Analytic Report: EC

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MEMORANDUM

To: Professor McQueeney

From: Daniel Soroudi

Date: 05/16/04

Subject: Executive Compensation

Here is the analytic report you assigned for Bus 305.

In this report, I analyzed executive compensation of some well known executives at major corporations. I researched the reasons why their pay has increased so rapidly during the past few years, and why there has been a public uproar about their compensation levels. I concluded the report by giving my recommendation as to whether or not the SEC should set new limits and regulations regarding executive compensation packages.

As this report is reviewed, I believe it may be important to note that I use the terms CEO and executive interchangeably. When people think about and discuss top level management, typically the CEO is the person who is representative for the group as a whole.

One of the things which surprised me most was that the report did not end up being nearly as difficult as I had first imagined it would be. When I read in the syllabus on the first day of class that I was expected to write a 13 to 15 page analytic report, I nearly dropped the class. The only thing that kept me here was the fact that this is my last quarter at Cal State LA, and I absolutely must take this course if I want to graduate in June. Fortunately, as the quarter has gone on, this report has turned out to be a lot easier than I had anticipated because a lot of the pages are not part of the actual research portion of the report. In addition, I found the examples which were provided to be very helpful guidelines for writing and formatting.

CONTENTS

PAGE

Synopsis …………………………………………………………………………………... 4

CHAPTER 1 – INTRODUCTION ………………………………………………………... 5

Background ………………………………………………………………………... 5

Statement of Purpose ……………………………………………………………… 6

Scope ……………………………………………………………………………… 6

Limitations ………………………………………………………………………… 7

Methods of Research ……………………………………………………………… 7

CHAPTER 2 – FINDINGS ……………………………………………………………….. 8

Comparisons of Executive Pay …………………………………………………… 8

Measuring Performance …………………………………………………………… 10

Proposals to Limit and Regulate Compensation …………………………………... 11

CHAPTER 3 – CONCLUSTIONS AND RECOMMENDATIONS ……………………... 14

Conclusions ……………………………………………………………………….. 14

Recommendations ………………………………………………………………… 14

Works Cited ……………………………………………………………………………….. 15

SYNOPSIS

Executive compensation is the pay, which an executive receives for services rendered to his respective company, and may take a variety of different forms, including stock options. There have been two main factors which have made executive compensation a hot topic recently. Firstly, a boom in the stock market during the mid 1990’s led to options gaining great value and giving CEO’s disproportionate compensation when compared to their employees or executives of similar positions in other countries; and second, due to the recent exposure of numerous fraud and accounting scandals at large corporations, some corrupt executives gained great personal wealth while shareholders and employees were left with little or nothing.

Compensation boards in charge of creating attractive packages claim large stock option grants are needed in order to be able to retain talented leaders and other key personnel. However, three examples of possible overuse and misuse of stock options have been presented in this report. They include the compensation packages of Michael Eisner, CEO of Disney, Larry Ellison, CEO of Oracle, and Donald Carty, former CEO of AMR. Each of these individuals accepted massive stock option grants while their companies performed poorly, and in the case of Mr. Carty, nearly declared bankruptcy.

Setting executive compensation is an imperfect process. This is due in part due to the fact that executives are typically granted stock options several years before being allowed to exercise them and realize potential gains, making it very difficult to gauge just how much potential an individual is worth. One major problem with using performance-based pay as a motivating factor is that these measures are typically short-term, thus giving an executive incentive to cut corners for his own personal benefit, without taking the long-term financial well being of the corporation into account. Shareholders want both immediate profitability and long-term growth, and as such, bonus and stock programs should be tied in to achieving these goals.

There are a number of proposals to limit and regulate executive pay. One of the most likely proposals would be to require companies to report stock option grants as an expense on their financial statements. One of the largest unions, the AFL-CIO, strongly supports this plan because it would help prevent companies from artificially boosted profits, as well as reducing the pay gap between CEO’s and workers, since most corporations would be much more stringent in their compensation packages should they have to put them on the books.

The SEC is the government agency which has the authority to establish financial accounting and reporting standards for publicly held companies. It delegates part of this responsibility to the Financial Accounting Standards Board (FASB) for input and guidance. The FASB has recently recommended that all corporations be required to expense stock options.

EXECUTIVE COMPESNATION

CHAPTER 1 – INTRODUCTION

Background

Executive compensation is the pay, both direct and indirect, which an executive receives for services rendered to his respective company. Executive compensation exists for privately held firms, public corporations, and non-profit organizations. Compensation takes many forms; it can include base salary, bonuses, stock options, personal benefits (also known as “perks”), or other compensation agreements. Information about compensation can be found in several types of documents filed by the company with the Securities and Exchange Commission (SEC). The most important and informative of these documents include the organization’s annual proxy statement, the annual report Form 10-K, and any registration statements filed by the company to register securities for sale to the public (SEC).

A stock option is a contractual arrangement between a company and an individual, usually an employee, where the company offers the recipient the opportunity to purchase a specified number of shares of stock of the company at a specified, pre-determined price (typically, the market price of the company's stock on the date of grant) for a specified period of time. The recipient is under no obligation to purchase the stock being offered by the company (SEC). This specific type of compensation has come under mounting scrutiny during the past few years as executives have cashed out on ever-increasing option packages.

There have been two primary factors which have led to executive compensation becoming a hot topic of debate during the past few years. Firstly, with the boom in the stock markets during the mid- 1990’s, many top-level executives received stock options with ballooning values, while their respective company’s and employees may or may not have reaped the same benefits. Second, with the recent revelations of possible fraud and other accounting scandals at major corporations, executive pay has come under increased scrutiny, as some dishonest executives achieved great personal wealth while their companies floundered or even declared bankruptcy. This has left groups such as stockholders, investors and union’s angry and demanding reforms and new regulations which may possibly limit the amounts and types of compensation given to top level executives.

Statement of Purpose

The purpose of my report will be to study the reasons which have led to rapidly increasing levels of executive compensation, and the outcry which has followed. This report will analyze compensation packages of executive level officers at several major corporations in the United States, and to come to a conclusion as to whether or not executives have been justified in asking for and receiving expanded compensation.

Scope

The report will discuss several aspects of executive compensation packages, including whether compensation should be tied to the performance of the firm, and how levels of performance can be measured. Based on this evidence, this report will give a recommendation as to whether or not the SEC should heed the demands of the public in imposing new restrictions and regulations regarding executive compensation packages.

Limitations

The extent of my research will be limited because of the time restraint in this course. I will have approximately six weeks to conduct research, form an outline of the material I wish to present, and write and revise the report. In addition, no funds are available to conduct primary research.

Methods of Research

The method of research for this report will be secondary research. Various internet resources and websites will used to locate current and past articles and supporting information on the subject of executive compensation. The resources available at the Beverly Hills Public Library and Santa Monica Community College Library will be main sources of print articles and books. The resources available at the John F. Kennedy Library at California State University, Los Angeles, may also be used.

CHAPTER 2 – FINDINGS

Compensation for top level executives at major corporations in the United States continues to set new records and reach ever increasing heights. According to Business Week’s annual survey of executive pay, compensation for 15 CEOs of major U.S. corporations averaged $35.8 million in 2002, and perhaps surprisingly, this figure was down considerably from the $135 million average in 2001 when many of these CEOs had exercised large amounts of stock options granted to them in prior years (Lavelle). Compensation boards in charge of creating attractive packages claim large stock option grants are needed in order to be able to retain talented leaders and other key personnel, because they present an opportunity for an individual to reap large rewards if the company is prosperous and the firms stock price increases, while not costing the company millions of dollars, since stock options are not currently counted as an expense on financial statements. This has led many groups to allege that companies are becoming overly reliant on the use of stock options in order to hide true compensation costs to top level executives.

Comparisons of Executive Pay

Two of the most infamous cases of compensation for CEOs which have become rallying cries by advocates who wish to enforce new limitations on executive pay have been the packages of Larry Ellison, CEO of Oracle, and Michael Eisner, CEO of Disney. In 1997, Mr. Eisner received compensation topping $575 million, almost entirely through the cashing in of stock options. Meanwhile, in January of 2001, Ellison collected among the largest ever paydays, $706 million, after exercising stock options and immediately selling the shares. What many people fail to realize is that when their respective companies perform poorly and stock prices plummet, as Disney’s did in 2001, these packages lose much of their value, and in fact, Eisner suffered a paper loss exceeding $260 million when Disney reported a net loss in 2001 (Steiner, 690). A third and fairly recent example is that of former AMR (parent of American Airlines) chief, Donald Carty. At a time in which the company was on the verge of bankruptcy, the compensation committee of AMR was more than generous to its CEO, granting him large bonuses and contributions to a trust fund that was fool-proof should the company be forced to declare bankruptcy. This information was not revealed to the public until after AMR had secured over $1.6 billion in wage and benefit concessions from its employees. After details of the compensation package were made public, Carty was pressured into resigning (AFL-CIO).

While mentioning the enormous gains by a few executives which often skew averages, it is also important to note that according to an article published in an April 2003 issue of Business Week, CEO compensation has decreased by as much as 33% in the latest year for which data was available, 2002, reducing overall pay for top executives back to 1996 levels. Many of the stock options executives which were granted became virtually valueless, such as those given to Edward Barnholt, CEO of Agilent Technologies, who received no other form of compensation beyond his base salary, as his company saw its profits and stock prices plunge (Lavelle).

Chief Executive Officer pay is much higher in the United States than in other developed countries. That’s true both in absolute dollar terms, and relative to pay for the average worker. According to a recent article in Business Week, an American CEO earns 475 times as much as an average blue-collar worker. German CEOs make, on average, just 13 times as much as a typical manufacturing worker. The chart on the following page shows how pay for U.S. CEOs compares with that of their peers in several other countries (IPS).

Clearly, no other country comes even relatively close when comparing CEO pay to that of an average worker.

Measuring Performance

Setting executive pay is an inexact science at best. While many executives benefit or suffer each year right along with company shareholders, others may continue to reap benefits while investors watch the value of their holdings plummet. This is due in part due to the fact that executives are typically granted stock options several years before being allowed to exercise them and realize potential gains.

There are a number of problems with using performance-based pay as incentive to motivate corporate executives. Chief among these are that the measures used to gauge performance are typically short term, raising the danger that executives will be encouraged to pursue short-term gains at the expense of the workforce – and of the company’s long-term performance. In fact, it’s not unusual for CEOs to receive big pay increases simultaneously terminating thousands of workers. For example, American Express fired 3,300 workers in 1997. That same year, its CEO’s compensation package soared 224 percent, to $33.4 million (Sklar).

Company compensation programs are most often settled on an annual basis. But annual settlement of goals is too short a cycle for the top executives. By definition, work in such positions calls for achieving goals set for much longer periods. Compensation, therefore, should be determined based on a clear policy which ties in rewards to long-term results, and aligns the interests of the management board to those of investors and shareholders.

Shareholders want both immediate profitability and long-term growth, and as such, bonus and stock programs should be tied in to achieving these goals. Executive compensation should also reflect the difficulty of the performance objectives set relative to peers, and although this measure may be set somewhat arbitrarily, it can still be used as a broad guideline when determining overall compensation. According to an article by Mae Ding, President of consulting group Personnel Systems, when setting the level of stock options, it is important to analyze both the expected value of options as a percent of the total compensation package as well as in relationship to competitive peer company stock practices. Stock option value which focuses management on long term results should be balanced with bonus plans which focus only on annual results (Ding).

Proposals to Limit and Regulate Executive Pay

Stock options make up the biggest part of a typical CEO's paycheck. At many companies, this cost is hidden from shareholders because companies are not required to expense stock options as a form of compensation. As former Enron CEO Jeffrey Skilling explained to Congress, "You issue stock options to reduce compensation expense and, therefore, increase your profitability (AFL-CIO)."

Not expensing stock options has also widened the pay gap between CEOs and workers. Executives disproportionately benefit from stock options and this cost has been kept off the books. Moreover, not expensing stock options has artificially boosted profit reports, thereby generating further increases in CEO pay. These reasons have led to stock options becoming overused in executive pay. Because stock options have received preferential accounting treatment, companies have been reluctant to innovate when it comes to executive compensation (AFL-CIO).

According to a study by compensation consultant Pearl Meyer & Partners for The New York Times, while total CEO pay fell just 8 percent between 2002 and 2003, this study found the estimated value of stock option grants to CEOs fell nearly 40 percent in 2003. Not coincidently, nearly 500 companies have voluntarily started expensing the cost of stock options. The figure below shows the difference in the structure of CEO compensation between 2002 and 2003.

Source: Pearl Meyer & Partners study for The New York Times

One of the chief proponents for introduction of new rules and limitations of compensation has been unions, namely the AFL-CIO. As many recent corporate accounting scandals have focused new attention on benefit packages, the AFL-CIO has been at the forefront, pushing for reforms. The AFL-CIO believes that by forcing companies to show stock options as an expense, corporations would be much more mindful before handing out huge chunks of shares as it would have the potential to significantly reduce earnings when they are reported.

The SEC has the authority to establish financial accounting and reporting standards for publicly held companies. However the Commission’s policy has been to rely on the Financial Accounting Standards Board (FASB) for input and guidance. The mission of the Financial Accounting Standards Board is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information (FASB).

In the early 1970’s and again in the mid 1990’s, the FASB twice was of the opinion that employee (and of course executive) stock options should be treated as an expense (Dechert). Both times, this opinion was vehemently opposed by major corporations and the policies were not adopted.

Now, with executive compensation at the forefront of discussions, the FASB has again recently recommended that stock options be reported as expenses on company financial sheets. Currently, the FASB is working on a new draft document which is due to be completed by the end of 2004, which will setup the recommended guidelines for the mandatory expensing of employee stock-based compensation (ExecPay).

The new exposure draft, as it is being called, covers a wide range of equity-based compensation arrangements. Under the Board’s proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date (FASB).

CHAPTER 3 – CONCLUSIONS AND RECOMMENDATIONS

Conclusions

The findings of this study signify that the Securities and Exchange Commission, or other governmental agencies which have proper authority, should set guidelines for executive compensation packages and how they are reported. In addition, the Financial Accounting Standards Board should further analyze the effects on corporate profits that expensing stock option grants would take, and come to a fair and balanced solution which would encourage corporations to expense options given to executives. However, enforcing strict limitations on the amounts or types of package options would violate free market policies and may severely interfere with business operations and conditions, and may affect the national economy as a whole.

Recommendations

Based on the conclusions presented above, the following actions are recommended:

1. The Securities and Exchange Commission should not impose monetary or other limitations on executive compensation packages. Organizations must remain free to set compensation levels as they see appropriate to attract and retain important personnel.

2. The Financial Accounting Standards Board should introduce appropriate directives in determining a fair-value for the mandatory expensing of stock options. Once this system has been established and approved, organizations which have not begun the voluntary expensing of options should be required to do so.

WORKS CITED

2003 Trends in Executive Pay. AFL-CIO. 14 May 2004

<http://www.aflcio.org/corporateamerica/paywatch/pay/index.cfm>.

Chingos, Peter. Responsible Executive Compensation for a New Era of Accountability.

New York: John Wiley & Sons, 2004.

Corporate Compensation News. Exec Pay Inc. 15 May 2004

<http://www.topexecpay.com/news/index.php?id=08>.

Dechert, LLP. Employee Benefits & Executive Compensation. Apr 2004

<http://www.dechert.com/library/Emp_Ben_4-04.2.pdf>.

Ding, Mae. Executive Compensation Plan Design Trends & Recommendations. Personnel

Systems Associates. 14 May 2004 <http://www.personnelsystems.com/excompln.htm>.

Financial Accounting Standards Board (FASB). Facts.