Thursday, March 23, 2006

Executive Compensation = M.A.D. Money

In 1980, a chief executive made $42 for every dollar earned by a blue-collar worker. By 1990, according to figures published by the labor federation, the AFL-CIO, that gap was $85. But the real gains in the boardroom were made in the decade that followed as firms ramped up share options. By 2000, chief executives were earning $531 for every dollar taken home by a typical worker.

Another way of looking at the growth is that the compensation given to the top five executives in a company accounted for about 10% of that firm's earnings in 2003, compared to 5% in 1995, according to a Harvard study.

There are many controversies about executive compensation. None, however, are as colorful as the unending media coverage of the other components of an executive compensation package, which may include such perks as generous retirement plans, a dental plan, a chauffeured limousine, use of the corporate jet, interest free loans for the purchase of a house—in theory, all expenditures that come out of the pockets of company shareholders.

The stock performance of OfficeMax, Inc. (OMX-$27.96), the nation’s third largest office supply retailer, has trailed both the S&P 500 and the S&P 500 Specialty Store indices the last two years, with an annual return of (2.81%) in 2004 and (17.54%) in 2005, compared to positive annual returns for both aforementioned indices.

The Compensation Committee of OfficeMax reviews performance by using metrics including, but not limited to, revenue, sales, cash flow, EPS, ROE, ROA, margins and cost savings achieved—the 10Q Detective notes that stock performance is not on the list of objective criteria assessed.

According to disclosures in OfficeMax’s just filed Annual Proxy Statement, the top paid executives in the last two years were the following individuals:

Mr. Christopher Milliken, who served as president and CEO, beginning October 29, 2004 until February 11, 2005, “earned” $125,192 and $1,060,900 in CASH salary for 2005 and 2004, respectively; $9,634 and $396,415 in $$$ bonuses for the years 2005 and 2004, respectively.

Mr. George Harad, who served as CEO, during the period beginning February 11, 2005 through April 14, 2005 (and as executive chairman of the board until June 30, 2005), earned $576,1256 and $1,500,000 in CASH salary for 2005 and 2004, respectively; $1,500,000 and $1,542,973 in $$$ bonuses.

Mr. Sam Duncan, who became president and CEO beginning April 14, 2005, earned CASH salaries and CASH bonus paid to him last year of $588,461 and $850,000, respectively.

The incentive compensation $$$ do not even include the millions—yes millions—paid to each of the aforementioned executives in long-term compensation in the form of Restricted Stock Units and Stock Options.

Within ten days of Mr. Harad leaving the employment of OfficeMax, according to his signed Separation Agreement, the Company paid him a bonus of $1,320,000. This bonus payment was afforded to him in lieu of Mr. Harad's participation in the company's 2004 long-term incentive program after October 29, 2004, and in lieu of his participation in any of the company's 2005 incentive programs. As a retention payment for continuing to serve the company during this period, the Board of Directors also agreed to pay Mr. Harad a retention bonus of $1,500,000. At the time of his separation from service, pursuant to the agreement, Mr. Harad was also paid severance equal to three years of his annual salary ($1,100,000) and target bonus ($1,320,000), for an aggregate severance payment of $7,260,000.

For three years following the Separation Date, Mr. Harad will continue to be eligible to participate in the company's healthcare programs, including disability and accident insurance plans Mr. Harad will also receive a financial counseling allowance of $5,000 per year for three years.

For purposes of Mr. Harad's pension benefit, he will be deemed to have accrued three additional years of service in addition to any service accrued through June 30, 2005. He will also be deemed to have earned compensation for each year of the three additional years of service equal to his annual salary of $1,100,000 and target bonus of $1,320,000. This additional pension benefit has an estimated aggregate value of $4,300,000.

OfficeMax has also agreed to reimburse Mr. Harad for two years of “pretending-to-work.” He will be afforded office space and secretarial assistance in an amount not to exceed $80,000 per year!

If any payments or benefits paid to Mr. Harad are deemed to be parachute payments pursuant to the Internal Revenue Code, Mr. Harad will be entitled to receive an additional gross up payment to place Mr. Harad in the same position he otherwise would have been had the excise tax not been payable. [ed. note. Did he have a financial hardship such that he could not afford to pay the taxes himself?]

The Company disclosed under “Other Annual Compensation,” that Sam Duncan, the new CEO, received $93,211 for relocation expenses. For working eight-months in 2005, Mr. Duncan also received stock options of 180,000 shares, 39% of which fully vest in three years instead of in five-years.

On January 27, 2006, the SEC issued proposed rules amending the disclosure requirements for executive and director compensation, related party transactions, director independence, and other corporate governance matters. The public comment period on the proposed rules ends on April 10, 2006. The SEC is not expected to issue final rules until the summer of 2006 at the earliest.

One of the discussions held had to do with corporate perquisites. The current threshold for disclosure of perquisites and other personal benefits would be reduced from an aggregate value of $50,000 to $10,000 and each perquisite or other personal benefit would be identified by footnote. If a perquisite or personal benefit exceeded $25,000 or 10% of the total amount of perquisites and personal benefits, it must be quantified in the footnote.

The issues being debated by the SEC focus attention on the following: (1) the amount and type of compensation paid to chief executive officers and other highly compensated executives of public companies; (2) the degree of Board of Directors’ oversight of the executive compensation process; and, (3) will lowering the disclosure threshold affect the appropriateness, manner of review, and reasonableness of executive severance arrangements?

On March 20, 2006, ServiceMaster Co. (SVM-$12.88), the operator of Merry Maids, Terminix, Rescue Rooter and other chains providing home maintenance services, filed its DEF 14A with the SEC. The Company disclosed that effective February 1, 2006, James C. Day, the CEO, received an increase in his annual salary from $900,000 to $950,000. In accordance with the Company’s short-term incentive plan, Mr. Day was also awarded a bonus of $1,377,000 in 2006, relative to 2005 performance. ServiceMaster also paid for the annual country club dues for Mr. Day and other senior executives.

ServiceMaster disclosed in its Annual Proxy Statement that the Company’s compensation plan for executive officers was designed to “attract, motivate, and retain highly-qualified executives.”

Shareholders’—on the other hand—might just have said, let the executives walk. In the last 12-months, the shares of ServiceMaster, with a loss of (6.73), significantly under performed the S&P 500 Index, which rose 11.30 percent.

Baxter International Inc. (BAX-$38.59), through its subsidiaries, assists healthcare professionals with treatment of complex medical conditions by offering a plethora of products used to deliver fluids and drugs for cancer, hemophilia, immune disorders, kidney disease, and trauma patients. In its recent DEF 14A filing, the Company disclosed that Baxter also provided its officers with certain perquisites that Baxter believed were “reasonable and competitive.” These perquisites included: car and financial planning allowances, executive physical exams, airline club memberships and certain subscription dues. Officers could also use the company aircraft for personal travel [if such aircraft usage was pre-approved by the Chief Executive Officer]. In addition, if circumstances warranted, Baxter would also provide home security systems for certain officers.

The 10Q Detective, after examining a plethora of similar SEC DEF 14A filings, has concluded that greater Federal oversight legislation would do little to change perceived abuses in both the reasonableness of senior executives’ and directors’ base/incentive compensation and the process by which it was determined.

The 10Q Detective is more concerned with an executive compensation doctrine we call Mutually Assured Destruction (M.A.D.).

Mutual assured destruction (MAD) is a doctrine of military strategy in which a full-scale use of nuclear weapons by one of two opposing sides would result in the destruction of both the attacker and the defender. It is based on the theory of deterrence according to which the deployment of strong weapons is essential to threaten the enemy in order to prevent the use of the very same weapons. The strategy is effectively a form of Nash Equilibrium, in which both sides are attempting to avoid their worst possible outcome—nuclear annihilation.

In business, the MAD doctrine can help our readers to understand the behavior of Compensation Committees [in the last 20 years] in fulfilling their governance responsibilities to all shareholders in attracting, motivating, and retaining the broad-based management talent critical to achieving the respective company’s’ business goals.

A CEO will look around at his peers and say, “I want what they are getting.” The Compensation Committee, fearful of losing [in many cases] the executive, acquiesces and deploys the appropriate monies to deter the competition from trying to recruit the so-named executive.

Unfortunately, as with the M.A.D. doctrine in warfare, deterrence leads to escalation. The noun escalation is defined to mean: “an increase to counteract a perceived discrepancy.”

When our hypothetical executive hears that one or more peers are getting a bigger raise or more perks, our executive now wants the same package. And so the next escalation cycle has begun….

Despite the best of intentions, better disclosure in Annual Proxy Statements will do nothing to change this historically observed behavior.

  • If with the serpent wisdom we unite the serpent guile, terrible will be the damage we do; and if, with the best of intentions, we can only manage to deserve the epithet of "harmless," it is hardly worthwhile to have lived in the world at all. - Theodore Roosevelt (1858–1919) The Strenuous Life.

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