Performance Anxiety

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Performance Anxiety
The GAAP Gap
Discipline of the Capital Markets?
The Market versus the Externalizing Machine
The Babe: "I Had a Better Year"
Endnotes

Performance Anxiety


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The notion that the marketplace imposes meaningful restraint on corporations boils down to the question of profit. And yet, for most large American corporations, any meaningful financial accountability can be deferred for a long time, certainly beyond the retirement date of any current senior executives. The conventional wisdom is that profit is an indispensable key to new capital. The model of profit maximization has been a convenient formulation, particularly for scholars, because it supposedly provides "a single, objective, easily monitored [residual] goal."1 Nothing could be more misleading.


What Is Profit?

First, the pursuit of profit is not the pursuit of a single goal, but involves decisions and actions in furtherance of numerous goals. Second, it is not objective. What costs and benefits, for example, are to be included in the calculation of profits? If social costs are to be included, how are various social costs and benefits to be valued? How are potential future economic benefits and costs to be quantified given the uncertainty of future markets? Third, it is not an easily monitored goal. How can decision-makers be made accountable on the basis of profit when their decisions involve making predictions of future returns from uncertain markets?

Lynne Dallas


Source: "Two Models of Corporate Governance: Beyond Berle and Means," University of Michigan Journal of Law Reform, 22(1), 1988, p. 104.
Profit is part of any definition of a private corporation. The incentive to invest comes from the expectation of profit. This core dynamic is essential for two reasons. First, the motivation for profit is what keeps companies competitive. Second, an important justification for the legitimacy of corporate power derives from the limits imposed on activity by its need to be profit-related.

When corporate management is confronted with the failure of other mechanisms of accountability, it unfailingly points to the marketplace as the ultimate means of accountability.2 That makes sense, at least to the true believers in efficient markets, who argue that the corporation must be efficiently organized or it would go out of business. Corporations exist to maximize profits, according to those theorists, and that is the definitive accountability.

The problem with that approach is that it neglects the impact of the corporation as externalizing machine. Imagine that a management is presented with two optionsone that increases profits, with some risk, through marketplace competition, and the other offering less profit but more certainty in the short run. Without meaningful accountability to shareholders and independent boards of directors, management will go for the second option. That has often been the case, as the examples in this chapter demonstrate.

Profit maximization is an ideal, but there is no formula to achieve itindeed, no way to know for sure if you have. In 1982, a best-selling book called In Search of Excellence told stories of glorious success and wonderful profits at companies selected for their superb performance. The authors distilled what they learned from observing these corporations into a list of recommendations, and the book was as wildly successful as the companies it described. Yet, only a few years later, Business Week noted that at least 14 of the 43 companies touted as excellent in the book had "lost their luster."33 And other companies who tried to adopt the strategies outlined in the book learned that it wasn't so easy. The volumes written on the subject of maximizing profits are as abundant in number and varied in approach as the volumes on how to lose weightand they are about as effective. In Chapter 2 we talked about fads such as conglomeration and leveraged buyouts. They and many other corporate strategies are all attempts to maximize profits over the long term. As with fad diets, any results may be temporary.


The GAAP Gap


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As the lawsuit Art Buchwald brought against Paramount made clear, profits for one purpose are losses for another, and generally accepted accounting principles (GAAP) are infinitely flexible. In his lawsuit, Buchwald charged that Eddie Murphy's 1988 movie Coming to America had been plagiarized in part from an original story by Buchwald, and that he was thus entitled to a share of the profits. What appeared to be a hitgrossing about $300 millionwas shown on the books of Paramount as losing $18 million as of December 1989.4 The economicsof movieshasbeen changed to defy traditional methods. Increasingly, starsand directorsget a percentage of the gross. The studiothe traditional ownermakesitsprofit by charging the largest possible feesfor use of facilities, distribution costs, interest on loansto the film, and other expenses. Thus, with "Hollywood accounting," it no longer mattersif the movie makesa profit or not; everyone hastaken hispiece of the pie beforehand. Ultimately, a California state court appointed an accountant to examine Paramount'sbooksto see if Buchwald can receive a percentage of the "profits." (I am a director of a company that acquired a division from another company, and I learned that the entire deal had been restructured to make sure that the CEO of the seller would qualify for hismaximum bonus.)

There are many levelson which to try to understand profit, and a lot dependson which level you start from. Both management and shareholdersclaim to be interested in long-term profitsand accuse each other of focusing on the short term. On close examination, both are right, and both are wrong.

All of the wisdom of the agescan be employed in the effort to achieve long-term profit, and yet the effort can fail for reasonsbeyond anyone'spower of contemplation. Adam Smith (the contemporary businesswriter, not the eighteenth-century economist) quotesa memorable report: "The light we saw at the end of the tunnel . . . wasa freight train coming the other way."5in coming the other way."5 Business school case studies are filled with examples of companies that snatched defeat from the jaws of victory, such as Bendix fighting for Martin Marrietta, only to lose itself to Allied. These were companies that were doing well until they embarked on an overly ambitious and faulty plan. Short-term profit, on the other hand, is usually a course of action that someone else takes. The only self-admitted short-termers are the arbitrageurs, whose involvement in the takeover process is so critical and accordingly so subject to criticism.

Short term denotes profit you can take today; long term is what you hope to get tomorrow. At the end of one of his bravura performances at a Polaroid annual meeting during the 1960s, Dr. Edwin Land, following hours of impassioned involvement with an audience of several thousand across the extraordinary range of his vision, was brought up a little short by a question from a financial type asking about the "bottom line." The great man was a little taken aback by this plunge into the mundane but managed to compose the ultimate formulation. "The bottom line," he said, "is in heaven."


Buffett on the GAAP

. . . auditors annually certify the numbers given them by management and in their opinion unqualifiedly state that these figures "present fairly" the financial position of their clients. The auditors use this reassuring language even though they know from long and painful experience that the numbers so certified are likely to differ dramatically from the true earnings of the period. Despite this history of error, investors understandably rely on auditor's opinions. After all, a declaration saying that "the statements present fairly" hardly sounds equivocal to the non-accountant....

Our approach to this accounting schizophrenia is to ignore GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses. Using this approach, we establish our own ideas of business value, keeping these independent from both the accounting values shown on our books for controlled companies and the values placed by a sometimes foolish market on our partially owned companies. It is this business value that we hope to increase at a reasonable (or preferably unreasonable) rate in the years ahead.

Warren Buffett Source: Berkshire Hathaway, Inc., Annual Report to the Shareholders, 1985, pp. 13-17.


There is a reason that accounting principles are called "generally accepted" and not "certifiably accurate." GAAP represents a generally good-faith effort to delineate a language of numbers that will consistently apply comprehensible standards. It doesn't purport to deliver truth, only some kind of consistency. As with most codes, what turns out to be important is not what is intended but what was unintended. Accounting conventions can create an environment that compels particular business conclusions. For example, the treatment for "good will" in an acquisition amortization over a relatively short periodcreates such pressure on earnings for so long that public acquirers with sensitivity to reported earnings per share are put at a disadvantage in competition with private groups. This simple convention, as much as any other factor, may account for the widely proclaimed "death of the public company."

Accounting methods have proven so manipulable that a company such as Prime Motor Inns can celebrate net income of $77 million one year and go bankrupt the next. Forbes notes that Prime Motor Inns is by no means an unusual case; W.T. Grant, Penn Central, Crazy Eddie, Miniscribe, and many savings and loans all reported impressive earnings and still went bankrupt.6

If leases are "off balance sheet," corporations lease their executive jets. If they must be recorded, usually the company will buy the airplane; why give a profit to the leasing company? Often, the most valuable assets of a company are not recordable on the financial statements under GAAP for example, the creativity of Dr. Land in the early days of Polaroid, the "rights" of the major oil companies with respect to reserves in other countries, franchises or licenses, or brand names (the critical asset in the huge RJR transaction).

Profits calculated according to GAAP should not be confused with the myth of value maximization. The current practice of "big bath" accounting has considerably diminished the credibility of annual numbers. A sort of "ooops!" by the accountants, this is a practice increasingly resorted to across the board in American industry. At intervals of 5 to 10 years, an enormous "one-time" charge is made, usually attributable to prior operations and often, as with Honeywell, when a new head of the company comes in. This is the treatment used when a company makes a mistake with respect to the acceptability of a new product. All of the costs are written off at one time. The effect is to change previously reported earnings retroactively (without changing bonuses based on them) and, by the establishment of reserves, to "hard-wire" earnings levels for the succeeding several accounting periods. There is therefore no real time in which management has to live with the consequences of the mistake. During the period of time when, for example, the new product bombs, earnings are being reported normally. All of the ultimate adjustments for writing off development costs, prepaid selling expense, inventory adjustments, and the like are wrapped up in the one huge "big bath." At the time of the "big bath," prior-period earnings may be reduced, but there is no adverse impact on current or future reported results. Indeed, the opportunities for anticipating future costs in the "big bath" are irresistible. This does not seem to be the basis for a "discipline" imposed by the marketplace. You can believe neither the past nor the future. The figures are virtually meaningless.


Discipline of the Capital Markets?


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The Business Roundtable spoke in early 1990 of "the powerful accountability imposed by markets.... Financial markets also quickly reflect their evaluation of the quality of accountability through the price of equity and debt."7 The theory is that companies will be disciplined by the marketplace when they need to raise new capital; the practice has been different.

An incidental consequence of the "hostile takeover" boom of the late 1980s was the revelation that large American companies were overcapitalized. The "raiders" demonstrated a capacity to pay a premium over market value, liquidate assets to pay down their acquisition cost, and still keep a fortune for themselves. Managements showed themselves to be true believers through MBOs. Company after company, year after year, bought back their own shares in large volumes. The chart in Figure 3 shows the staggering reduction of equity capital by America's principal companies. Merrill Lynch compiled the list shown in Figure 4 of the biggest stock buybacks over the last five years of the decade.

Large companies simply did not need new capital in the decade of the 1980s. They apparently had no use for it. It is difficult to speak of an effective discipline that is based on a demonstrated lack of need for access to the capital markets.

They did not need to go outside for investment capital because they could provide it themselves, through an ESOP. The tax-aided Employee Stock Ownership Plan (ESOP) not only provided a popular antitakeover function but became an important source of new financing that was essentially internally generated. "ESOPs are utilized in more than 11,000 U.S. corporations covering an estimated 11 million employees with a total stock value of approximately $70 billion."8


FIGURE 3 New Stock Sales, Minus Shares Rehred in Stock Buyback Programs (in Millions of Dollars).

Estimated

SharesAmount I

IssuerYear(in millions)(in millions)

1.General Electric Co.21989173.9$10,000

2.General Motors Corp.34198774.05,125

3IBM Corp 2,3198950 15 ooo

4.Santa Fe Southern Pacific Corp.198760.03.375

5.Union Carbide Corp.198638.83,298

6Goodyear Tire & Rubber Co.3198660.02,985

7.Allegis Corp.198835.52,840

8.General Motors3 5198653.02,735

9.IBM3198615.02,061

10.Ford Motor Co.2198727.92,000

11IBM2198817.82,000

12.E.l. du Pont de Nemours & Co.198920.01,928

13.CSX Corp.3198860.01,858

14.Coca-Cola Co.198740.01,800

15.Henley Group3198764.51,756

16.Sears, Roebuck and Co.198840.01,745

17.Norfolk Southern Corp.198945.01,654

18Gencorp198712.51,625

19IB M23198712.91,574

20. Philip Morris Cos 2198936.11,500

FIGURE 4 The Biggest Buybacks of 1986-1989: Repurchase Announcements by US. Companies. (Source: Reprinted by permission of Merrill Lynch, Pierce, Fenner & Smith lncorporated ~ Copyright 1990.)

' Estimated dollar amount equals (a) the number of shares announced multiplied by the prior-day closing price for open-market programs: (b) the actual dollar amount, if announced, for private transactions; (c) the number of shares announced multiplied by the tender-offer price for self-tenders (or the maximum price for Dutch-auction self-tenders): (d) the number of shares announced multiplied by the stated value of the cash plus debt or stock plus debt or stock equivalents of exchange offers.

' Announced as a dollar amount: number of shares equals the dollar amount divided by the prior-day closing price .

Totals include more than one announcement.

~ Totals include 64 million shares of common stock, 5 million shares of Class E common stock, and 5 million shares of Class H common stock.

5 Totals include 10 million shares of common stock, 20.5 million shares of Class E common stock, and 22.5 million shares of Class H common stock.


The fascinating story of ESOPs starts in the creative mind of San Francisco lawyer Louis O. Kelso. Graduating from law school in Colorado in the 1930s, Kelso devoted a substantial amount of his energy to coming to grips with the failures of capitalism that were apparent on all sides. In 1958, in collaboration with Mortimer J. Adler, he published the book entitled The Capitalist Manifesto that set forth the theoretical bases of his theories of ownership. The title indicated the book's intent to be a direct refutation of Marx, whose Communist Manifesto purported to prove the intrinsic contradictions in capitalism.

Kelso argued simply that the traditional notion that net profit or value added in a corporation should accrue entirely to the benefit of the passive shareholders was arbitrary and undesirable. Although capital is entitled to rent, so is labor. Kelso urged that workers be entitled a portion of ownership as an incident to their labor. This is a practice that entrepreneurs have long styled as "sweat equity," but no one other than Kelso had theorized it as a normal practice involving the entire work force. Kelso is a determined and a persuasive man. Over decades his proselytizing was undiscouraged and little availing. In one of those coincidences that embellish history, he finally caught the ear of the one man in the United States able not only to understand but to convert single-handedly Kelso's ideas into law. Russell Long, son of the Kingfish, senator at age 30, and legendary chairman of the Senate Finance Committee, had the kind of power that accounted for the favorable tax treatment to ESOPs or TRASOPs (ultimately encompassing a veritable acronym zoo) in every tax bill passed over a decade. Even with this encouragement, Kelso's dream of employee ownership was slow to develop until, as for so many other corporate devices, the unmistakable pressure of hostile takeovers in the 1980s alerted creative minds to previously unsuspected possibilities.

Kelso and Russell Long ultimately created the so-called leveraged ESOP. This is a device whereby a newly formed ESOP acquires a substantial stock position with borrowed money. The loan from a bank is guaranteed by the employing corporation, with payback over a period of years as shares are allocated to eligible employees. The company contractually commits to provide sufficient funds to pay all debt service, regardless of the company's earnings and profits. Favorable federal income tax treatment is accorded to virtually all stages of the transaction, with the intention of creating a competitive new source for corporate finance that will result in employee ownership.

ESOPs solve three problems. First, they are a convenient place for overcapitalized corporations to put their money. Second, they are tax-aided sources of new capital. Third, they provide protection against hostile takeovers.

In addition, world capital markets have become increasingly liquid and fungible at the same time, as the Securities and Exchange Commission has deregulated the sale of new securities to financially sophisticated buyers.99 The traditional shareholders' protection of preemptive rights (very much insisted on by British institutions) is only a memory in the United States, so managements are able to pick and choose their shareholders among countries and categories to minimize the possibility of their acting collectively in the future. (We earlier discussed the almost keiretsu-like financing by Cummins from its customers in the summer of 1990 )

In sum, although the argument of "the discipline of the financial marketplace" continues to be the favorite myth of those who argue that existing systems of accountability are functional, the reality is plain that companies demonstrate little, if any, need for access to the marketplace to fulfilltheir requirements for new capital.


The Market versus the Externalizing Machine


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Consider the use of nuclear power by public utilities. For years, the low cost of nuclear power convinced companies, customers, and voters of the efficiency of this fuel and technology. Did cost include amortization of the developmental technology? Did it include the cost of manufacturing the processed fuel? Did it include insurance costs? Allof these costs were, in fact, funded by the federal government. Not only did citizens underwrite these projects with their tax dollars, but the government also passed on additional costs to society as a whole by limiting the amount of claims recoverable from a nuclear accident. We stillhave no idea of what the cost willbe of decommissioning the plants themselves or of the ultimate disposal of spent fuel. Because of the extent and the changing nature of government involvement in nuclear power, it is virtually impossible to determine whether many private utility companies are actually profitable.

Take a more prosaic examplecoal mining in eastern states. For many years, public utilities burned so-called high-sulphur coal from Pennsylvania and West Virginia. Changing social standards regarding air pollution resulted in the closing of most of these mines, and yet nothing had changed respecting the underlying economic logic of extracting and transporting the coal, burning it in boilers, and converting the steam to electrical energy. What changed was that society was no longer willing to bear the cost of a contaminated atmosphere, and industry was unable to develop cost-competitive techniques for clean burning. Should, and do, the costs charged to utilities and customers include the ultimate expense of retraining and relocating "obsolete" coal miners? Where does the cost fallfor supporting those who either can't or won't relearn or move?

A further externality affecting the coal industry is seen in the capacity of government to affect markets. Politicians find it difficult to resist acting in the corporate interest. The increased revenue, jobs, and other benefits to a politician's region outweigh the cost to the nation as a whole. Corporate interests, for example, keep the Pentagon buying coal, even though it no longer wants or needs it. Congressmen from coal industry states, notably Pennsylvania, routinely include a requirement in spending bills that the Pentagon purchase $20 million of anthracite coal, even though the Department of Defense has enough to last for the next four years. Back in 1962, Representative Daniel Flood, a congressman from Pennsylvania, convinced the Kennedy administration to use U.S. produced anthracite coal, rather than coke produced in Germany, to heat bases. When military bases began to phase out coal in favor of other fuels, coal state legislatures "delayed the conversion of coal furnaces, required the Pentagon to consume more coal, and for a time even required that U.S. coal be shipped to Germany for stockpiling.''10

There is no general agreement as to what costs are appropriate in a given situation; there is instead a continuing effort by companies to incur as little of the costs as possible and to externalize them to society as a whole. Nuclear power and coal production are two examples of the way in which changing government and society priorities become controlling elements in determining the profitability of a particular industry. To the extent that the industry itself is a moving force in creating the government policies, it is important to note that what is profitable for the industry may wellbe hurtful to society as a whole.

Exclusive focus on the financial measure of corporate performance is a relatively recent and domestic practice. In the original concept of a corporation, charters were granted to meet a particular perceived need. Each company had an industrial purpose. Courts made sure that a corporation's activities were limited to those specifically authorized in its charter. Companies could be directly compared with their competitors on a variety of levelstechnology, quality, range of products, as wellas size and profitability. The corporation's mission was seen as providing goods and services that society had determined to be desirable. As the industrial rationale of corporations eroded, the objective of pure financial performance took its place. Reviewing the last 75 years, we can perceive the trend that brought us to where we are today.

Joseph Schumpeter, a leading philosopher on business organizations in the mid-twentieth century, considered a world in which companies competed; some survived, some failed. With the passage of time, some products became obsolete.11lete.ll All of this was accompanied by uncertainty closing of plants and loss of jobs. Schumpeter characterized the capitalist process as "creative destruction." Out of the ashes of the failed industries the phoenix of the new emerged. To his way of thinking, the "genius" of capitalism was in its giving outlet to human creativity to deal with the prevailing circumstances without the burden of the past.

The disinclination of the business community to continue a world of perpetual competition was apparent at the turn of the nineteenth century in the trend toward monopolies. In the twentieth century, companies have adopted different strategies to deal with the threat of competition. We have already noted the tendency to seek governmental protection.

The trend toward conglomeration severed the last ties to the corporation with an industrial rationale. The new companies would have a diversified capacity to survive. The brief claims that managerial genius enabled a few to run all manner of businesses better than anyone else were dashed in the stock market crashes of 1974 and 1975. Conglomerates became just a presence, an energy prepared to move in any direction but committed to none. These were companies of financiers, not researchers, not production men, and not industry specialists. Harold Sidney Geneen, not Henry Ford. The goals were survival, growth in size, and diversification of sources of revenue. As Louis Auchincloss said, "The age of the tycoon could only be followed by the age of the fine print."

Herbert Simon coined the term satisficing to characterize the conduct of large corporations in the 1960s. By this he meant that the energy and the sacrifices necessary to achieve optimal results had drained out of the enterprises, and the dynamic of "managed growth" had been substituted. The best manager is one who not only achieves this year a specified improvement over the last, but who also achieves the same next year. The corporation, a creature of risk and change, was converted into something resembling a public utility with an "acceptable" rate of growth.

Early in the 1980s, another trend became pronounced. It was commonplace for a company to have assets that were worth vastly more than its value in the marketplace. A spectacular example is the Ford Motor Company, which sits on nearly $15 billion in cash and securities in an industry that has excess capacity. The company already has significant positions in defense and finance. And yet the management is reluctant to give the cash to its shareholders.

We believe that profit maximization means that managers must avoid practices that are irrelevant to or inconsistent with ultimate profit. This might include charitable contributions unrelated to any of the corporation's constituencies, compensation policy unrelated to profit, and acquisitions that add size and not profitmost generally any allocation of corporate resources that promotes some objective other than profit maximization .

As we discussed in Chapter 3, the new "stakeholder" statutes explicitly authorize directors to prefer the claims of nonshareholder constituencies, thus endorsing non-profit maximization goals. Like "prudence," "profit maximization" is a process, not a guarantee of results.

There is no way to ensure that a particular decision is "profit maximizing," but two axioms should be observed. First, as the Business Roundtable has urged, it is absolutely essential that the business judgment rule be interpreted liberally to permit management that level of risk taking essential to the healthy future of business enterprises. The only limit we would add is that it should not protect officers or directors when they are acting in the context of a conflict between their interests and the interests of shareholders. Second, in the absence of a quantifiable standard of performance, managements must be meaningfully accountable to someone. If there is no self-executing mechanism for determining that management in a given company is bad and should be changed, the health of the system requires that there be a structure of accountability. Those who can keep power without being accountable are tyrants, whether in a political or a business mode.


The Babe: "I Had a Better Year"


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In 1930, Babe Ruth was asked to justify why his $80,000 salary was higher than the $60,000 that President Herbert Hoover received that year. The Babe's unforgettable answer: "I had a better year." The unassailable logic of this response has never been persuasive in boardrooms, where directors routinely approve compensation plans with no more relation to performance than those for the kings who annually received their weight in gold.

The concern over compensation is nothing new. Alfred Conard reports that "for more than half a century, observers of the corporate scene have denounced excessive compensation of executives."12 In fact, the question of compensation goes back even further. Plato thought that the perfect society would pay the top person no more than five times what it paid the average worker. Even a bona fide capitalist such as J.P. Morgan championed an equitable compensation system: each person was paid no more than 1.3 times the next lower rank. 13 Today CEO pay is 157 times that of the average worker.14 It is increasingly harder even to identify the multiplier these days, because the compensation packages are so complicated.

Crawford H. Greenewalt, former president of Dupont, argued in 1959 that managers need to view their business with "the eye of the owner," and he believed that less cash and more company stock in the yearly package was the way to achieve this. Greenewalt went on to propose two systems: enough stock so that the dividends alone would at least equal the executive's retirement pay, and enough stock to equal five times the final salary.15

It was perhaps Michael Jensen and Kevin Murphy, however, who put it most eloquently: "The relentless focus on how much CEOs are paid diverts public attention from the real problemhow CEOs are paid. . . . On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that with so many CEOs acting like bureaucrats rather than the value-maximizing entrepreneurs, companies need to enhance their standing in world markets?''16

Jensen and Murphy are right. A $10 million compensation package may not be enough for a CEO who turned a failing company around, whereas a $1 million package is too much for a CEO who has presented shareholders with declining earnings. Disney chairman Michael Eisner is the best thing to happen to the company since Mickey Mouse. Shareholder returns at Disney have averaged over 60 percent per year for the last three years. Eisner deserves to be rewarded for this remarkable achievement, and he has: in fiscal 1989, Eisner received over $9 million in salary and cash bonus, and he exercised options that profited him $68 million. It was the billions that Eisner helped Disney to earn that brought him the millions in stock option profits.

I sit on the board of Tyco Labs, where a CEO made over $50 million for bringing the stock from $3 11'2 to $65. You won't find a single director who will complain about it, and I imagine you won't find an unhappy shareholder, either. In exchange for executives taking cash salaries on the low end of the scale, the board authorized the grant of 3,400,000 shares to management in 1983. The grants would vest over a 10-year period, and the company would loan executives the cash sums necessary to pay taxes. Some 3,100,000 shares have been granted through May 31, 1990. Simultaneous with this program, the board also authorized repurchases of the company stock in the open market. Since 1983, some 8 million shares have been acquired at an average cost of pennies less than $10 per share. Although the granted shares have a market value (assuming $50 per share) of $150 million, it can be argued that the cost of this executive compensation system to the long-term Tyco shareholders is only the $30 million that the company spent to purchase the shares in the marketplace. This is as close to a win/win situation as you can find. Problems may be anticipated concerning the future motivation of rich managers, but the correlation of manager and shareholder wealth is an optimal result. On an ongoing basis, it is reassuring to consider that senior management owns a significant percentage of the total outstanding capital stock.

In 1989, the average CEO at the top 200 American companies received $2.8 million in salary and bonuses, in addition to lucrative pension and insurance packages. Towers Perrin reported that CEO salary rose 8 percent in 1989. But American business did not have a particularly "good year," to use the Babe Ruth standard. CEOs always manage to have better years in terms of compensation, but, as Figure 5 shows, profits and the wages of others don't always warrant it. Were CEOs requiring more pay for lackluster performance to keep pace with inflation? No, CEO pay also outpaces inflation. Were they covering for tax increases? Hardly. Graef Crystal, a compensation expert, surveyed 10 CEOs over the past decade and a half, with these results: Between 1973 and 1975, CEOs' after-tax pay averaged 24 times that of the average manufacturing worker. By 1987 to 1989, the differential was 157 times the average manufacturing worker. But taxes for CEOs declined from 50 percent to 28 percent, while worker taxes increased from 20 percent to 21 percent. 17

American CEOs may be behind the Japanese and Europeans in competitiveness and productivity, but we sure have outpaced them in compensation. Pay packages of American CEOs at billion-dollar companies are two to three times greater than their equals in Japan, France, Britain, Germany, and the Netherlands.18 In Japan, performance compensation takes another twist: CEOs who "disturb society"by polluting the environment or being responsible for some public disaster, for example often take pay cuts as a way of expiation. 19 Following a Japan Air Lines crash in 1985 that claimed 520lives, the president of JAL made personal visits to the families of the victims. In 1981, after a series of leakages from a power station owned and operated by the Japan Atomic Power Company, the chairman and the president of the company resigned, in the hope that trust in nuclear stations would be restored under new leadership.200 Other CEOs resign after poor performance. American CEOs just figure they are not being paid enough. At companies such as Manufacturers Hanover Trust, Borden, Phillips Petroleum, General Dynamics, Tenneco, Amoco, and Caterpillar, CEOs took home fatter paychecks in 1989 than they did the previous year, despite a drop in each company's return on equity.21

Compensation at the top levels of management has become so outrageous that even the bastions of capitalismBusiness Week, Forbes, and Fortunedecry it with yearly cover stories that have become the business press equivalent of the "swimsuit issue"the one everyone waits for. Intended to provide information for the marketplace, such coverage should permit "consumers"in this case, shareholdersto have some kind of impact. In practice, however, management reads the compensation issues only to make sure that it is in the top group and, if not, to justify getting there. These stories have become an important factor in the spiraling increases.

Overcompensation is another example of externalizing costs through neutralizing mechanisms for accountability. Who is there to say no when the CEO asks for a raise? Shareholders are pretty much locked out of the process. Directors are picked by the CEO and are unlikely to oppose him; after all, he sets their pay. The system has no checks. Alfred Conard wrote:

Overcompensation is particularly immune to correction by existing mechanisms of corporate governance. The "independent directors" who predominate on corporate boards are doubly biased; most of them owe their jobs to the executives whose compensation they must determine and are themselves executives of other corporations, where they hope for the reciprocal favor.... When levels of compensation are reviewed in derivative suits, judges can only compare compensation in the case before them with compensation in other enterprises that are subject to the same biases.22

Also encouraging overcompensation is the fact that compensation experts, brought in to devise pay packages, usually are selected byand report tothe CEO, not outside directors.

Shareholders represent the only groupunlike directors, officers, or governmentwhose self-interest dictates approval only of compensation packages that are in the best interests of the corporation. They have every incentive to award lucrative contracts to attract the best minds to the corporation and to make sure that payment does not cripple the cost of operating the company. Shareholders can judge, for example, what sort of base pay will keep a corporation competitive within its industry, whether there is reason to limit top management's pay to a certain ratio of employee wages, and how much compensation should be provided through stock-based plans.

But shareholder involvement in the compensation issue is almost nonexistent. Under state law, shareholders have no direct voice in compensation decisions: the power to determine types and levels of executive compensation rests solely with the board of directors they elect. Most state corporation statutes also allow the board to determine its own compensation.

Under federal law, shareholder involvement is still limited. The SEC does not permit shareholders to file proxy proposals dealing with compensation, on the grounds that compensation constitutes ordinary business of the corporation. In 1990, the SEC made a significant reversal of its earlier policies and permitted the first shareholder resolution on a compensation matter, concerning golden parachutes, because of the role parachutes play in corporate takeovers. If they were purely a question of compensation, they would not have passed the SEC. On the other hand, it also proposed rules seriously limiting even further the required disclosures about compensation that companies must make.

State and federal rules thus preclude virtually any direct involvement by shareholders in matters concerning compensation. The presumption is that the board of directors will represent the shareholders' interests in executive compensation and other corporate policy matters, so all shareholders have to do is elect qualified representatives. The SEC's proxy disclosure rules require detailed descriptions of management compensation before each annual meeting. By requiring extensive disclosure, the SEC clearly intends for shareholders to have information with which to exercise broad oversight over the entire executive compensation program, not just those few items that must be submitted for shareholder approval. But, in most cases, shareholders who object to a company's compensation program have no way to demonstrate their objections other than to withhold votes for management nominees or to write a note on the back of the proxy cardboth symbolic gestures at best.

There is one exceptionalmost an afterthoughtone area where compensation issues are put to a shareholder vote. It is found in the Internal Revenue Code's requirements for eligible stock option plans and the SEC's proxy disclosure and short-swing profit rules. The federal tax code requires that, to qualify for preferential tax treatment, a stock option plan must be submitted for shareholder approval within a year before or after its adoption.23 The Code also requires that employee stock purchase plans be submitted for shareholder approval within a year.24 Thus, through the Code, shareholders "creep" into the decision making process for at least some types of compensation plans.

The SEC's short-swing profit rule, meant to prevent the unfair use of inside information by corporate officers and directors, prevents insiders from trading company stock for a period of six months after the purchase date. There are a number of exceptions to this rule, many of which depend on shareholder approval of compensation plans that include company stock subject to the short-swing profit rule.25 Just like the Internal Revenue Code, this rule gives shareholders an indirect entree into the compensation decision making process.


"Secondary Control" of Compensation

Technically speaking, the compensation of management falls partly within and partly without the purview of stockholder decision. However, since all elements of compensation are required to be disclosed in proxy statements relating to the election of directors, it seems to be the intention of our present laws that stockholders should exercise at least secondary control over the entire field. (Emphasis added.)

Benjamin Graham, David L. Dodd, and Sidney Cottle


Source: Security Analysis: Principles and Techniques, 4th ed., McGraw-Hill, New York, 1962, p. 672.
Overcompensation has many ill effects. One is the negative effect on employee morale. The Pittston workers on strike saw the management that was opposing their requests raise its own pay 61 percent. Imagine the feelings of the General Motors workers when, after massive layoffs of middle managers and operatives in 1987, the company proposed to pay executives large cash bonuses. Only the intervention of board member Ross Perot in conjunction with several key institutional investors stopped the management proposal. The impact on shareholder morale can also be devastating.

At Coca-Cola Bottling, J. Frank Harrison III was granted an option to purchase 150,000 shares of common stocknearly 2 percent of the company. Harrison happened to be the son of the chairman of the board, J. Frank Harrison, and together the father-and-son team already held 9 percent of outstanding common stock. But the worst offense was that Harrison III was also chairman of the compensation committee, giving him the unique privilege of presiding over the body that decided to reward him. What shareholder would want to invest in the company after that?

But the most serious problem is the morale of the CEO. What contact with overall commercial reality or the specific commercial reality of his own company does such a person have? The only other people in that pay range represent the ultimate in pay for performance: investment bankers, entertainers, and sports figures. No one else gets so much for so long without somehow, somewhere, sometime having to deliver.

In the worst cases, lucrative packages are granted to CEOs whose companies are sliding into oblivion. Instead of paying the captain to go down with the ship he wrecked, the board should find a new captain. ICN Pharmaceutical gave top officers raises as high as 91 percent in 1989, despite ICN's $82 million loss that year. The CEO, Milan Panic, received a 39.6 percent pay hike, bringing his salary to $574,050, not including $71,390 in legal, accounting, and insurance fees provided by the company. The reason? ICN wanted to "ensure his retention." But Panic founded ICN in 1960, and founders rarely leave their companies.

"Retention" is an empty catchword used to justify the unjustifiable. Says Michael Halloran of Towers Perrin: "It is rare that the CEO of one company leaves to become CEO of another. Retention is only an issue for employees below that level."26 Retention could not have been a factor when First Interstate Bancorp gave CEO Joseph J. Pinola a 12.4 percent raise in 1989 for presiding over a $124 million net loss that year. Pinola retired that year, making the raise look more like a golden parachute than compensation for good work.

At its 1989 annual meeting, Toys "R" Us asked shareholders to approve a grant of 500,000 stock options, roughly 0.4 percent of current outstanding shares, for CEO Charles Lazarus. Lazarus, however, had already made a profit of over $72 million over the last three years on his stock options and was taking home another $4.4 million a year in base salary and "incentive compensation." How much more of an incentive did Lazarus need? Furthermore, under the plan, Lazarus was borrowing money from the company to purchase the stock, then selling the stock to realize a profit. One could hardly claim the CEO was investing in the company.

The most disturbing trend in compensation is its ability to change with the times, always appearing to be designed to reward management for performance, but rarely actually doing so. Stock options emerged as the dominant form of performance-tied compensation, curbed somewhat by tax reform and depressed P/E ratios in the 1970s.27 But these plans could just as easily be designed to shield the executive from risk. Executives seemed to have no qualms with developing compensation packages that were apparently tied to performance but in fact were rigged with safety nets that ensured a hefty minimum amount of compensation. The obscurity of compensation write-ups was best described by Graef Crystal, who awarded his 1988 Proxy Obfuscation Award to Citicorp "for strewing [CEO John] Reed's pay information across some 20 pages of numbing text."28


Buffett on Options

Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (so long as a manager stays in the company), the sluggard receives rewards from his options precisely as does the star. A managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better "incentive" system.

(I can't resist commenting on one long-term option given an "outsider": that granted the U.S. government on Chrysler shares as partial consideration for the government's guarantee of some life-saving loans. When these options worked out well for the government, Chrysler sought to modify the payoff, arguing that the rewards to the government were both far greater than intended and outsize in relation to its contribution to Chrysler's recovery.... [T]o my knowledge, no managersanywhere have been similarly offended by unwarranted payoffs arising from options granted to themselves or their colleagues.)

Ironically, the rhetoric about options frequently describes them as desirable because they put owners and managers in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a giftbut I'll never buy one.)

Warren Buffett


Source: Berkshire Hathaway. Inc., Annual Report to the Shareholders, 1985, p. 12.
When a company grants options to a manager, the incentive comes from the fact that the executive knows he will not make money unless the stock goes up from the date of the grant. The executive has the right to purchase a certain amount of options at a certain price, called the "strike price," which is usually the market price of the stock on the day of the grant. He can hold on to the option for a certain amount of time, usually between 5 and l0 years. If he exercises that option 5 years later and the stock price has climbed 50 percent, he buys the stock at the option price, sells at the present market price, and keeps the 50 percent difference as his compensation, or he just uses a stock appreciation right (SAR) to cash in on the profit. If the stock depreciates in those five years, his options will be worth substantially less. If he is caught holding them at the end of their term and they are below the strike price, they are useless, because exercising them means he actually loses money. The theory of options is that they spur the director to drive his stock price up for 5 to 10 years; he then exercises his options just before they expire, for a maximum profit.

Executives, needless to say, did not like the degree of risk brought by options. So, as documented by Crystal in his bimonthly Crystal Report on Executive Compensation, the compensation industry has invented a number of tactics to ensure that executives will still profit even if their options are losing money. One of the first innovations was "underwater" repricing, which came of age after the stock market crash of 1987 left many executives holding options with market values less than the strike price. At Northrop in 1989, CEO Thomas Jones was able to swap 1.2 million options with a $45.88 strike price for 1.2 million options with a $29.88 strike price because Northrop stock had declined since his first option grant. In effect, Jones's options were "repriced." Thus, even though the company lost market value, Jones was rewarded with repriced options worth up to $4.5 million more than his old ones.29

AMR gave its executives floor protection: a cash make-up payment would be made to its CEO if the free shares they gave him dropped below the market price.30 And at Bally, restricted stock grants are designed to cover any increase in the tax rates automatically. With packages like these, there is no way an executive can lose.

Sears, Roebuck & Co. came up with the most innovative compensation scheme to increase compensation without appearing to do so at the expense of shareholders. The Tax-Benefit Right entitles the executive to a cash payment equal to the company's tax deduction on the compensation payment. Thus, the executive gets his options' profit or bonus, plus the tax dollars that the company saved. Shareholders dish out the compensation, then lose the tax break they would have received, forfeiting that to the executive as well over the vesting period. There is little risk when executives can keep exercising options for every little jump in price, without having to worry if they missed the most opportune time to exercise.

If shareholders are able to increase their influence and vigilance in the area of compensation, the obscene payment amounts and fraudulent pay packages may abate. Already, thanks to increasing pressure by the public and institutional investors, many corporations are tying compensation to performance. At Reebok and Jefferies, the boards actually reduced the compensation packages of their CEOs to reflect slowdowns in performance. A Reebok spokesman stated that "directors believed that it was particularly appropriate to tie [Reebok CEO Paul] Fireman's long-term compensation directly to increases in value for Reebok's stock.''31 Jefferies CEO Frank Baxter was even more direct: "We feel we have to perform to get paid. We don't want to get paid for showing up." Although Chrysler is no paragon of virtue in the executive compensation department, the corporation did take the unprecedented step of asking its top 100 executives to own stock equal to a certain percentage of their salaries.32 And in 1990, Bear Stearns introduced a new compensation package, approved by shareholders, allowing officials to acquire shares of company stock by deferring part of their cash compensation for a minimum of five years. "While participation in the new deferred compensation plan is voluntary," noted Bear Stearns president James E. Cayne, "initial indications are that nearly all eligible employees will participate."

At the heart of all of this is director compensation. On one hand, directors get paid too little for what we ask them to do. On the other hand, they get paid far too much for what they actually do. Directors have an extremely important job, but, for the most part, they spend a very small amount of time doing it while getting paid a very large amount of money. According to Spencer Stuart, the average "total" 1990 compensation for outside directors at 100 major corporations was $45,650.33 According to a 1989 Korn/Ferry study, fully one-fourth of the outside directors received an average of $60,609 a year34 while serving at companies with over $1 billion in sales. Like officers' plans, these plans are often designed to appear to bear a relationship to performance; and, like the officers' plans, they more often do not.

Most directors receive an annual retainer and a board meeting fee. At Boeing, for example, a director earns $26,000 a year and receives $2,000 at the end of each board meeting. Usually, such compensation is exchange for attending about 10 meetings a year. In 1988, CEOs estimated their directors spent about 108 hours on board-related business, which included reviewing and preparing for meetings, as well as attending and traveling to them.35 This amounts to less than three weeks' work a year.

But this does not take into account the fringe benefits. If, for example, a director serves on a committee, his compensation increases. In 1988, the average director who also served on the audit committee for a Fortune 100 company received a total of $37,761 for board service. In exchange, he had to attend an average of four extra meetings a year.

Other fringe benefits include accident insurance, travel expenses for spouses of directors, and life insurance. Over 90 percent of the Fortune 100 reimburse travel expenses, and 51 percent grant matching education gifts. Sixty-seven percent of the Fortune 100 offer retirement plans. Medical and dental coverage, travel accident plans, and accidental death coverage are also available at some companies.

Thus, even a $50,000/year package is misleading. If you sit on the board of Texas Instruments, you receive $40,000 as an annual retainer. If you sit on the audit, corporate objectives, or finance committee, the retainer increases to $50,000. If you chair one of those committees, add another $2,500; and if you serve on a subsidiary of Texas Instruments, add an additional $2,500. Every year, Texas Instruments holds a strategic planning conference. If you attend, you get $5,000. If you attend any special company events, you get another $1,000 per day. If you serve on the board for five years, you get a retirement package worth 60 percent of your retainer at the time of retirement for the number of years served as a director, up to 10 years. You also get life and travel accident insurance, as well as medical and dental coverage. Thus, you could receive in excess of $60,000 a year plus benefits and, upon retirement, receive roughly $24,000 a year.

At Allied-Signal, a director immediately receives $24,000 a year. Every meeting brings in another $1,500. Each committee membership is worth an extra $5,400, and chairmanship of the audit or compensation committee carries a $4,000 bonus. The director receives restricted stock, $350,000 worth of business travel insurance, $100,000 in life insurance, and medical and dental coverage for himself and his dependents. The director also gets a retirement package equal to the annual board retainer for the rest of his life if he retires at age 70 or later. If he retires between the ages of 60 and 70, the director receives a retirement package for the number of months served on the board. If he dies before this is fully paid, his spouse will receive the payments until the package is fully vested or at the end of 120 months, whichever is earlier.


The Components of Director Compensation

Annual retainer

Regular board meeting fee

Committee meeting fee

Special position fee (e.g., chairman)

Stock grants

Pension plan

Life insurance

Travel accident insurance

Medical/dental coverage

Perks from company's product line

Gifts to charity (matching and insured)


Many corporations also grant golden parachutes for directors so they will be compensated in the event of a change in control. Pension funding is also available in limited cases. A Sears director is eligible for a full pension from the first day he is on board. Directors also get company products. GM directors often get free cars, and airline directors get free travel for themselves and their families.

Charitable contributions are the newest form of compensation. Several companies have decided to pay their directors, in part, by making contributions to their directors' favorite charities through purchase of insurance policies that name the charity as beneficiary. General Electric, PPG Industries, Westinghouse, General Mills, and Waste Management, Inc. all have such charitable packages in place, although only Waste Management notes the package's existence in its proxy. Companies like them because they can deduct the cost of premiums as an expense and deduct the benefit as a gift. Directors like them because they provide a way for them to give their favorite charity $500,000-$2 million without actually spending any moneyquite a nice payment for their services as a director, and one utterly unrelated to their performance. The only people who don't like them are the people who don't get to vote on themthe shareholderswho ultimately pay for the annual premiums, which run as high as $25,000 per director.

With directors setting management pay and managers setting director payand, often, with the two parties switching roles at another company's board meetingit is a most friendly, congenial, and convenient arrangement. But it is shareholders who foot the bill, and it is clear that, too often, they do not get what they pay for.

We have found in Part II that much of big business in America at this time is not necessarily involved in profit. It is involved with ensuring an environment within which its prerogatives can be better preserved. It has lost an "industrial" purpose; it has not enough sense of the long term; it conforms to the pattern of other large institutions, without ideological base. It will have great difficulty in successfully competing with industries, which are driven by the goals of profit, quality, industrial purpose, and even national interest. There is need for a system of governance that will help to guide the genius and energy of business and bring it back to accountability to some entity, outside of itself. Owners must be involved. That is the subject of Part III.



Endnotes


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1 Robert Clark, Corporate Law, Little, Brown, Boston, 1986, p. 692.
2 The Business Roundtable's 1990 report on Corporate Governance and American Competitiveness is a good example, pointing to the "powerful accountability imposed by the markets" (p. 15).
3 "Who's Excellent Now?" Business Week, November 5, 1984, p. 77.
4 "Buchwald Suit: Profit Study Set," New York Times, October 23, 1990, p. D13.
5 Adam Smith, Powers of Mind, Random House, New York, 1975, pp. 3-4.
6 Dana Wechsler Linden, "Lies of the Bottom Line," Forbes, November 12, 1990, p. 106.
7 Business Roundtable, Corporate Governance and American Competitiveness, March 1990, p. 15.
8 Jeffrey R. Gates, ESOP Expert Returns from Meetings with Soviet Economic Reformers, paper from Powell, Goldstein, Frazer, & Murphy, Washington, D.C., September 14, 1990.
9 Securities Act of 1933, Rule 144A. See also Regulation D.
10 David Wessel, "Pentagon Spreads Coal Purchases over Five Years," Wall Street Journal, October 5, 1988, p. A-22.
11 Joseph A. Schumpeter, Capitalism, Socialism and Democracy, Harper & Row, New York, 1942, pp. 74-75.
12 Alfred Conard, "Beyond Managerialism: Investor Capitalism?" University of Michigan Journal of Law Reform, 22(1), Fall 1988, p. 165.
13 Alan Farnhan, "The Trust Gap," Fortune, December 4, 1989, p. 74.
14 Graef Crystal, "Cracking the Tax Whip on CEOs," Business World (New York Times), September 23, 1990, p. 48.
15 Frederick W. Cook, "How Much Stock Should Management Own?" paper prepared for clients, dated February 28, 1990, pp. 2-3.
16 Michael C. Jensen and Kevin J. Murphy, "CEO IncentivesIt's Not How Much You Pay, but How," Harvard Business Review, May-June 1990, p. 138.
17 Crystal, "Cracking the Tax Whip on CEOs," p. 48.
18 Ibid.
19 Graef Crystal, "Is There No Dignity?" Crystal Report on Executive Compensation, 2(3), May/June 1990, p. 12.
20 "Nuclear Executives in Japan Resign Over Recent Mishaps," New York Times, May 14, 1981.
21 Graef Crystal, "Pay for Non-Performance," Crystal Report on Executive Compensation, 2(3), May/June 1990, p. 10.
22 Conard, Beyond Managerialism, pp. 165-166.
23 Internal Revenue Code [[section]] 422(b)( 1 ) .
24 Internal Revenue Code [[section]]423(b)(2).
25 SEC Rule 16(b)-3(a).
26 Kathy M. Kristof, "The Pay-for-Performance Myth," Washington Post, August 22, 1990, p. H3.
27 George B. Paulin, "Long-Term Incentives for Management: An Overview," Compensation and Benefits Review, July 1989, p. 36.
28 Graef Crystal, "The Great CEO Pay Sweepstakes," Fortune, June 18, 1990, p. 98.
29 Graef Crystal, "The Option Swappers," Crystal Report on Executive Compensation, 1(1), September/October 1989, p. 4.
30 Graef Crystal, "Bob Crandall and His Magic Safety Net," Crystal Report on Executive Compensation, 2(1), September/October 1989, p. 2.
31 Amanda Bennett, "Reebok's Fireman Gets Hosed Down in New Pay Pact," Wall Street Journal, August 7, 1990, p. B1.
32 Bradley A. Stertz, "Chrysler Urges Its 100 Top Executives to Bet More of Their Pay on Firm's Fate," Wall Street Journal, April 2, 1990, p. A4.
33 Spencer Stuart, Spencer Stuart Board Index 1990 Proxy Report: Board Trends and Practices at 100 Major Companies, 1990, p. 32.
34 Korn/Ferry International, Board of Directors' Sixteenth Annual Study, 1989, New York, 1989, p. 9.
35 Ibid., p. 11.