The Next Big Trust Scandal: Options Backdating

The scandal du jour is options backdating. Recently, it was illegal snooping by a Board Chairman. We’ve seen late-trading and front-running charges at mutual funds, payoffs and rigged bids in the insurance industry. We’ve seen over-reported oil reserves, and under-reported profits.

The mothers of all recent scandals—Worldcom and Enron—have pretty much wound down. In perhaps the longest-playing scandal, Walter Forbes, former Chairman of Cendant, was convicted of accounting fraud in 1998 in his third trial in 8 years.

So—what’s up next?

You could make a case for executive compensation.

CEO Compensation Through Time

You’ve read about the increasing gap between CEO compensation and that of the rank and file. The Economic Policy Institute says the ratio of CEO total compensation to annual earnings of a full-time minimum wage employee went from 51 in 1965 to 821 in 2005 (due in part to low increases in minimum wage, and in larger part to increases in CEO compensation).

The Institute for Policy Studies and United for a Fair Economy in 2005 says “the ratio of CEO pay to average worker pay increased from 301-to-1 in 2003 to 431-to-1 in 2004. By contrast, in 1990, the average large company CEO made just 107 times the pay of the average production worker.”

Let’s assume the general direction is true: a higher gap, not a lower one. (If you think these sources are flawed, check their methodologies and feel free to add a comment on other sources here).

Now check Gretchen Morgenson’s excellent NYTimes article on 26 November, 2006, “Peer Pressure: Inflating Executive Pay.”
Morgenson maps a cross-institutional morass of plausible deniability, heretofore obscured by the absence of disclosure requirements. Here’s how it works.

A CEO’s compensation is generally determined by a subcommittee of the Board (note the interesting dynamics that creates between Board and CEO). The Board, in turn, typically hires an external executive compensation consultant. Some of the big ones are Hewitt Associates, Towers Perrin, Hay Group, and Watson Wyatt; executive compensation is one of several lines of business for them, so visibility is a little obscure.

Most importantly, the accepted methodology is to identify “comparable companies” for purposes of comparing base CEO pay; and also for purposes of comparing performance. Note: it’s better for the CEO if you compare base pay to bigger companies, and performance to lower-performing companies. Amazingly (well, it was to me), there’s no requirement those two comparable groups be the same.

So, how do those groups differ? Dunno—they don’t have to say, and choose not to.

Finally, what company, board or compensation consultant enjoys declaring that “our policy is to have our CEO paid in the bottom half of his comparables list?" The temptation is to dodge the issue by fudging the comparison bases, and hoping no one asks. As Morgenson points out, this is Lake Wobegon on steroids—all the CEOs are above average. (Are you comfortable with the idea that there’s a 50% chance your doctor graduated in the bottom half of his or her class at med school? Think about it.)

That’s a lot of opportunities for blame-throwing and conflict-avoiding people to point fingers at others, hide behind “methodologies,” and generally obfuscate.

Do you believe it when someone says “the reason for high CEO pay is that it’s a competitive market?” I like free markets, but I’m finding this one hard to believe. I don’t think the supply side is the issue here; it’s the demand side.

Maybe that’s about to change. Beginning December 15, the SEC will require a company “to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy.” According to Mercer HR’s website, “the new rules allow companies to withhold specific, confidential performance criteria only if disclosing it will result in competitive harm. The SEC is expected to scrutinize this area to ensure robust disclosure in the CD&A.”

Scandal time? Consider this: SEC Chairman Chris Cox said of executive compensation, “no issue in the 72 years of the Commission’s history has generated such interest.”

More likely, it’ll be another crack in the dam. But as more data emerge, one thing will become clear yet again—the real crime is the cover-up.

CEO compensation is significant, it could make a difference if redeployed, and we don’t like such evident greed. But the even bigger issue is the cost we pay as a society when institutions are seen to have tweaked data, kept information secret, and in various ways loaded the dice—all the while claiming not to be doing so.

We are all creditors to a system based on trust; and we’re all left holding the bag when some players default on that trust. Trust betrayed is trust eroded. Let’s start letting some sunshine in.