Thursday, January 04, 2007

Expensing Options Didn't End Compensation Abuse

Several years ago, Warren Buffett petitioned regulators to make the expensing of stock options mandatory. Some accused Buffett of trying to get rid of options altogether, but his real motivation was to end the abuse. Several noted economists said expensing options would only make them more rare, but it would not end abuse.

They were right. Today options have to be expensed, and corporations use less of them. Yet executive compensation abuse continues. Home Depot's shareholders are the latest to be ripped off. CEO Robert Nardelli resigned and walked off with $210 million. Less than a year ago, Pfizer shareholders paid the price as CEO Hank McKinnell left with $200 million in his pocket.

Most shareholders don't object to paying someone well if he is doing a good job. But it's not like these guys deserved all that cash. After all, shares of both Home Depot and Pfizer were poor performers under their watch. Nardelli and McKinnell simply proved that one sure road to wealth is to become a CEO, do a poor job, then negotiate a resignation.

Whether stock options should or should not be expensed was never the appropriate battle to be fighting. The real problem is inappropriate executive compensation approved by boards of directors who are too weak-kneed to tell the CEO he can't rob the bank.

When directors discuss how much to pay the CEO, the first thing they do is hire a consultant. The consultant comes up with a list of peer companies. Of course, the CEO makes sure only high-paying firms are included in the list. The directors also convince themselves that their CEO is better than average; therefore, he must be paid better than average. This process drives up pay for all CEOs year after year.

Buffett has some excellent ideas on how to structure executive compensation. These include stock options with escalating exercise prices. He was wrong about expensing options, but so many of his other ideas make good sense.