It has been a while and this somewhat long and wonkish.
CEO are so cute especially during earnings season. But remember that they are Mogwai. The normal rules for Mogwai apply. They have worked so hard to get where they did not get to where they are by being nice. There is typically a trail of tears (not theirs) and bodies (not theirs) that got them to the promise land.
So now that Mr./Ms. Big is here in the promise land they want/need to be rewarded/compensated for the journey to date, and they want/need this compensation to carry them into the after life. Gender is not a differentiating factor for greed.
How to do that? The answer is simple stock options, on top of their bloated salaries. More salary is not the answer, taxes on salary can be expensive, more so for the company than the individual (tax law limits the amount of salary that can be claimed as a business expense, which is not the case for most other corporate expenses). And it just so happens that in the case of stock options that is no limit on the expense.
So how does one engineer this feat? Simple via the compensation committee, which you (Mr. Big) just happens to have a large voice in appointing. You (Mr. Big) design (Your not going let the Harvard/Yale/Princeton/Wharton/Duke/University of Chicago/Stanford MBA go to waste) a set of metrics that your performance will be judged against. Now then what metrics do you choose? There are many to pick from, many of which you as a CEO/President/Board Member do not have any control over (So you do not pick them, or if you do they have a minor modification effect on the size of your bonus). But there are few that you and your hand picked crews of cutthroats (CFO/Treasurer, Corporate Secretary) have a great deal of control over (so you will pick from this bucket). You might pick many, but I believe that simpler is better less moving parts to get caught up in, it also reduce the amount of possible evidence.
One of the easiest is EPS, Earnings Per Share. It seems pretty simple have a high earning per share and you shall be rewarded like the king you think you are (of course you will have to share some of the booty with crew). Many might jump to the conclusion that if the earnings per share that one must have HIGH earnings. Many might not actually look may be the case. There are at least 5 ways to calculate EPS, so much for simple.
The first method is Reported EPS or GAAP (Generally Accepted Accounting Practices) EPS; this is what the company tells the SEC. This is the one that if reported incorrectly might get the corporation fined, and the corporate officer sanctioned. It is the reported Earnings divided by reported shares outstanding. One issue with this number is that from one period to the next may not appear to be very smooth (which could imply that you Mr. Big do not have a firm hand on the tiller, and maybe someone else could do better).
The second method is Ongoing EPS. This number is not reported to the SEC, and the reason will become very apparent. This number is some type of normalized/averaged earnings less any unusual/one time earnings event (as picked by management) divided by typically reported shares outstanding. This is one of the problems in of a class where the first question is not what is the answer, but what do you want the answer to be? The method and assumptions are reported in the footnotes of the annual report, but please note they are expressed in a nearly non-readable and incomprehensive format and manner. This method tends to smooth out the EPS curve, make you Mr. Big look like you have control and mastery over the situation.
The third method is the Pro Forma EPS. Again this number is not reported to the SEC. This is another one of the “what do you” want the answer to be calculation. There is an application of some specific secret sauce (Typically some expenses are deleted in calculating the earnings). The secret sauce is reported in the footnotes of the annual report. Same caveats apply to this number as to the ongoing EPS. Another number you might want to take to the bank. Again it is a smooth number lending credence to the illusion that you Mr. Big have control and mastery over the situation.
The fourth method is the Headlines EPS, typically not calculated by the company and certainly not reported to the SEC. This number has the added benefit for the corporation of plausible deniability. The corporate investor relations department or the corporate media relations department, in many cases they can be one in the same, provides sanitized information to members of the media or brokerage houses with the expressed statement and understanding that this information in no shape, manner, or construct is to be considered to be a forward looking. That it is offered with no conclusions being stated or implied by the corporation, and in some cases may not be quoted or cited, or alluded to in any shape form or manner. This number is produced but some type of analysis or talking head, for purposes unknown. Typically for this EPS the reader has no idea as to how this number is generated (both method and source data). As the Title suggest it is for Headlines.
The fifth method is the Cash EPS. Again this number is not reported to the SEC. This EPS is operating cash flow divided by diluted shares outstanding. This particular EPS is considered by some to be a better measure of a company’s EPS. Although a talented and motivated management team can with the proper inducements engineer this number since they have control over the income statement, and corporations use an accrual accounting versus cash accounting method. Again it can be used to promote the illusion that you Mr. Big have control and mastery over the situation.
There they are, the 5 recognized different Earning Per Share methods.
Now back to the question of executive compensation. Mr. Big wants big money, but he wants his money in such a way that he pays little to no tax. So Mr. Big decides that most of his compensation will be in the form of Stock Options, and that the amount of his stock options will be determined by how under is tenure as CEO he has by the skillful manipulation of the various controls of management have increased the Earning per Share, via a method that is advantageous to him, and by assumption good for the corporation.
Mr. Big then has the compensation committee (member of which he had appointed/elected to the board) approve the plan. The next step if for the board as whole to approve the plan (Same as before most if not all of the members there are there because Mr. Big wanted them there). Mr. Big will typically recuse himself on voting for the plan; otherwise it might appear to be at very least unethical much less unseemly.
In some cases the plan must be approved by the shareholder in which case, the compensation plan is written and refined by a wordsmith/lawyer to such an extent to render it almost unreadable much less comprehensible by most individuals. Finally the plan is attached to the proxy statement (typically in the back and in the footnotes), with the recommendation by the board that the shareholder approve it. Shareholders for the most part being sheep will approve it and life goes on as before.
Now to the mechanics of the dirty deed it self. The corporation with all of the proper approval by the board and the shareholders embark on a quest where the corporation will buy back its shares in the name of improving shareholder value. The theory is that as the number of outstanding shares is reduced and everything else being equal the price of the shares should increase. Sound great. Off course Mr. Big bonus is based on some questionable EPS calculation, but this is minor concern (Never mind the man standing behind the curtain). Mr. Big EPS will be based on outstanding shares it will be the small of any and all share calculation. Mr. Big EPS calculation will also be based on some extremely highly exotic modified manifestation of a non GAAP Earnings, he shots he scores.
The existing stockholder love it, they see their net worth increasing via the untapped unrealized gain as the stock price climes (in the words of Buzz Lightyear “To Infinity ..and Beyond !”). If and when they decide to sell assuming that they have held on to the stock long enough any gain will be taxed at the much small long term capital gains rate rather than their current ordinary income tax rate, another win.
Mr. Big and his gang of cutthroats win, since they will now get stock options typically with either a zero cost or some extremely nominal exercise price/cost. It gets even better in that when Mr. Big exercises his options the first place the corporation looks to get the stock is from their own warehouse of non outstanding stock, what a deal, virtually scot free.
Then all Mr. Big and his cutthroats have to do is hold on to the stock for a year and a day, and via some 10b5-1 plans sell those shares on the market at the market. He is only required to pay tax on the gain at the much smaller long-term capital gains rate. If Mr. Big is good and many if not all of them are good is to make sure that his 10b5-1 plan share sales line up with his schedule stock bonus events. That way when he reports his share holding to the SEC as he is required, the rest of us do not get scared when we see Mr. Big dumping his stock, and causing the rest of herd to panic and sell their share, thus reducing the gain Mr. Big might have seen.
But wait it gets even better, the corporation is still buying back it shares; you know the ones it gave Mr. Big for free.
So how does the corporation pay for this? There are three distinct methods which can be used by itself or in some combination. If Mr. Big and his cutthroats are good, then they would shift the costs associated with this endeavor around between the various methods, and they would do it on a regular basis much like a game of Three-card Monte. This whole endeavor of corporation compensation via stock options has a lot more in common with the short con Three-card Monte, but that as we use to say in college is up to the reader to determine, although long-term corporate claw back of bonuses would go a long way in stemming the tide of this con.
The corporation could us money from their cash flow, off course this expense would not be used to reduce the earnings that Mr. Big uses in calculating his version of the EPS for his bonus, but it would reduce the earning that corporation reports to the SEC. It would not be my first choice.
The corporation could browed the money form a bank, and I would suspect that interest expense associated with this program would not be used to reduce the earnings that Mr. Big uses in calculating his version of the EPS for his bonus. This debt could be buried in the bowels of the corporation GAAP compliant balance sheet, and as such would be duly reported to the SEC. It would be reported in the aggregate but not reported in the specific.
The corporation could issue unsecured subordinated debt/bonds to finance this endeavor. There is a name for this type of instrument, and it is call JUNK, and as such these instruments will have a higher coupon/interest rate at issue, and in all likelihood would have higher yield via a reduce bid price. This debt could also be buried in the bowels of the corporation GAAP compliant balance sheet, and as such would be duly reported to the SEC. It would be reported in the aggregate but not reported in the specific. Again as before the interest expense associated with this path would not be used to reduce the earnings that Mr. Big uses in calculating his version of the EPS for his bonus.
The corporation via the Mr. Big and the CFO could use a blend of these methods to fund the corporation’s buy back of shares. In the mean time Mr. Big could institute program within the company again with board approval to make the corporation more efficient via redundancy, modification of retirement plan or retirement plan conversion, reduction in company contribution to retirement plan, reducing contribution to health insurance plan, outsourcing, and offshoring, reducing salaries while employees are in training, require training that the employee is required to pay for, with the intent of maximizing earning by reducing personnel expenses. Sound familiar (IBM).
My favorite line from the move “Operation Petty Coat” is “There is profit in confusion”
So my fellow amigo be careful out there. “ It’s a jungle out there full of disorder and confusion”. “If you paid attention you would be worried too” Much thanks to Randy Newman for putting a voice to my paranoia.