Misreporting CEO Pay

This is the season for tallying CEO compensation, and for shaming those who profited while shareholders suffered.

I’m no defender of high CEO pay, but much of the reporting on it is inconsistent at best, and in many cases it’s highly misleading.  The problem arises from combining two things that should be separate: pay granted by the board and stock gains taken by the executive.

Most analyses look at the CEO’s annual compensation award – salary, cash bonus, perqs, and the present value of equity grants that typically vest over several years.  So far, so good.  But then they add on the amount of equity gains that were realized by the CEO.

And that’s where the problem begins.

When you bundle annual pay and equity gains in a single amount and treat it as if the CEO “earned” it in that year, you get a picture of how much pre-tax cash the CEO took home – not a measure whether the CEO’s pay was aligned with shareholder returns.

For that, you really need to look at the annual award alone, separate from any realized stock gains, and focus on whether the compensation was in line with the company’s performance.

Yet many of the compensation and governance experts assess CEO pay by including gains from stock options and restricted shares that were awarded years earlier.

Governance research group GMI just reported its ranking of top-paid CEOs, singling out Herbalife CEO Michael Johnson for the equity gains he harvested.   Of Johnson’s nearly $89 million in 2011 “pay” cited by GMI, $77 million – 87 percent – came from options gains.

A big number makes headlines, but it distorts the picture.  Johnson’s options were awarded years earlier, and their rise in value over time was a benefit enjoyed by all shareholders.  Some reports point that out, but it’s usually buried deep. Here’s what the Guardian said – seven paragraphs into its story:

“…some might say that Johnson deserved the profits he made on exercising his stock options. Most of the options that were exercised in 2011 were awarded between 2003 and 2005, when Herbalife’s shares traded below $10. Since then, the stock price has done well. Total shareholder return, for example, rose by nearly 292% over the last five years. During 2011, it was mostly trading in the $50-plus range.

Realized stock gains simply shouldn’t be included in the annual compensation tally.  It’s only “annual compensation” in the sense that it all occurred in the same year as the rest of the CEO’s pay.

Let’s look at an example, using a couple of fictitious companies:

John Bounty is CEO of Megacorp, which had a bad year and a stock price that fell by 15 percent.  The Megacorp board trimmed Mr. Bounty’s pay, awarding him no cash bonus and stock options valued at just $2 million – a smaller grant than he received in prior years when Megacorp performed well.  Yet despite the sag in the Megacorp shares over the past year, Mr. Bounty still had substantial unrealized gains in the Megacorp shares he’d received in prior years.  So he decided to reap some of those gains, realizing $40 million (pre-tax).

Across town, Vikram Plunkett also presided over a mediocre year at his company, Giantbank, where the shares also fell by 15 percent.  He, too, received no cash bonus but his board awarded him a whopping number of stock options, with an estimated present value of $11 million.  By cutting back on dinners out and private jet travel, Mr. Plunkett figures he can get by on his salary and decides not to realize any of his long-term gains in Giantbank stock.

Now, most governance experts would say the Megacorp board acted responsibly by lowering Mr. Bounty’s annual pay award, while the Giantbank board was careless in doling out a pile of options to Mr. Plunkett after a poor year.

But because Mr. Bounty realized $40 million in stock gains, most reports will say he was “paid” this amount plus his salary and new stock options, and the Megacorp board will be singled out for scorn for “giving” Mr. Bounty a bounty when shareholders saw their wealth tumble.  Meanwhile, Mr. Plunkett, who didn’t take any cash off the table and got a juicy $11 million equity award, will escape notice.

The CEO’s annual salary, bonus and equity award are based on a board-level decision.  But harvesting equity gains is the CEO’s decision, and one that’s often driven by tax and estate-planning needs.  Boards can – and should – impose minimum stock-ownership and holding-period requirements, but the decision to take gains ultimately is up to the CEO.

What matters most is the board’s decision on current-year pay.  And there’s plenty to criticize when it comes to boards making overly generous annual comp awards, including outsized stock and option grants.  But if we’re going to have a reasoned discussion about CEO pay, we should start by communicating the facts clearly.

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