A recent white paper from compensation consultancy Farient Advisors brings a new approach to valuing executive compensation. It premises three main concerns about the existing alternative approaches to  putting a number to compensation – realized pay (the GMI Ratings approach which includes vested stock and exercised stock options) and realizable pay (which attempts to put a value on outstanding equity awards). These are:

• Mismatched time periods for pay and performance.
• Different option valuation methodologies, some of which systematically understate the value of options.
• Using target vs. actual number of shares earned in performance share plans, thereby overstating or understating their value

The authors, Robin Ferracone and Jack Zwingli, discuss a solution to these issues developed by Farient which it calls performance-adjusted compensation (PAC). The key differences between PAC and realizable pay are that PAC gives value to out-of-the-money stock options since they have life left in them and therefore could move into the money, and it only values performance shares once they have vested, rather than trying to ascribe a value to the “target” number shares as realizable pay does.

While I believe this does address some of the flaws of realizable pay, none of the arguments are strong enough to move me away from realized pay because, as the authors admit, “it captures the actual value of the awards received and is not subject to interpretation or manipulation.” The two main arguments against realized pay put forward by the paper only apply if you use it without properly understanding what you are dealing with. Yes, it is nonsense to try and match the profits from a stock option award that has been held for 10 years to a three-year performance period. GMI Ratings does not do that. And, yes, it can create spikes in compensation because executives have power over when stock options are exercised. But this is only an issue when you look solely at a single year’s compensation. GMI Ratings does not do that.

However, the paper serves a very useful purpose in checking the headlong rush towards realizable pay that is occurring at the moment, by calling attention to some of the flaws in that approach and suggesting solutions to them.  These solutions take time, analysis and expertise – never a popular combination because it is expensive – and the only flaw is that they again utilize the Black-Scholes method of option valuation which is, when not in the right hands, as subject to as much manipulation and interpretation as any other pay evaluation… except realized pay.

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An edited version of this op-ed appeared on Bloomberg View on October 3, 2012 and this version appeared today on my blog on Forbes.com

It was announced in the FT today that the Financial Services Authority expects banks to reduce or clawback bonuses in British banks and non-U.K. banks with operations in London as a result of the series of scandals that have wrought the industry during 2012. Such an announcement could not have come at a more opportune time.

But why haven’t banks been taking such actions already? The financial crisis happened in 2008. How many cash bonuses and equity awards have been clawed back from the banking executives who caused the crisis? None, that I can ascertain from required financial disclosures.

Of course some executives experienced the ultimate clawback: losing their job and watching their unvested and unexercised stock vanish to bankruptcy, creditors, and/or worthlessness. But what about all the cash bonuses and stock that had already been paid out for illusory earnings and revenues based on valueless investments? Little or nothing has been recouped.

So what can we expect of the latest round of bank value destruction and scandals, from  JPMorgan’s London trading losses to Barclays’ Libor manipulation to HSBC’s money laundering and mis-selling of payment protection and interest-rate insurance to Standard Chartered’s Iran dealings?

Again, some have paid the price with their job. Barclays’ CEO Bob Diamond and JPMorgan’s Chief Investment Officer Ina Drew both resigned as a direct result of the events that brought losses or scandal or both to their respective employers. As a result, both also lost a significant amount of future compensation because of their terminations. But neither has had existing compensation clawed back. Thus far, based on the absence of filings with the Securities & Exchange Commission, not a single senior executive in the U.S. has had to return compensation that has already been paid out as a result of violating codes of ethics codes, behavior that regulators judged to be illegal, or excessively risky behavior. Certainly no one has had to relinquish compensation for simple immorality.

Not all the CEOs and executives who might be considered the buck, as in “the buck stops here,” have left their companies. Peter Sands remains the CEO of Standard Chartered Bank. James Dimon not only remains the CEO of JPMorgan, but successfully resisted attempts earlier this year to strip him of his chairmanship.

On the other hand, at HSBC, the current CEO took over in 2011. This was after the period during which, according to the Senate investigation, the bank was laundering money. But, with 30 years international experience at HSBC, of late at very senior levels, and a member of the parent company board since 2008, it is not credible that Stuart Gulliver can escape blame, though the previous CEO Lord Green, currently the Trade Minister in an increasingly scandal-ridden Conservative cabinet, is yet more culpable.

Given the current crop of scandals, it seems clear a simple expectation that the exercise of moral decency would prevent illegal activity is futile. Nor does increased internal and external oversight and regulation appear to have decreased the level of risky or illegal behavior in banks. Thank goodness we have been relieved by the election from the possibility that a potential Republican administration might have rolled back oversight and regulation rather than increase its enforcement. Indeed, President Obama, interviewed in Rolling Stone, has indicated that curtailing Wall Street incentives for risky behavior is one of his priorities during the next term of office.

According to a survey by whistleblower protection law firm Labaton Sucharov, 81 percent of Americans do not believe the government has done enough to stop corporate wrongdoing. Clearly the electorate believes the current level of oversight to be inadequate or at best inadequately enforced.

In fact, there is a widespread belief that the only way overly risky or illegal behavior can effectively be checked is for it to affect executives’ paychecks. At many institutions, clawbacks only come into play when there has been a financial restatement. Why? Yes, the actions that led to the financial crisis did not lead to restatements, far worse, they led to massive, and, in some cases, permanent , destruction of value. But because there were no restatements – though arguably there should have been – no incentives have been recouped.

Actions such as selling credit default swaps based on rotten loans, money laundering, interest rate manipulation, and excessive risk-taking can be as objectively determined as financial restatements. Therefore there is absolutely no reason why they should not also be added to the list of behaviors that might cause a clawback. Furthermore, such recoupment should not only apply to those with direct responsibility for or direct knowledge of illegal or other such actions.

Clawback provisions, which have been common in the U.K. since 2009, were mandated in the U.S. by the Dodd-Frank Act, though the SEC has yet to implement this part of the law. Nevertheless, many U.S. companies have voluntarily adopted them, though most apply only in the event of a financial restatement. The best of these require pay to be returned whether the executive was directly responsible for the accounting fraud that led to a restatement or not. This is because any bonuses and equity incentives will have been artificially inflated in value because of fraudulent financials. In the same way, whether executives knew about the money laundering or rate manipulation, such illegal behavior should result in the return of incentives by any member of senior management who was in post when it happened. Ultimate responsibility for wrongdoing of this magnitude lies at the top of an organization because, even without direct complicity, it occurred due to a lack of management oversight. The same might also be claimed of the board.

The behavior of the executives involved, the lack of oversight or the clear evidence of complicity, would seem to indicate that the current provisions the banks have to recoup pay are ineffective, insufficient or nonexistent. This isn’t so. Though compensation hasn’t been recouped, all the banks involved – even JPMorgan, which has looser governance standards than European banks – say they can take back or cancel incentives in the event of illegal or damaging behavior of one kind or another.

For example, at Standard Chartered most incentive compensation is deferred and subject to recoupment: “if an individual exhibits inappropriate values or behaviour” or “if there is a material event including … breach of regulatory guidelines or failure in risk management at a Group or business level.” At HSBC, compensation can be clawed back for “non-compliance with Risk and Compliance procedures and expected behaviour” though the bank does not define what these behaviors are in its annual report. Barclays lists a set of events that may lead to clawbacks, including: “employee misconduct, harm to Barclays reputation.” They can also be applied “where an employee is under investigation for a regulatory or disciplinary matter.” At JPMorgan, with the US bank typically lagging behind European governance standards, only equity awards are subject to any kind of recoupment for “material financial or reputational harm to the Firm or its business activities.”

With all of this in place, why are we still waiting for significant clawbacks to be announced for employees directly involved in risky behavior and illegal activity, as well as for the managers supervising them? In each of these cases there has been clear violation.

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This is a summary of a presentation given by Jeffrey Gramlich, L.L. Bean/Lee Surace Professor of Accounting, at the University of Southern Maine, made on behalf of GMI Ratings at the recent Leet Symposium at the Case Western Law School in Cleveland. Professor Gramlich’s thoughts are his and do not  necessarily represent the views of GMI Ratings.

There are two general schools of thought about the primary drivers of executive compensation. The first is that managers control their own salaries through the power they exert over the board. The second is that managers pay is aligned with changes in shareholder wealth. In an excellent review article, Frydman and Jenter (2010) argue that neither of these schools explains executive compensation completely. 

The mechanisms for executive pay have changed over time. Early on, most managers got straight salary. Then many companies added bonuses based on hitting accounting targets like income from continuing operations or a specified return-on-equity formula. In the late 80s and early 90s we saw growth in stock option compensation and this lasted until the early 2000s when FASB and other forces combined to shift the emphasis in executive pay from stock options to restricted stock. Recently, we’ve seen some effort to move toward a balanced scorecard system, though that approach has not caught on significantly just yet. Some form of stock-based compensation dominates today.

That raises the question: what drives stock prices? Well, lots of news events pertaining to the economy, industry, products, EPS surprises, EPS guidance, and analysts’ revisions of EPS forecasts. In addition, we know that corporate governance has a small but significant positive relationship with the level of relative stock prices, as do corporate sustainability efforts. And, of course, there’s the catch-all of all other company news.

If EPS plays a pretty powerful role in stock prices, and good performance is reflected in accounting profits, then we should see a positive relationship between an executive’s compensation and stock price returns.

Not so. Here’s a case in point: Abbott Laboratories. This is CEO Miles White’s compensation for his years as CEO:

It turns out that Mr. White’s compensation over the past four years exceeds 123% of the average of other Big Pharma companies: JNJ, BMY, LLY, PFE and MRK. Yet the stock returns for Abbott don’t appear to be as impressive:

Comparing Mr. White’s total compensation with Abbott’s return on invested capital, we see a 13% negative correlation between the two sets of figures.

Still, Abbott Labs has been a profitable company. Maybe it makes sense to pay the top person handsomely. But does it matter how that money was earned? I think so. Take a look at the articles pasted below. While some of Abbott Labs’ activities are certainly respectable, the company has also recently been involved with several forms of organized crime.

1. Does it matter that the company illegally markets a powerful psychotherapy drug to be used to silence innocent elderly patients?

2. Does it matter that Abbott Labs schemes to defraud Medicare and Medicaid by developing a kickback arrangement?

3. Does it matter that Abbott Labs conspires to eliminate its competition?

In my view, how the company makes money can be as important as whether the company makes money.

Is Abbott operating in the best interests of its shareholders? Well, some of them maybe. But a lot of shareholders, through their interests in pension and mutual funds, and other financial intermediaries, have friends and relatives that are affected by Abbott’s egregious actions. If you try to convince these stakeholders how great a company Abbott is, and then tell them about CEO Miles White’s compensation package you’ll get a somewhat different reaction.

So, what do we need? We need shareholders who are involved with the companies they own. We also need stakeholders, more broadly, who are ready and willing to come together and tell companies what we expect from them. And to compensate their leaders in accordance with these expectations.

In a 1992 Harvard Business Review article, Harvard professors Bob Kaplan and David Norton developed the idea of the balanced scorecard as a dashboard-type tool for management to quickly see what is happening inside the firm. The idea is that management should identify a few key metrics, both financial and non-financial, to measure its success. Kaplan and Norton’s balanced scorecard, which they further developed in later HBR articles, included four aspects: a customer perspective, a financial perspective, an internal business perspective, and an innovation and learning perspective. I encourage you to read some of the articles to learn more about these components.

The balanced scorecard has caught on and most companies use some form of it. But, while there has been some movement toward using balanced scorecard measures to determine executive compensation (see, for example, a 2011 working paper by Pollanen and Xi) not that many companies use the scorecard this way. This needs to change.

Before companies jump on the balanced scorecard notion, one additional facet needs to be added: the community perspective. The scorecard would then look something like this:

In the compensation sense, the term “balanced scorecard” in the graphic above would be replaced with “executive bonus.”

Visit a few companies’ websites. I challenge you to find a company that does not portray itself as a great community citizen. Obviously, management of these companies believes that community citizenship is important. But do we ever see managers getting compensated based on key metrics that measure the effectiveness of a company’s citizenship efforts? There are a few out there that I described in my presentation, like Xcel Energy and to a lesser extent Pacific Gas & Electric (take a moment to think about why PG&E has adopted safety as a pillar in its executive pay arrangement). You can watch a recorded practice version of the presentation here.

So, what’s to be done? Executives need to be compensated based on an effective balanced scorecard. Development of that scorecard should start with the balanced scorecard measures that the executive gets on her desk on a regular basis. Then add in key metrics related to community, including the company’s effects on people (suppliers, customers and employees), planet (carbon footprint and traditional pollution measures), and profit (measured as the economic impact of the company on its community (like measures of the quality and quantity of jobs). Only then will we have true alignment of management with the interests of shareholders who live in the community. 

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Yesterday the Financial Times wrote that the former CEO of News International, Rupert Murdoch’s U.K. newspapers business, Rebekah Brooks received a golden parachute of more than £7 million on her resignation. The paper describes the payments as comprising cash, pension payments, an allowance for legal fees and the use of a chauffeur-driven car. Given that Ms. Brooks is awaiting trial on multiple charges relating to the phone hacking scandal, the allowance for legal fees may turn out to be much higher than currently estimated. More importantly, however, any kind of payment should have been predicated on her being cleared of the six charges of conspiracy she is facing. The FT does indicate that the package contains “significant” clawback provisions, but does not know what circumstances would lead to a clawback.

News Corp is, of course, rated “F” on ESG (environmental, social, governance), and has been rated an “F” since 2002. Apart from the current lawsuits and prosecutions, the company’s excessive compensation, non-independent board, controlling shareholder, and dual class stock all contribute to placing the company in our lowest possible rating.

The post £7MM Pay-off for News Corp’s Rebekah Brooks appeared first on GMI Ratings.

Citigroup announced the resignation of CEO Vikram Pandit this morning. The website release said:

Given the progress we have made in the last few years, I have concluded that now is the right time for someone else to take the helm at Citigroup.

However, the proximity of the resignation to yesterday’s announcement of an 88% drop in third quarter net income, despite earnings exceeding expectations, cannot be ignored. The drop in income was largely due to losses on the Morgan Stanley Smith Barney joint venture, a loss, as I have already commented, from which Mr. Pandit’s bonus was somewhat unjustifiably ringfenced.

Almost as a footnote, the release also announced that COO John Havens had also resigned. From the release:

Mr. Havens said that he had already been planning retirement from Citi at year-end but decided, in light of Mr. Pandit’s resignation, to leave the Company at this time.

A replacement for Mr. Pandit has been announced – Mike Corbat – but no replacement for Mr. Havens was included in the release.

Citigroup receives an ESG (environmental, social, governance) rating of “D”, largely because of compensation problems and ongoing significant litigation, including numerous fines and settlements for misleading investors, abusive foreclosure practices, and current investigations from a number of authorities about interest rate manipulation. Citigroup’s AGR® (accounting and governance risk) rating is 19, indicating a greater accounting risk than 81% of other companies. While it has lately improved from a “Very Aggressive” rating, it has not improved by much. This low rating is caused by a very high level of loan interest and fees. Relatively large loan interest and fees is a red flag for revenue recognition issues at financial institutions. Loan interest and fees have a large impact on financial institution earnings and consequently are susceptible to potential earnings management.

Neither Mr. Pandit nor Mr. Havens retires with any kind of pension from the bank. In addition, it looks like much of their outstanding and unvested stock and option awards will expire unexercised or be forfeited, and no severance arrangements are in place for either executive except in the event of a change of control or death or disability. For example, Mr. Pandit forfeits unvested options if he terminates his employment for any reason before the options have vested. As it happens, one third of the 500,000 stock options that were awarded last year have already vested in May this year, but all are currently underwater. Vested options he holds from before the financial crisis – with prices ranging from $244 to $366 – are even deeper underwater. As far as the restricted stock awards that were made to the executives as a result of the 2011 bonus plan, these are only subject to accelerated vesting and payment on the executive’s death, under current circumstances these awards will continue to vest according to their original schedule. On the other hand, shareholder opposition to the company’s executive pay packages, with almost 55% voting against them at this year’s annual meeting, may be enough of a warning to the compensation committee to allow these awards to lapse. Both executives received just under $4 million in deferred stock during 2011 and it is likely that similar awards were made early 2012. Mr. Pandit does leave with around $21.5 million in stock he already owns, though there are restrictions on almost two-thirds of that.

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With more news on Deutsche executive remuneration, following on from last week’s rejig of pay, the Financial Times reports that Werner Wenning, the former CEO of Bayer, who is on the Deutsche Bank board of directors is a supporter of pay limits. According to the FT, Herr Wenning said in an interview on Sunday with the Frankfurter Allgemeine: “It is necessary and right to put an end to pay excess . . . I am in favour of caps…. No manager, also no investment banker, needs to earn an amount in the double-digit millions.” This was shortly after the Deutsche co-CEOs had indicated that they were not in favor of caps.

Credit Suisse has already taken steps towards capping the amount of money it spends on incentive pay, by limiting the pool it uses to pay out bonuses to 2.5 percent of net profit. While this does not set a limit to individual bonuses, it does restrict the bank’s proportionate spending, which is a positive move.

Such an idea is hardly revolutionary. Even in the U.S. most industries set a cap on cash incentives by structuring plans so they have threshold, target and maximum amounts. That is not the case for most investment banks, however.

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We published, two weeks ago, a story detailing a windfall to the CEO of Universal Detection Technology and other employees and directors which was based on incorrect assumptions and analysis. In putting together the story, in order to determine what happened to the stock price subsequent to the awards of billions of shares valued initially at $0.0001, we checked here to determine the current value of the stock price and its progress since the award. Unfortunately, there was no mention or indication of any kind at this source that a 1: 20,000 reverse stock split occurred. Had there been some indication or mention, we would have located the filing describing the split and it would have negated the commentary we offered. As a result of the stock split, the shares that vested with the CEO, for example, were worth hundreds of thousands of dollars not billions and therefore not worthy of note. We have removed the blog posting and apologize for any misunderstanding that it may have caused.

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Darty plc’s CEO, Thierry Falque-Pierrotin, will leave by “mutual consent” in December 2012. The press release announcing this makes no mention of the fact that the firm is facing a shareholder revolt over a payment to the CEO, originally made in 2009 when he joined Darty, then known as Kesa Electricals. It’s a typical US-style make-whole payment, compensating Mr. Falque-Pierrotin for unvested stock awards he left on the table at his former employer, French retailer PPR. While this should raise objections on its own, as I have said many times and most recently here, the situation was made more embarrassing by the fact that the company recently had to admit that the share award was not tied to TSR performance, as it had previously asserted. This is how the 31 August release puts it:

On joining the Company, Mr Falque-Pierrotin forfeited option and stock entitlements linked to his previous employment worth, at that point, at least €775,000. The remuneration committee, as part of his recruitment package, agreed at that time to compensate Mr Falque-Pierrotin through a one-off conditional share award, with the only condition to vesting being his continued employment with the Company for three years. The 2009 Annual Report and Accounts erroneously stated that a TSR performance condition also applied; this was not the case.

Of course, the time vesting criterion was met in January this year so, although he is leaving in December, he will, in theory, be leaving with the share award. Had there been a TSR condition attached to it, it is unlikely that this would be the case. Over the last three years, Darty shares have fallen from 140 pence to just over 50 pence, and the shares would have inevitably lapsed. Darty’s executive pay policy is rated an “F” by GMI Analyst.

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In a statement yesterday from Deutsche Bank’s co-chairmen Jurgen Fitschen and Anshu Jain, it was announced that significant changes were going to be made to the bank’s business model, strategy and compensation practices. Most significantly from a governance standpoint, bonuses at the bank will be reduced and instead of being deferred over three years will cliff vest at the end of five years. During that time, they will probably be subject to partial or full recoupment if the results that generated them turn out to be false. They may also be subject to additional performance tests in order to vest in full. This is what the chairmen said:

Leading cultural change

The Bank recognizes that change to its corporate culture is imperative. Following a period of reflection and dialogue with stakeholders, it has set itself the aim of being at the forefront of cultural change in the banking sector. Compensation practices are one important way to achieve behavioral change and align incentives to longer-term sustainable performance on behalf of all stakeholders. The Bank is committed to reducing bonus payments in relation to business performance and will increase the time horizon for deferred bonus payouts to top management, with a single payment after five years rather than staggered payments over three. In addition, Deutsche Bank will be a pioneer in appointing an independent external panel to review the structure and governance of compensation. The panel will consist of industry leaders, academics and compensation experts, and its recommendations will immediately influence annual compensation for 2012.

Deutsche Bank, along with other European banks like Credit Suisse and UBS, were already well-ahead of US investment banks in compensation governance both before and immediately after the financial crisis in 2008. For example, in my white paper for the CII, Deutsche Bank’s compensation policy in 2010 was an annual cash bonus based on ROE, with a mid-term incentive (MTI) based on TSR versus peers over two years. In addition, a minimum of 60 percent of incentives was deferred into restricted incentive awards and restricted equity awards. Restricted incentives were then further based on ROE growth over the three-year vesting period. The value of the restricted equity depended solely on the share price at the time of vesting, which took place over four years. At that time compensation policy was improved further when base salaries were increased for all management board members but target bonuses were reduced accordingly. Furthermore, the annual bonus was changed to reflect two years of performance, and the MTI was measured over three years and deemed a long-term incentive. The cash bonus was still part-deferred into restricted incentive awards and the long-term award was largely deferred, but into restricted equity awards.

Now the restrictions on cash bonuses are even more onerous and US investment bank policy hasn’t even caught up with post 2009 European bank compensation practices.

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According to the Wall Street Journal, banking giant JPMorgan Chase & Co. (JPM) is considering bonus cuts for senior managers, including CEO Jamie Dimon. Though details are few, JPM’s board is expected to slash executive bonuses in an about face on executive compensation following an estimated $5.8 billion in credit derivative trade losses this year. The compensation committee certainly won’t have to fiddle with current performance metrics to reduce bonuses. Bonuses at JPMorgan are at the discretion of the compensation committee, averaging $4.4 million per named executive officer in 2011 and $4.7 million the year before.

Citigroup meanwhile is grappling with how to improve pay practices following its surprising advisory pay vote failure in April. At the time, board chairman Dick Parsons called the rejection a “serious matter” and pledged to actively counsel with key shareholders on compensation policy. Following the failed vote, the board has hired a new compensation consultant and looks to win “broader support among investors”, according to the Journal.  Similar to compensation at JPMorgan, executive pay at Citigroup is determined largely on the compensation committee’s assessment of discretionary elements.

Truth be told, neither of these banks has been eager to hold pay to any meaningful performance standard. For instance, each year, executives at JPMorgan receive bonuses with tidy rounded figures ending in a lot of zeroes, a sure sign for discretionary bonuses. The company does not even disclose a category for Non-Equity Incentive Compensation, the bonus category based on pre-determined performance metrics, because at JPMorgan, there are no pre-determined performance metrics. For compensation year 2011, the bonus for CEO Jamie Dimon was based on “continued leadership and several financial metrics”. Monday-morning quarterbacking financial metrics which happened to improve isn’t good enough. For those non-U.S. readers, Monday-morning quarterbacking is a reference to rewarding with the benefit of hindsight rather than sticking to a pre-determined reward system.

Equity granted to NEO’s at JPMorgan in fiscal 2011 consisted of stock appreciation rights and restricted stock units that vest ratably over time. These awards amounted to an even $17 million in grant date value for the CEO in 2011 alone. For 2012, the company added protection-based vesting conditions to equity awards. In accordance, half of RSU’s scheduled to vest in 2015 will be cancelled if the company does not meet a 15% Cumulative Return on Tangible Common Equity over the period 2012, 2013 and 2014. Also to its credit, JP Morgan has long-standing recovery provisions for incentive compensation. Recovery of incentive awards for “appropriate circumstances” is permitted and the company is expected to clawback millions from executives at the heart of the trading disaster.

In addition to its failed Say on Pay vote, Citigroup failed a spring stress test used to determine whether America’s largest financial institutions could survive another sever economic downturn. The stress test failure came just a month after Citigroup and four other U.S. banks agreed to pay U.S. government $25B to end an investigation into abusive foreclosure practices in connection with the collapse of the housing bubble. In the wake of recent upheaval, you’d think the company would be eager to appease shareholders with some governance improvements.

However, following a release from TARP restrictions in 2011, CEO Vikram Pandit’s base salary was soon increased to $1.75 million, or 75% over the IRC tax deductibility limit. Additionally, he received an aggregate mega-grant of 500,000 time-vesting stock options valued at more than $7.8 million in fiscal 2011. Citigroup does have some performance conditions attached to its most recent equity grants but they are discretionary. Deferred stock awards granted to Mr. Pandit scheduled to vest in 2013, 2014, 2015, will only vest if the compensation committee is satisfied with regulatory considerations, organizational culture, and talent development.

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