Sunday, December 31, 2006

My 2007 Predictions: Does this count?

Not really, I guess. On Dec. 27, just a few hours before I made my New Year's predictions (here), incoming House Financial Services Committee chairman Barney Frank issued this press release criticizing the SEC's December 22 decision to align its executive compensation disclosure rules with existing accounting rules. This new rule, which you can read here (if you a real masochist), replaces the existing SEC rule that says that when companies give executives stock options, these options have to be disclosed at the time of the grant. The new rule follows Financial Accounting Standard 123R (which you can read here, if you are really really really masochistic), so that public companies now only have to disclose the grant as they are exercised (i.e., when the executive actually calls in the grant and the company has to fork over the money to buy the shares).

There is some logic to this new rule, since a grant of stock options is worthless until it is exercised, and they can be exercised at different times. In other words, under the old approach, a company could disclose that it issued a CEO 1000 stock options in one year (not necessarily indicating the price of the stock), and nothing over the next five years, with an annual salary being (for example) $500,000. The disclosure would then look like $500K +1000 stock options in Year 1, then $500K for Years 2 through 6. Under the new rule, the company would have to disclose the stock options, and the fair market value, when the options become exercisable. In other words, if 100 of the 1000 options become exercisable each year, in Year 1, the company would disclose $500K in salary, in Year 2 $500K + 100 stock options at $1000 per share, in Year 3 $500K +100 stock options at $1100 per share, etc. The idea is to give investors an idea about how much the CEO is costing the company each year, and how much the CEO is actually making in each year. Furthermore, this is how companies currently have to account for stock options. (In the past, issuers did not have to expense stock options at all.)

Despite the logic behind the SEC's decision, you could argue that it comes at a bad time. Executive stock options are in the news because of the backdating scandal. Most people don't understand what the issue is about, except that it's bad. Add on top of that the view of some that what investors really want to know about is when the board decides to grant stock options (not necessarily when the come due or when the CEO exercises those options), and it could look like the SEC is making it harder for investors to know how overpaid the CEOs of their companies are. And that, of course, is what Barney Frank is saying.

I am very disappointed with both the substance and the procedure used to reach the SEC’s Christmas Eve decision to loosen reporting requirements for the pay of the top executives of public corporations. It is especially ironic that the SEC would relax the rules regarding stock options at precisely the time that widespread abuses of the practice are coming to light. The problem of executive pay that is both greatly excessive and deliberately obscured is a grave one. I had been encouraged when the SEC recognized this problem in its initial proposal, and while that continues to provide improvements in the relevant rules, this slippage is regrettable both substantively and for not having been open to more public discussion. Backtracking by the SEC on this important matter of stock options reinforces my determination that Congress must act to deal with the problem of executive compensation that is now unconstrained by anything except the self restraint of top executives, a commodity that is apparently in insufficient supply.
Frank also indicated that he will seek legislation to allow shareholders to vote on executive compensation. If this legislation succeeds, it will be the second direct foray of the federal government into corporate governance issues, an area of U.S. law that traditionally has been the province of state law. (The first, of course, being the Sarbanes-Oxley Act, which set requirements for issuer board composition.)

So, I guess my prediction that Barney Frank will hold hearings on executive compensation is a no-brainer. (I guess we'll have to see about the professors and Lake Woebegon.) However, if Frank does go ahead with corporate governance legislation rather than some kind of windfall tax, I'll have been happily proven wrong.

1 comment:

Re:TheAuditors said...

I agree. You would think that the corporations and the auditors are running the SEC based on their capitulation with regard to this issue and with regard to SOx for small companies.

The reason why stock options backdating continued after SOx, even though the disclosure rules were tightened is that companies just disclosed late and were not caught, let alone punished. It took a humble academic to call this abuse out. So the SEC has now admitted that it is unwilling and unable to rein in this practice. That's the message being sent to corporate management and Directors.