awarded

140 million USD even though he only worked for the corporation for one year and two

months. Stepped up retirement benefits also can be used to compensate retired

executives. These benefits can include generous termination bonuses and massive step-

ups in pension amounts. Corporations can also elect to make charitable contributions to

the favorite causes of chief executives, which in the end can give the CEO the benefit of a

tax credit.

Changes in control agreements represent yet another source of executive pay.

These payments kick in when an acquisition by another corporation results in the

duplication and eventual elimination of executive positions. Very often the result is the

doubling (or more) of the executive’s last full year salary and bonus. Other companies

are successful in hiding payouts in smaller amounts. Very often restricted stock cannot be

redeemed or sold for several years after it is given to the executive. Sometimes, though,

dividends can be collected on them before the executive technically owns them. When

companies pay high dividends on this restricted stock, the payouts can easily amount to

hundreds of thousands of dollars per year.

Even though the Securities and Exchange Commission has had disclosure

requirements in place for publicly held companies, it has not made significant changes to

these requirements since 1992. At that point in time, it substantially overhauled the code

and introduced the current tabular format and summaries that are detailed in the form of a

narrative. While the rules have been amended over the years and the basic core elements

have essentially remained the same, the disclosure system has not kept pace with the

dramatic changes in executive pay strategies and techniques.

Under the current system, companies’ annual proxy statements are required to

provide detailed information about the compensation of the company’s CEO and the four

most highly paid executive offices (other than the CEO). Much of this information is

provided in table form, accompanied by explanatory footnotes and narrative. The

primary disclosure requirements are found in Item 402 of the SEC’s Regulation S-K.

Also, since 2004, the SEC requires companies to file Form 8-K (which is filed with the

SEC within four business days). Form 8-K can disclose several different possibilities: if

companies enter into, or materially modify, a compensation plan, contract or other

arrangement involving senior executives’ compensation. They also must file copies of

these documents with the SEC as part of their annual reports on Form 10-K (the yearly

report to the SEC that includes an overview of the company’s business, audited financial

statements, details about pending litigation and other key data) and reports on Form 10-Q

(quarterly reports that include financial statements for the quarter, management’s

discussion of results, and other key information, such as key accounting policy changes.)

Separate SEC rules require disclosure of any transactions with the company involving

specified related parties (such as executive officers, directors, director–nominees,

significant shareholders, and any of their immediate family members.) In addition to the

SEC requirements and regulations, the various stock exchanges also play a key role in the

compensation setting process through their corporate governance listing standards. The

primary listing standard that influence executive pay are the requirements regarding the

composition and operation of board compensation committees (including director

independence) and shareholder approval of nearly all equity-based compensation plans.

This listing must be accompanied by a performance graph that compares the company’s

total shareholder return over the last five fiscal years to both a set of peer group

companies and a broad equity market index. For example, the New York Stock Exchange

(NYSE) listing standards require the compensation committee to consist solely of

independent directors having no direct or material relationship with the company; to have

a written charter; to determine and approve CEO compensation based on performance

evaluation; and to conduct an annual self-evaluation. NASDAQ’s standards are

comparable, but require CEO pay to be determined by either a majority of independent

directors or a compensation committee made up entirely of independent directors.

SEC’s Proposals

In January 2006, the SEC proposed far-reaching changes to its executive

compensation disclosure rules. This major revision requires companies to disclose total

compensation figure and the fair value of stock option grants for each named executive

and would further require table describing grants of performance-based incentive and

equity awards, outstand equity interests, and potential post-employment payments and

benefits.

The current board compensation committee reports and the performance graph are

to be replaced by a new Compensation Discussion and Analysis (CD&A). The CD&A

would be a company-initiated disclosure, not one created by the board compensation

committee. It would set the context for other required disclosures (both tabulated and

narrated) by addressing policies and objectives of the company’s executive compensation

program and how this program is implemented. The proposals take a “principle-versed”

approached to the disclosure to discourage the use of boilerplate commentary on