Thursday, January 29, 2015

Overpaid CEOs come from Screwing You

According to ThinkProgress, CEO pay increased 127 times faster than worker pay over last 30 years. According to Forbes, the average CEO makes 331 times as much as the average worker.

Many people are outraged at this.  However, the source of this outrage is jealousy or envy.  Most people do know why CEOs are overpaid.  They just get irked by other people making way more money than themselves.  This is the wrong reason to be outraged.

People should be angry, but not because of jealousy.  If they knew why CEOs are overpaid, they would be angry nevertheless, but have a good reason to be angry.  CEOs overpay themselves by lying, cheating and ripping off shareholders.

Most people own mutual funds, stocks or pension funds.  If you own them, then you've been ripped off for multiple decades.  Even if you do not directly own stocks, you will receive pension payments from your government when you retire.  These government pension funds are invested in stocks.  The less shareholders get, the less you get.

Carl Icahn and Warren Buffett partly explain why CEOs are overpaid in this article:  Leaders:  Not the Smartest in the Room.

Gordon Gekko explains it as well in the 1987 movie "Wall Street".  He is the largest shareholder of Teldar Paper and he lambastes management for screwing the owners by being do-nothing and overpaid.  Watch this video:

The best explanation is from Warren Buffett's letters to shareholder.  Essentially, the Board of Directors, who are supposed to look after the owners (shareholders), are useless patsies, who let the CEOs lie, cheat and screw the owners.

If you want to do something about it, you should complain to your politician, board of directors, company management at shareholder meetings, your securities regulator and accounting firms.  The squeaky wheel gets greased.  CEOs complain to politicians and hence have the upper-hand over shareholders.  Speak up or forever get screwed.

Here is Warren Buffett's explanation:

Stock options make up the far majority of a CEO's compensation.  Buffett explains clearly that stock options is an expense to the company, which in turn is an expense to the owners (shareholders).  CEOs and managers have been able to thwart accounting efforts to account options as an expense.  By doing this, they have been able to award themselves huge numbers of options and make obscene amounts of money at the expense of owners. From Warren Buffett's 1992 letter:
         The most egregious case of let's-not-face-up-to-reality behavior by executives and accountants has occurred in the world of stock options.  In Berkshire's 1985 annual report, I laid out my opinions about the use and misuse of options.  But even when options are structured properly, they are accounted for in ways that make no sense.  The lack of logic is not accidental:  For decades, much of the business world has waged war against accounting rulemakers, trying to keep the costs of stock options from being reflected in the profits of the corporations that issue them.  
         Typically, executives have argued that options are hard to value and that therefore their costs should be ignored.  At other times managers have said that assigning a cost to options would injure small start-up businesses.  Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued. 
         Oddly, the Council of Institutional Investors has chimed in with a variation on that theme, opining that options should not be viewed as a cost because they "aren't dollars out of a company's coffers."  I see this line of reasoning as offering exciting possibilities to American corporations for instantly improving their reported profits.  For example, they could eliminate the cost of insurance by paying for it with options.  So if you're a CEO and subscribe to this "no cash-no cost" theory of accounting, I'll make you an offer you can't refuse:  Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock.
         Shareholders should understand that companies incur costs when they deliver something of value to another party and not just when cash changes hands.  Moreover, it is both silly and cynical to say that an important item of cost should not be recognized simply because it can't be quantified with pinpoint precision.  Right now, accounting abounds with imprecision.  After all, no manager or auditor knows how long a 747 is going to last, which means he also does not know what the yearly depreciation charge for the plane should be.  No one knows with any certainty what a bank's annual loan loss charge ought to be.  And the estimates of losses that property-casualty companies make are notoriously inaccurate. 
         Does this mean that these important items of cost should be ignored simply because they can't be quantified with absolute accuracy?  Of course not.  Rather, these costs should be estimated by honest and experienced people and then recorded.  When you get right down to it, what other item of major but hard-to-precisely-calculate cost - other, that is, than stock options - does the accounting profession say should be ignored in the calculation of earnings?
         Moreover, options are just not that difficult to value.  Admittedly, the difficulty is increased by the fact that the options given to executives are restricted in various ways.  These restrictions affect value.  They do not, however, eliminate it.  In fact, since I'm in the mood for offers, I'll make one to any executive who is granted a restricted option, even though it may be out of the money:  On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option.  So if you find a CEO who says his newly-issued options have little or no value, tell him to try us out.  In truth, we have far more confidence in our ability to determine an appropriate price to pay for an option than we have in our ability to determine the proper depreciation rate for our corporate jet.
         It seems to me that the realities of stock options can be summarized quite simply:  If options aren't a form of compensation, what are they?  If compensation isn't an expense, what is it?  And, if expenses shouldn't go into the calculation of earnings, where in the world should they go? 
         The accounting profession and the SEC should be shamed by the fact that they have long let themselves be muscled by business executives on the option-accounting issue.  Additionally, the lobbying that executives engage in may have an unfortunate by-product:  In my opinion, the business elite risks losing its credibility on issues of significance to society - about which it may have much of value to say - when it advocates the incredible on issues of significance to itself.
This Alice-in-Wonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations. In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost. Small wonder then that the use of options has mushroomed. This lop-sided choice has a big downside for owners, however: Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders. 
         Whatever the merits of options may be, their accounting treatment is outrageous. Think for a moment of that $190 million we are going to spend for advertising at GEICO this year. Suppose that instead of paying cash for our ads, we paid the media in ten-year, at-the-market Berkshire options. Would anyone then care to argue that Berkshire had not borne a cost for advertising, or should not be charged this cost on its books? 
         Perhaps Bishop Berkeley -- you may remember him as the philosopher who mused about trees falling in a forest when no one was around -- would believe that an expense unseen by an accountant does not exist. Charlie and I, however, have trouble being philosophical about unrecorded costs. When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding. 
         Readers who disagree with me about options will by this time be mentally quarreling with my equating the cost of options issued to employees with those that might theoretically be sold and traded publicly. It is true, to state one of these arguments, that employee options are sometimes forfeited -- that lessens the damage done to shareholders -- whereas publicly-offered options would not be. It is true, also, that companies receive a tax deduction when employee options are exercised; publicly-traded options deliver no such benefit. But there's an offset to these points: Options issued to employees are often repriced, a transformation that makes them much more costly than the public variety. 
         It's sometimes argued that a non-transferable option given to an employee is less valuable to him than would be a publicly-traded option that he could freely sell. That fact, however, does not reduce the cost of the non-transferable option Giving an employee a company car that can only be used for certain purposes diminishes its value to the employee, but does not in the least diminish its cost to the employer. 
         The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made. 
         A few years ago we asked three questions in these pages to which we have not yet received an answer: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
Warren Buffett wrote an article for New York Times in 2002, accusing CEOs of deceiving owners in two ways to increase their compensation:  1)  stock options are not expensed  2)  using wildly optimistic pension returns to increase earnings:
Who Really Cooks the Books?

There is a crisis of confidence today about corporate earnings reports and the credibility of chief executives. And it's justified. 
For many years, I've had little confidence in the earnings numbers reported by most corporations. I'm not talking about Enron and WorldCom -- examples of outright crookedness. Rather, I am referring to the legal, but improper, accounting methods used by chief executives to inflate reported earnings. 
The most flagrant deceptions have occurred in stock-option accounting and in assumptions about pension-fund returns. The aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom. 
In calculating the pension costs that directly affect their earnings, companies in the Standard & Poor's index of 500 stocks are today using assumptions about investment return rates that go as high as 11 percent. The rate chosen is important: in many cases, an upward change of a single percentage point will increase the annual earnings a company reports by more than $100 million. It's no surprise, therefore, that many chief executives opt for assumptions that are wildly optimistic, even as their pension assets perform miserably. These C.E.O.'s simply ignore this unpleasant reality and their obliging actuaries and auditors bless whatever rate the company selects. How convenient: Client A, using a 6.5 percent rate, receives a clean audit opinion -- and so does client B, which opts for an 11 percent rate. 
All that is bad, but the far greater sin has been option accounting. Options are a huge cost for many corporations and a huge benefit to executives. No wonder, then, that they have fought ferociously to avoid making a charge against their earnings. Without blushing, almost all C.E.O.'s have told their shareholders that options are cost-free. 
For these C.E.O.'s I have a proposition: Berkshire Hathaway will sell you insurance, carpeting or any of our other products in exchange for options identical to those you grant yourselves. It'll all be cash-free. But do you really think your corporation will not have incurred a cost when you hand over the options in exchange for the carpeting? Or do you really think that placing a value on the option is just too difficult to do, one of your other excuses for not expensing them? If these are the opinions you honestly hold, call me collect. We can do business. 
Chief executives frequently claim that options have no cost because their issuance is cashless. But when they do so, they ignore the fact that many C.E.O.'s regularly include pension income in their earnings, though this item doesn't deliver a dime to their companies. They also ignore another reality: When corporations grant restricted stock to their executives these grants are routinely, and properly, expensed, even though no cash changes hands. 
When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don't belong in the earnings statement, where in the world do they belong? 
To clean up their act on these fronts, C.E.O.'s don't need ''independent'' directors, oversight committees or auditors absolutely free of conflicts of interest. They simply need to do what's right. As Alan Greenspan forcefully declared last week, the attitudes and actions of C.E.O.'s are what determine corporate conduct. 
C.E.O.'s want to be respected and believed. They will be -- and should be -- only when they deserve to be. They should quit talking about some bad apples and reflect instead on their own behavior. 
Recently, a few C.E.O.'s have stepped forward to adopt honest accounting. But most continue to spend their shareholders' money, directly or through trade associations, to lobby against real reform. They talk principle, but, for most, their motive is pocketbook. 
For their shareholders' interest, and for the country's, C.E.O.'s should tell their accounting departments today to quit recording illusory pension-fund income and start recording all compensation costs. They don't need studies or new rules to do that. They just need to act.
Furthermore, if CEOs cannot allocate earnings to get a good return, they should pay out the earnings as dividends to the owners.  Instead, CEOs retain the earnings in order to increase the value of their options.  From Warren Buffett's 1985 letter:
Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings - i.e., earnings withheld from owners.  For example, ten-year, fixed-price stock options are granted routinely, often by companies whose dividends are only a small percentage of earnings. 
         An example will illustrate the inequities possible under such circumstances.  Let’s suppose that you had a $100,000 savings account earning 8% interest and “managed” by a trustee who could decide each year what portion of the interest you were to be paid in cash.  Interest not paid out would be “retained earnings” added to the savings account to compound.  And let’s suppose that your trustee, in his superior wisdom, set the “pay-out ratio” at one-quarter of the annual earnings. 
         Under these assumptions, your account would be worth $179,084 at the end of ten years.  Additionally, your annual earnings would have increased about 70% from $8,000 to $13,515 under this inspired management.  And, finally, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth year.  Each year, when your manager’s public relations firm prepared his annual report to you, all of the charts would have had lines marching skyward. 
         Now, just for fun, let’s push our scenario one notch further and give your trustee-manager a ten-year fixed-price option on part of your “business” (i.e., your savings account) based on its fair value in the first year.  With such an option, your manager would reap a substantial profit at your expense - just from having held on to most of your earnings.  If he were both Machiavellian and a bit of a mathematician, your manager might also have cut the pay-out ratio once he was firmly entrenched.
         This scenario is not as farfetched as you might think.  Many stock options in the corporate world have worked in exactly that fashion:  they have gained in value simply because management retain earnings, not because it did well with the capital in its hands. 
         Managers actually apply a double standard to options.  Leaving aside warrants (which deliver the issuing corporation immediate and substantial compensation), I believe it is fair to say that nowhere in the business world are ten-year fixed-price options on all or a portion of a business granted to outsiders.  Ten months, in fact, would be regarded as extreme.  It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital.  Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period. 
         The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. (Negotiating with one’s self seldom produces a barroom brawl.) Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital.  As a result, these managers end up profiting much as they would have had they had an option on that savings account that was automatically building up in value. 
         Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental.  Once granted, the option is blind to individual performance.  Because it is irrevocable and unconditional (so long as a manager stays in the company), the sluggard receives rewards from his options precisely as does the star.  A managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better “incentive” system. 
          (I can’t resist commenting on one long-term option given an “outsider”: that granted the U.S. Government on Chrysler shares as partial consideration for the government’s guarantee of some lifesaving loans.  When these options worked out well for the government, Chrysler sought to modify the payoff, arguing that the rewards to the government were both far greater than intended and outsize in relation to its contribution to Chrysler’s recovery.  The company’s anguish over what it saw as an imbalance between payoff and performance made national news.  That anguish may well be unique: to my knowledge, no managers - anywhere - have been similarly offended by unwarranted payoffs arising from options granted to themselves or their colleagues.) 
         Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat.  In reality, the boats are far different.  No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all.  An owner must weigh upside potential against downside risk; an option holder has no downside.  In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift - but I’ll never buy one.)
         In dividend policy also, the option holders’ interests are best served by a policy that may ill serve the owner.  Think back to the savings account example.  The trustee, holding his option, would benefit from a no-dividend policy.  Conversely, the owner of the account should lean to a total payout so that he can prevent the option-holding manager from sharing in the account’s retained earnings. 
Consequently, options makes up the bulk of CEOs' compensation, at your expense.

A director's job is to look after the interest of the owners.  Instead, they look after themselves and the CEOs, who in turn look after the directors.  This enables the CEO to overpay him/herself and screw the owners (shareholders).  Here are excellent explanations of how this happens.  From Warren Buffett's 2002 letter:
Corporate Governance
Both the ability and fidelity of managers have long needed monitoring. Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking (Luke 16:2) approvingly of “a certain rich man” who told his manager, “Give an account of thy stewardship; for thou mayest no longer be steward.” 
Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ’90s, as a result, CEOs who traveled the high road did not encounter heavy traffic. 
Most CEOs, it should be noted, are men and women you would be happy to have as trustees for your children’s assets or as next-door neighbors. Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements. These otherwise decent people simply followed the career path of Mae West: “I was Snow White but I drifted.” 
In theory, corporate boards should have prevented this deterioration of conduct. I last wrote about the responsibilities of directors in the 1993 annual report. (We will send you a copy of this discussion on request, or you may read it on the Internet in the Corporate Governance section of the 1993 letter.) There, I said that directors “should behave as if there was a single absentee owner, whose long-term interest they should try to further in all proper ways.” This means that directors must get rid of a manager who is mediocre or worse, no matter how likable he may be. Directors must react as did the chorus-girl bride of an 85-year old multimillionaire when he asked whether she would love him if he lost his money. “Of course,” the young beauty replied, “I would miss you, but I would still love you.” 
In the 1993 annual report, I also said directors had another job: “If able but greedy managers overreach and try to dip too deeply into the shareholders’ pockets, directors must slap their hands.” Since I wrote that, over-reaching has become common but few hands have been slapped. 
Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws – it’s always been clear that directors are obligated to represent the interests of shareholders – but rather in what I’d call “boardroom atmosphere.”

It’s almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced. It’s equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisors are present and unanimously support his decision. (They wouldn’t be in the room if they didn’t.) Finally, when the compensation committee – armed, as always, with support from a high-paid consultant – reports on a megagrant of options to the CEO, it would be like belching at the dinner table for a director to suggest that the committee reconsider. 
These “social” difficulties argue for outside directors regularly meeting without the CEO – a reform that is being instituted and that I enthusiastically endorse. I doubt, however, that most of the other new governance rules and recommendations will provide benefits commensurate with the monetary and other costs they impose. 
The current cry is for “independent” directors. It is certainly true that it is desirable to have directors who think and speak independently – but they must also be business-savvy, interested and shareholder-oriented. In my 1993 commentary, those are the three qualities I described as essential. 
Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire’s) and have interacted with perhaps 250 directors. Most of them were “independent” as defined by today’s rules. But the great majority of these directors lacked at least one of the three qualities I value. As a result, their contribution to shareholder well-being was minimal at best and, too often, negative. These people, decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence. 
So that we may further see the failings of “independence,” let’s look at a 62-year case study covering thousands of companies. Since 1940, federal law has mandated that a large proportion of the directors of investment companies (most of these mutual funds) be independent. The requirement was originally 40% and now it is 50%. In any case, the typical fund has long operated with a majority of directors who qualify as independent. 
These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. When you are seeking investment help yourself, those two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic. 
Many thousands of investment-company boards meet annually to carry out the vital job of selecting who will manage the savings of the millions of owners they represent. Year after year the directors of Fund A select manager A, Fund B directors select manager B, etc. … in a zombie-like process that makes a mockery of stewardship. Very occasionally, a board will revolt. But for the most part, a monkey will type out a Shakespeare play before an “independent” mutual-fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance. When they are handling their own money, of course, directors will look to alternative advisors – but it never enters their minds to do so when they are acting as fiduciaries for others. 
The hypocrisy permeating the system is vividly exposed when a fund management company – call it “A” – is sold for a huge sum to Manager “B”. Now the “independent” directors experience a “counterrevelation” and decide that Manager B is the best that can be found – even though B was available (and ignored) in previous years. Not so incidentally, B also could formerly have been hired at a far lower rate than is possible now that it has bought Manager A. That’s because B has laid out a fortune to acquire A, and B must now recoup that cost through fees paid by the A shareholders who were “delivered” as part of the deal. (For a terrific discussion of the mutual fund business, read John Bogle’s Common Sense on Mutual Funds.) 
A few years ago, my daughter was asked to become a director of a family of funds managed by a major institution. The fees she would have received as a director were very substantial, enough to have increased her annual income by about 50% (a boost, she will tell you, she could use!). Legally, she would have been an independent director. But did the fund manager who approached her think there was any chance that she would think independently as to what advisor the fund should employ? Of course not. I am proud to say that she showed real independence by turning down the offer. The fund, however, had no
trouble filling the slot (and – surprise – the fund has not changed managers). 
Investment company directors have failed as well in negotiating management fees (just as compensation committees of many American companies have failed to hold the compensation of their CEOs to sensible levels). If you or I were empowered, I can assure you that we could easily negotiate materially lower management fees with the incumbent managers of most mutual funds. And, believe me, if directors were promised a portion of any fee savings they realized, the skies would be filled with falling fees. Under the current system, though, reductions mean nothing to “independent” directors while meaning everything to
managers. So guess who wins? 
Having the right money manager, of course, is far more important to a fund than reducing the manager’s fee. Both tasks are nonetheless the job of directors. And in stepping up to these all-important responsibilities, tens of thousands of “independent” directors, over more than six decades, have failed miserably. (They’ve succeeded, however, in taking care of themselves; their fees from serving on multiple boards of a single “family” of funds often run well into six figures.) 
When the manager cares deeply and the directors don’t, what’s needed is a powerful countervailing force – and that’s the missing element in today’s corporate governance. Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by owners – big owners. The logistics aren’t that tough: The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior. In my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved. 
Unfortunately, certain major investing institutions have “glass house” problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards. But Jack Bogle of Vanguard fame, Chris Davis of Davis Advisors, and Bill Miller of Legg Mason are now offering leadership in getting CEOs to treat their owners properly. Pension funds, as well as other fiduciaries, will reap better investment returns in the future if they support these men. 
The acid test for reform will be CEO compensation. Managers will cheerfully agree to board “diversity,” attest to SEC filings and adopt meaningless proposals relating to process. What many will fight, however, is a hard look at their own pay and perks. 
In recent years compensation committees too often have been tail-wagging puppy dogs meekly following recommendations by consultants, a breed not known for allegiance to the faceless shareholders who pay their fees. (If you can’t tell whose side someone is on, they are not on yours.) True, each committee is required by the SEC to state its reasoning about pay in the proxy. But the words are usually boilerplate written by the company’s lawyers or its human-relations department. 
This costly charade should cease. Directors should not serve on compensation committees unless they are themselves capable of negotiating on behalf of owners. They should explain both how they think about pay and how they measure performance. Dealing with shareholders’ money, moreover, they should
behave as they would were it their own. 
In the 1890s, Samuel Gompers described the goal of organized labor as “More!” In the 1990s, America’s CEOs adopted his battle cry. The upshot is that CEOs have often amassed riches while their shareholders have experienced financial disasters. 
Directors should stop such piracy. There’s nothing wrong with paying well for truly exceptional business performance. But, for anything short of that, it’s time for directors to shout “Less!” It would be a travesty if the bloated pay of recent years became a baseline for future compensation. Compensation committees should go back to the drawing boards.
Corporate Governance
In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren’t encouraging. A few CEOs, such as Jeff Immelt of General Electric, have led the way in initiating programs that are fair to managers and shareholders alike. Generally, however, his example has been more admired than followed. 
It’s understandable how pay got out of hand. When management hires employees, or when companies bargain with a vendor, the intensity of interest is equal on both sides of the table. One party’s gain is the other party’s loss, and the money involved has real meaning to both. The result is an honest-to-God negotiation. 
But when CEOs (or their representatives) have met with compensation committees, too often one side – the CEO’s – has cared far more than the other about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 shares or for 500,000 as monumental. To a comp committee, however, the difference may seem unimportant – particularly if, as has been the case at most companies, neither grant will have any effect on reported earnings. Under these conditions, the negotiation often has a “play-money” quality. 
Overreaching by CEOs greatly accelerated in the 1990s as compensation packages gained by the most avaricious– a title for which there was vigorous competition – were promptly replicated elsewhere. The couriers for this epidemic of greed were usually consultants and human relations departments, which had no trouble perceiving who buttered their bread. As one compensation consultant commented: “There are two classes of clients you don’t want to offend – actual and potential.” 
In proposals for reforming this malfunctioning system, the cry has been for “independent” directors. But the question of what truly motivates independence has largely been neglected. 
In last year’s report, I took a look at how “independent” directors – as defined by statute – had performed in the mutual fund field. The Investment Company Act of 1940 mandated such directors, and that means we’ve had an extended test of what statutory standards produce. In our examination last year, we looked at the record of fund directors in respect to the two key tasks board members should perform – whether at a mutual fund business or any other. These two all-important functions are, first, to obtain (or retain) an able and honest manager and then to compensate that manager fairly. 
Our survey was not encouraging. Year after year, at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessly approved fees that in many cases far exceeded those that could have
been negotiated. Then, when a management company was sold – invariably at a huge price relative to tangible assets – the directors experienced a “counter-revelation” and immediately signed on with the new manager and accepted its fee schedule. In effect, the directors decided that whoever would pay the most for the old management company was the party that should manage the shareholders’ money in the future. 
Despite the lapdog behavior of independent fund directors, we did not conclude that they are bad people. They’re not. But sadly, “boardroom atmosphere” almost invariably sedates their fiduciary genes. 
On May 22, 2003, not long after Berkshire’s report appeared, the Chairman of the Investment Company Institute addressed its membership about “The State of our Industry.” Responding to those who have “weighed in about our perceived failings,” he mused, “It makes me wonder what life would be like if we’d actually done something wrong.” 
Be careful what you wish for.
Within a few months, the world began to learn that many fund-management companies had followed policies that hurt the owners of the funds they managed, while simultaneously boosting the fees of the managers. Prior to their transgressions, it should be noted, these management companies were earning profit margins and returns on tangible equity that were the envy of Corporate America. Yet to swell profits further, they trampled on the interests of fund shareholders in an appalling manner. 
So what are the directors of these looted funds doing? As I write this, I have seen none that have terminated the contract of the offending management company (though naturally that entity has often fired some of its employees). Can you imagine directors who had been personally defrauded taking such a boys-will-be-boys attitude? 
To top it all off, at least one miscreant management company has put itself up for sale, undoubtedly hoping to receive a huge sum for “delivering” the mutual funds it has managed to the highest bidder among other managers. This is a travesty. Why in the world don’t the directors of those funds simply select whomever they think is best among the bidding organizations and sign up with that party directly? The winner would consequently be spared a huge “payoff” to the former manager who, having flouted the principles of stewardship, deserves not a dime. Not having to bear that acquisition cost, the winner could surely manage the funds in question for a far lower ongoing fee than would otherwise have been the case. Any truly independent director should insist on this approach to obtaining a new manager.

The reality is that neither the decades-old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees – and who may wish to enhance his income through election to other boards – is deemed independent. That is nonsense. The same rules say that Berkshire director and lawyer Ron Olson, who receives from us perhaps 3% of his very large income, does not qualify as independent because that 3% comes from legal fees Berkshire pays his firm rather than from fees he earns as a Berkshire director. Rest assured, 3% from any source would not torpedo Ron’s independence. But getting 20%, 30% or 50% of their income from director fees might well temper the independence of many individuals, particularly if their overall income is not large. Indeed, I think it’s clear that at mutual funds, it has. 
* * * * * * * * * * * 
Let me make a small suggestion to “independent” mutual fund directors. Why not simply affirm in each annual report that “(1) We have looked at other management companies and believe the one we have retained for the upcoming year is among the better operations in the field; and (2) we have negotiated a fee with our managers comparable to what other clients with equivalent funds would negotiate.” 
It does not seem unreasonable for shareholders to expect fund directors – who are often receiving fees that exceed $100,000 annually – to declare themselves on these points. Certainly these directors would satisfy themselves on both matters were they handing over a large chunk of their own money to the manager. If directors are unwilling to make these two declarations, shareholders should heed the maxim “If you don’t know whose side someone is on, he’s probably not on yours.” 
Finally, a disclaimer. A great many funds have been run well and conscientiously despite the opportunities for malfeasance that exist. The shareholders of these funds have benefited, and their managers have earned their pay. Indeed, if I were a director of certain funds, including some that charge above-average fees, I would enthusiastically make the two declarations I have suggested. Additionally, those index funds that are very low-cost (such as Vanguard’s) are investor-friendly by definition and are the best selection for most of those who wish to own equities. 
I am on my soapbox now only because the blatant wrongdoing that has occurred has betrayed the trust of so many millions of shareholders. Hundreds of industry insiders had to know what was going on, yet none publicly said a word. It took Eliot Spitzer, and the whistleblowers who aided him, to initiate a housecleaning. We urge fund directors to continue the job. Like directors throughout Corporate America, these fiduciaries must now decide whether their job is to work for owners or for managers.
From Warren Buffett's 2006 letter:
       In selecting a new director, we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say “truly” because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on directors’ fees to maintain their standard of living. These payments, which come in many forms, often range between $150,000 and $250,000 annually, compensation that may approach or even exceed all other income of the “independent” director. And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is not.) 
       Charlie and I believe our four criteria are essential if directors are to do their job – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?” 
       The questions I instead get would sound ridiculous to someone seeking candidates for, say, a football team, or an arbitration panel or a military command. In those cases, the selectors would look for people who had the specific talents and attitudes that were required for a specialized job. At Berkshire, we are in the specialized activity of running a business well, and therefore we seek business judgment.
Warren Buffett explains more on how CEOs avoid paying dividends to owners (keep owners away from the profits), in order to increase the value of the options.  From Warren Buffett's 2005 letter:
Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement. 
Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock. 
Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined  by 20% during the ten-year period.
Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options. 
A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.
CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.
It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)
Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline. 
Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.”
(Let me pause for a brief confession: In criticizing comp committee behavior, I don’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .
Warren Buffett implies that CEOs are corrupting politicians (Congress) on the issue of options.  You need to complain to your politician otherwise CEOs will continue to screw you.  From Warren Buffett's 2004 letter:
While we are on the subject of self-interest, let’s turn again to the most important accounting mechanism still available to CEOs who wish to overstate earnings: the non-expensing of stock options. The accomplices in perpetuating this absurdity have been many members of Congress who have defied the arguments put forth by all Big Four auditors, all members of the Financial Accounting Standards Board and virtually all investment professionals. 
I’m enclosing an op-ed piece I wrote for The Washington Post describing a truly breathtaking bill that was passed 312-111 by the House last summer. Thanks to Senator Richard Shelby, the Senate didn’t ratify the House’s foolishness. And, to his great credit, Bill Donaldson, the investor-minded Chairman of the SEC, has stood firm against massive political pressure, generated by the check-waving CEOs who first muscled Congress in 1993 about the issue of option accounting and then repeated the tactic last year. 
Because the attempts to obfuscate the stock-option issue continue, it’s worth pointing out that no one – neither the FASB, nor investors generally, nor I – are talking about restricting the use of options in any way. Indeed, my successor at Berkshire may well receive much of his pay via options, albeit logically-structured ones in respect to 1) an appropriate strike price, 2) an escalation in price that reflects the retention of earnings, and 3) a ban on his quickly disposing of any shares purchased through options. We cheer arrangements that motivate managers, whether these be cash bonuses or options. And if a company is truly receiving value for the options it issues, we see no reason why recording their cost should cut down on their use. 
The simple fact is that certain CEOs know their own compensation would be far more rationally determined if options were expensed. They also suspect that their stock would sell at a lower price if realistic accounting were employed, meaning that they would reap less in the market when they unloaded their personal holdings. To these CEOs such unpleasant prospects are a fate to be fought with all the resources they have at hand – even though the funds they use in that fight normally don’t belong to them, but are instead put up by their shareholders. 
Option-expensing is scheduled to become mandatory on June 15th. You can therefore expect intensified efforts to stall or emasculate this rule between now and then. Let your Congressman and Senators know what you think on this issue.

From Warren Buffett's op-ed piece:
This undervaluation, in turn enables chief executives to lie about what they are truly being paid and to overstate the earnings of the companies they run.
New regulations came down on options. However, management still lie and cheat to steal from owners.  From Warren Buffett's 2007 letter:
Fanciful Figures – How Public Companies Juice Earnings 
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting. 
An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense. 
After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value. 
A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for. 
It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market.
Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. 
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. 
This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been. 
How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century. 
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last. 
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome? 
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”). 
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win. 
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees. 
Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire. 
In his letters to shareholders, Warren Buffett explains numerous times on how CEOs love to acquire other companies.  However, these acquisitions frequently destroy wealth for his/her shareholders.  The main person that benefits is the CEO, who gets to expand his ego, prestige and compensation.  From Warren Buffett's 2009 letter :
Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 11⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation. 
Phil Fisher, a famous investor, wrote something similar to what Buffett wrote:
There is another and more serious way in which earnings are frequently retained in the business without any significant benefit to stockholders. This occurs when substandard managements can get only a subnormal return on the capital already in the business, yet use the retained earnings merely to enlarge the inefficient operation rather than to make it better.  What normally happens is that the management having in time built up a larger inefficient domain over which to rule usually succeeds in justifying bigger salaries for itself on the grounds that it is doing a bigger job.  The stockholders end up with little or no profit.
It is bad enough for directors and CEOs to screw owners, but it is even worse when the directors and CEOs are grossly incompetent and still screw owners.  Warren Buffett explains in his 2009 letter about the "unscathed" CEOs despite their "recklessness" in the financial crisis:
In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe. 
It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term. 
The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.
In fact, numerous CEOs were not only grossly incompetent, but criminal leading up to the financial crisis.  Nevertheless, none of them were punished.  Watch Inside Job and The Untouchables.

Target's CEO, Greg Steinhafel, was so incompetent that he caused Target to lose $5.4 billion in Canada.  Despite this, he screwed owners out of $61 million as part of his severance package.  According to CBC, this was more than what Target paid in severance to all 17,600 Canadian employees, which was $56 million.

For CEOs, it's "heads they win, tails you lose".

If you are a shareholder, you will get in the mail once in awhile, a letter from  a company that you own.  This letter will ask you to vote on proposals from management.  Always vote against them, especially the ones pertaining to compensation.  The far majority of time, these proposals enrich management at the expense of you, the owners.  Sometimes, there are proxy-advisory firms that give advice on how to vote.  Your interests are probably better served by following these proxy-advisory firms.

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