CFAs offered guidance on executive pay

When markets tank, executive compensation becomes a hot topic — nothing adds insult to injury to shareholders than overpaid executives. But just as superior fund performance can justify higher MERs, analysts are willing to forgive giant CEO paydays if their companies demonstrated relative strength. The big question is how is this determined?

The CFA Institute, which administers the Chartered Financial Analyst (CFA) designation worldwide, recently released a manual on executive compensation, with the goal of helping experienced investors determine if the compensation structure of a company is appropriate. Since compensation is a key indicator of overall corporate governance, compensation guidelines can be used as a valuation metric.

So when are executives overpaid? When are they a bargain? Speaking in Toronto on Thursday, James Allen, one of the manual’s authors and director of the Capital Markets Policy Group for the Institute’s Center for Financial Market Integrity, said there is no hard-and-fast rule; rather, analysts have to evaluate compensation on a case-by-case basis.

He used the example of the CEO of a sub-prime mortgage lender who is paid $30 million but oversees billions of dollars of write-downs versus somebody like Apple CEO Steven Jobs, who may work for a company with a smaller market capitalization but has been instrumental in making the company extremely profitable.

“Giving $30 million to somebody who lost $500 million and had to take a billion dollars in write-downs makes shareholders upset. Whereas $30 million to Steve Jobs, and his leadership of being able to boost the value of Apple Computer by $4 billion — that’s the sort of thing investors will look at and say that’s actually a pretty good deal,” Allen says. “Everything is going to be different, and it should be up to the shareholders to decide.”

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How executives are paid is almost as important as what they are paid. For instance, the CFA’s manual, entitled The Compensation of Senior Executives at Listed Companies, notes that U.S. public companies can’t deduct more than a million dollars on a single salary, so the majority of pay for CEOs of large listed companies comes from stock options rather than fixed salaries. Options are also popular because they tie the compensation of an executive to the performance of the stock.

Allen notes they can create a number of problems, though. For example, if the executive compensation is tied to the stock price, it can motivate abuse and stock manipulation.

“Two of our colleagues in Hong Kong were doing a survey of disclosures in Asia and came across a Taiwanese company that diluted their shareholder value to the tune of 20%, deeply discounting the stock options that were awarded to senior executives,” he says.

Many investors also forget that while stock prices can be an indicator, they are not a measure of how well a company is run. Similar to a mutual fund’s performance, much of a company’s success can be tied to the sector in which it operates, rather than any real skill of the fund’s manager.

“A company’s stock may have performed well, but it may not have had anything to do with the chief executive’s management capabilities; it may just have been the result of an increase in commodity prices,” he says. “For example, if you look at a mining company located in Western Canada, you have to assess whether management generated the increased value in some of the shares of those companies or was it just a general increase in the price of the commodities that they mine?

“Just the idea of performance is not necessarily good. You have to look at the company’s performance relative to others’ in that industry and how much the CEO’s performance[factors into the company’s success].”

Determining how much of a factor compensation is in a company’s success may not be possible. However, Allen notes there are red flags investors should look for when evaluating a company’s governance.

Probably most glaring are stock-option plans that don’t require relative performance measures. Both the CFA Institute and Canada’s Coalition for Good Governance (CCGG), which tracks Canada’s corporate compensation levels, are strong advocates of performance measures existing on options, requiring executives to accomplish certain goals before exercising their stock options.

Allen notes there are certain situations, which may or may not be in the interest of the company, where CEOs could create windfalls for themselves based on the stipulations of their contracts.

The CFA manual suggests investors pay close attention to “change-in-control provisions” — which are triggered solely by a change in ownership — and whether additional developments, such as an executive’s loss of employment or a substantial change in job duties, are needed to activate the severance package.

Of course, identifying red flags relies heavily on disclosure, something both the CFA Institute and the CCGG are working hard toward improving.

In general, compensation disclosure in the U.S. and Canada has been increasing, but more can be done.

One area of disclosure the CFA Institute would like to see improved is companies’ methods of determining relative compensation. Allen recently co-authored a letter to the U.S. Securities and Exchange Commission (SEC) arguing that companies should be required to disclose the names of specific competitors used to create the benchmark that determines their own executive compensation.

The CCGG has lobbied for a “one figure” number summarizing CEO pay, which it says is required by the new SEC regulations and will soon be required by the Canadian Securities Administrators.

To download the CFA Institute’s manual in PDF format, click here.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(01/23/08)

Mark Noble