Many CEOs richly rewarded for failure --- They didn't suffer as stocks tanked in new economy
David Olive

08/25/2002
The Toronto Star

'Greed has been severely underestimated and denigrated - unfairly so, in my opinion. There is nothing wrong with avarice as a motive, as long as it doesn't lead to anti-social behaviour.'

- Conrad Black, Anglo-Canadian

press lord, 1982

David Olive

In the spring of 2001, John Roth was reflecting on the swiftly declining fortunes of his company. "The speed of going from boom to bust is amazing," said the chief executive officer of Nortel Networks Corp., who was just on the phone with another client cancelling an order for Nortel's networking gear.

Roth was a star of the new economy, a technology-driven capitalism that dominated business in the 1990s and promised limitless wealth to "first movers" who beat their competitors to market with breakthrough products. It was an era when conventional prudence in profit forecasting and cost control went out the window as new-economy firms rushed to gain control of such lucrative new realms as wireless e-mail devices, online inventory control systems and Internet-based grocery stores.

But with start-up phone companies hurtling toward bankruptcy and entrenched carriers slashing their budgets for new telecom equipment, the once-celebrated Roth was now faulted on Wall Street for his acquisition spree of recent years and for ramping up production at his Brampton-based company to meet demand that was failing to materialize.

"Three months ago, 37 analysts who follow this company said we weren't out to lunch in forecasting 30 per cent revenue growth this year," said Roth, who was gamely making the always awkward transition from CEO of the year to emperor who's just lost his wardrobe. "Now they're saying we exaggerated. I don't get it. In only a few weeks time, 37 analysts have gone from expecting us to do 30 per cent to zero!"

In 2001, as it turned out, Nortel, which at the height of the telecom insanity the previous summer accounted alone for about one-third of the value of all Toronto Stock Exchange-listed companies, would lose $27.3 billion (U.S.) as its market dried up, easily the largest loss in the annals of Canadian history. And Roth would retire with $135 million (Canadian) in gains on stock options he exercised near the market peak in July, 2000. What Roth did was perfectly legal; his sale of company stock was publicly reported, as required by law.

Roth would leave his successor, Frank Dunn, to lay off tens of thousands of employees, close scores of plants and scramble to raise emergency financing while staring down rumours that Canada's most important tech firm was edging toward insolvency. Roth, meanwhile, had repaired to his tree farm in Caledon, where he now tends to his collection of vintage sports cars.

A great many CEOs of the new economy have been richly rewarded for failure. Gary Winnick might head the list. Between 1999 and 2001, the former junk-bond protege of Michael Milken pocketed $512 million (U.S.) in gross pay, including stock-option proceeds, before his ill-fated Global Crossing Ltd., a builder of fibre-optic pipelines, toppled into bankruptcy last January. Winnick has since left the company. Dennis (Deal-A-Day Dennis) Kozlowski, son of a Newark, N.J., police detective who used hundreds of takeovers to build Tyco International Ltd. into a $36 billion conglomerate, collected $426 million in total compensation from his company before Tyco succumbed to a federal probe into its questionable accounting practices. He quit the company in June, a day before his arrest on charges of sales-tax evasion.

More than the recent accounting scandals or the supposed genius of CEOs who overestimated the get-rich-quick potential of their firms, the truly nauseating aspect of the new economy's collapse is the preponderance of CEOs who didn't put their money where their mouths are. They championed a new capitalism in which the rapid exploitation of the Internet and other technological breakthroughs would soon enrich executives, Main Street investors and workers who had been encouraged to plow their retirement savings into their employers' stock.

But the zeal of those champions, many of whom benefited from intimate knowledge of industry and company conditions, did not stifle their instincts for self-preservation. They made their stock-market killings not long before the revelry ended, confirming the age-old truism that, to paraphrase Leona Helmsley, only the little people take losses. Speaking for the latter, a paper-mill worker in the U.S. northwest named Robert Hemsley, whose retirement plan loaded with company stock had tanked, acidly remarked, "The corporate captains have abandoned accountability while the crew sinks with the ship. In this free-enterprise system of risks and rewards, employees suffer most of the risks, while executives enjoy most of the rewards."

Long after the new economy was looking like a bankrupt idea, visionary CEOs were still touting the can't-miss propositions their enterprises had lucked into. Freshly laid fibre-optic pipelines. Wireless downloads of Britney Spears concerts. Online pet food vendors. German companies making U.S. autos for export to Japan. It was all going to pay off someday soon. But those CEOs didn't walk the talk.

Among those who cashed out before Newtonian principles reasserted themselves in the stock market were Josef Straus, long a media favourite for his charming habit of distributing replicas of his trademark black beret to the rank and file at Ottawa's JDS Uniphase Corp. ($152 million U.S. in stock-option proceeds); Steve Case, co-architect with Gerald Levin of the disastrous merger of America Online Inc. with Time Warner Inc. ($128 million); Ken Lay and Jeff Skilling, successive CEOs at Houston energy trader Enron Corp. ($247 million and $89 million, respectively); and Paul Allaire of Xerox Corp., who grossed a total of $16 million in 1998 and 1999, years in which Xerox has since been found to have faked its books to inflate the profits upon which Allaire's pay-for-performance rewards were based.

The '90s generation of executives might just be the greediest on record. Unlike the CEOs involved in such previous outbreaks of cupidity as the insider-trading and savings-and-loan scandals of the 1980s, the me-first executives were ostensibly upstanding professionals who ran both venerable blue-chip firms (Xerox, Kmart Corp.) and daring start-ups in the vanguard of the 21st-century information economy (Enron, America Online, WorldCom Inc., Cisco Systems Inc.). Not content with a generous salary, annual bonuses and the usual perks and benefits, many of the new-economy CEOs pressed their compliant boards for huge allotments of stock options that promised wealth beyond imagination if the share price rose above a pre-set level. They were lured with stupendous signing bonuses. They were kept in harness with extraordinary retention bonuses. They collected merger bonuses for consummating takeovers. They were granted company loans with low or no interest rates to buy company stock. And they were sent packing - if it came to that - with multi-million-dollar severance packages that often entitled them to continued use of company planes and annual consulting fees in six figures.

The new CEOs justified their astonishing remuneration by arguing they were rare brilliant visionaries. That they were creating enormous wealth for investors. And that their interests were aligned with those of ordinary shareholders as never before, given that the bulk of their compensation was to an unprecedented degree tied to the performance of their company's stock.

Yet in the past decade, CEO pay has not been aligned with shareholder gains or profit growth. Between 1990 and 2001, share prices increased by about 300 per cent, as measured by the Standard & Poor's 500 index. Growth in corporate profits in that period was a less than spectacular 116 per cent. But CEO pay soared by 535 per cent. The average U.S. worker, meanwhile, got by with scarcely 32 per cent income growth, while by 2000 CEO pay had risen to 531 times that of the average employee.

Even those numbers understate the wide gap between CEO pay and performance. There have been more than 500 restatements of corporate profits in the past two years to account for artificially inflated profits of earlier years - dozens of times the traditional rate. By most experts' reckoning, profits in recent years have been overstated by an average of 20 per cent, half due to the failure to account for the cost of executive stock options as a corporate expense and half resulting from fiddling with the books.

CEOs who have "managed earnings" with deceptive accounting methods have betrayed the trust of investors, Stephen Jarislowsky says. Their conduct has been "the opposite of professional behaviour - greed," the veteran Montreal fund manager said in a speech in May, giving his explanation for the waning public confidence in the stock market. "If someone hires a lawyer or an investment manager, he or she expects professional conduct. Professional conduct does not include taking the clients to the cleaners."

It's a wonder that Wired, Fast Company and the other 1990s bibles of new-age capitalism haven't given way to a new journal on corporate outrages of the week.

Examples:

George Shaheen, who helped trigger the exodus of blue-chip managerial talent to the dot-coms when he quit as CEO of Andersen Consulting (now Accenture) in the late 1990s to join the start-up online grocer Webvan, lasted less than two years in his new job. With annual sales of $790,000, a little shy of the yearly take at a single McDonald's burger stand, Webvan went public with an astounding first-day market value of $4 billion. But it was all downhill from there. Webvan was a disaster on all fronts - logistics, marketing, overstaffing, lax budget controls. But Webvan chose to let Shaheen go amicably with a $375,000 annual pension- a stunning but hardly isolated case of the not altogether dire consequences for extreme failure in the new economy. Writing of Shaheen's fall in Slate last year, business columnist Rob Walker was dumbfounded by the limits to downside risk for cloud-cuckoo-land visionaries. "I mean, really, what does a CEO have to do to avoid getting a sweetheart deal?" Walker asked. "Kill the shareholders with his bare hands?"

C. Michael Armstrong's turnaround strategy for AT&T failed abysmally. When the $97 billion worth of cable assets he acquired at the top of the market did not "synergize" with the firm's ailing long-distance phone business, Armstrong was forced to unload them for $62 billion. Armstrong's reward for destroying $35 billion in shareholder value was a total of $49.2 million in cash, stock options and other payments.

Soon after joining troubled steel maker LTV Corp. of Cleveland in November, 2000, as a turnaround CEO, William Bricker demanded and got a $1 million "retention bonus" to make him stay put, over and above his $700,000 salary and $200,000 signing bonus. Bricker needed that extra incentive, he explained, because he wasn't fully aware of LTV's perilous state until joining the company, despite having served on its board since 1982. LTV's problems indeed proved too much for Bricker, who abandoned LTV in November, 2001, a month before it filed for bankruptcy protection. But Bricker kept his contractually guaranteed "stay put" pay and other compensation - a quick $1.9 million for doing nothing to brighten LTV's prospects.

William Harrison collected a handsome $20 million merger bonus for leading his Chase Manhattan Corp. to the altar with rival J.P. Morgan & Co. in 2000. That was in addition to his $6 million in salary and regular bonuses that year. Harrison cheerfully acknowledged the deal took just three weeks to negotiate. Asked about Harrison's coup in snagging a $20 million bonus for just doing his job, Roy Smith, finance professor at New York University, said, "These bonuses are compensation as a round of applause by boardrooms filled with stuffed animals."

Ken Lay's payoff at Enron was eclipsed by that of Lou L. Pai, notorious within Enron for running up huge losses at his two largest projects, one to manage the energy use of national chains like J.C. Penney and the other to compete in the retail electricity market. Had it not been for his affair with a former topless dancer, Pai might not have been prompted to cash in his Enron stock options for $268 million in early 2000 as part of a divorce settlement. How Pai was entrusted with big Enron projects remains a mystery. "He had no fiscal abilities at all," said Rudy Sutherland, a former colleague of Pai's who lost his job in the Enron collapse. "It amazed so many people that it took them as long as they did to pull the reins from him. He had no appetite for it."

Dennis Kozlowski was hailed in Barron's as the next Jack Welch for his apparent triumph in turning Tyco International Ltd. into a rare conglomerate that didn't suffer for its diversity. Kozlowski was a philanthropist and outspoken critic of excessive pay for CEOs. Yet he was paid $400 million or so in the past four years in salary, stock grants and proceeds from selling stock options. Since his arrest in June on charges of sales-tax evasion on personal art purchases, it has been revealed that rather than reach into his own bulging pockets to fund his personal activities, Kozlowski arranged to have Tyco pay the $19 million cost of building his 15,000-square-foot waterfront mansion in Boca Raton, Fla. And to buy for his use an $18 million Fifth Avenue duplex in Manhattan and pick up the $11 million tab for outfitting it with art, antiques and furnishings, including a $6,000 designer shower curtain. And Tyco shareholders, not Kozlowski, unwittingly contributed $5 million toward the construction of Kozlowski Hall at the CEO's alma mater, New Jersey's Seton Hall University, $1.7 million for the new Kozlowski Athletic Center at his daughters' private school in Maine and a $2 million donation to the Nantucket Historical Association. Tyco shareholders were not informed of their unwitting largesse. Nor were they aware Kozlowski put his personal doctor, fitness trainer, chef, interior decorator and yacht-design consultant on the Tyco payroll.

To the person on the street, when things go so terribly wrong at a company that it takes refuge in bankruptcy and dumps its CEO, that's the end of the story. Well, not quite. Often the deposed CEO joins other creditors in picking over the carcass of the bankrupt firm. Linda Wachner, fired at lingerie maker Warnaco Group Inc. last November, five months after it filed for U.S. Chapter 11 bankruptcy protection, is suing her former employer for $25.1 million in severance pay. That Wachner's management style at Warnaco left something to be desired is well documented. She ran up a debt load of $3 billion, lost market share during a pointlessly prolonged legal dispute with licensor Calvin Klein and was so famously despotic that by the late 1990s no talented Seventh Avenue executive would accept an invitation to interview for jobs to replace the many subalterns who found they could not work with Wachner. "You're eunuchs," Wachner once told a group of male managers to whom she assigned typically impossible sales targets. "How can your wives stand you? You've got nothing between your legs."

Absurd as it seems, Wachner's pursuit of a multi-million-dollar send-off - in order, says her lawyer, that Wachner's "good reputation and her good name be preserved" - is the usual routine for CEOs at Fortune 500 companies whose pre-arranged exit packages are contractually guaranteed, bankruptcy or no. Al Dunlap, ousted CEO of Sunbeam Corp., is still waging a legal battle with the bankrupt appliance maker over millions of dollars in severance pay he feels he is owed.

Hailed neither as a visionary nor a turnaround expert, Ed Whitacre Jr. is one of the scores of plain-vanilla CEOs who head stable Fortune 500 companies that in many cases are run on autopilot. Yet like many of his peers, Whitacre is paid like a superstar, receiving $82 million in compensation last year. In his 12-year tenure as CEO of SBC Communications, a San Antonio, Texas-based "Baby Bell," shareholders have earned a middling 11.5 per cent average annual return, a touch below the 12.8 per cent for the S&P 500. Every time SBC's shares slump, its board gives Whitacre another whack of stock options that pay off if he merely gets the stock price back to where it was - a peculiar reward for jogging on the spot. As if he were some kind of flight risk, Whitacre has also been repeatedly lavished with retention bonuses, totalling $21.2 billion. Over the years, pay consultants have convinced boards to divide a CEO's pay into several categories, all measured by different yardsticks, and conveniently obscuring the magnitude of a CEO's total compensation. Thus in 2000, when SBC fell short of its annual targets, Whitacre's bonus was trimmed with great fanfare by 25 per cent; but his salary was boosted 32 per cent as an incentive for better future performance. Whitacre can't lose for winning.

And Whitacre's not alone, thanks to the proliferation of non-salary devices for enriching CEOs. Chief among these are stock options, which first won popularity in the 1950s when they gained favourable tax treatment. Options fell out of favour during the bear market of the 1970s, but came roaring back in the great bull market of the 1980s and '90s.

In a stark example of the law of unintended consequences, the U.S. Congress, in a bid to rein in excessive CEO compensation in the mid-1990s, put a $1 million cap on the tax deductibility of salaries while placing no such restriction on options. In hindsight, the result was predictable: CEO salaries promptly rose to $1 million, topped up by a plethora of non-salary goodies. Michael Eisner, who has disappointed investors in Walt Disney Co. for almost a decade, was paid $576 million in 1998. His salary that year was exactly $1 million, identical to Bernie Ebbers' salary at WorldCom Inc. Ebbers' employer made up for that penuriousness by granting him $408 million in low-interest company loans. Sandy Weill, CEO of Citigroup Inc., is also paid a $1 million salary. But Weill's total take in stock options and other non-salary compensation over the past decade is estimated at more than $1 billion.

Stock options are a form of compensation that typically do not show up on the profit and loss statement as a corporate expense, which spurred boards in the 1990s to dispense this "free money" like candy to CEOs and other top executives. But options nonetheless are a real cost to shareholders, who suffer as their holdings are diluted by the issue of massive amounts of "free" shares to privileged executives.

Stock options have become a narcotic, both in their addictive properties and their power to inebriate. Companies that rely on options as an incentive for executive performance trap themselves in a vicious cycle, forced to dole out more options at lower exercise prices every time the share price falls or risk losing valued employees. Or directors lower the exercise price of existing options, a notorious practice known as repricing, which accentuates the misalignment between managers and ordinary shareholders, who only wish they too could lower the price at which they bought their shares.

Options powerfully fuelled the market mania by creating the false impression of robust corporate profitability. The true cost of options at Microsoft Corp. last year was $3.3 billion, nearly one-third of the software giant's reported earnings. If Nortel and Cisco had reported stock-option costs as an expense in a manner similar to traditional pay, their losses last year would have deepened by $2.5 billion and $2.6 billion, respectively. (Cisco reported a loss for 2001 of $1 billion.)

Options also distort CEO judgment, contributing to the phenomenon of drive-by entrepreneurialism. By 2000, the average CEO of an S&P 500 company was receiving options worth $30 million. With option windfalls now accounting for 80 per cent or more of CEO pay, new-economy bosses had an overwhelming incentive to embrace strategies geared to boosting the stock in the short term. That's particularly true given the short-term nature of the CEO's own tenure, which a recent survey put at just three years on average in some sectors. That means in some cases a CEO has only three years to maximize his or her own personal profitability. Options have turned a generation of managers into rank speculators playing with the house's money.

"The stock-options culture is at the root of the current scandals on Wall Street," said Walter Cadette, a former vice-president at J.P. Morgan & Co. and now a senior scholar at Bard College, where he has studied the impact of options on corporate performance in the past 20 years. "Options, which are not counted as an expense and thus inflate earnings, bring with them a powerful incentive to cheat. All it takes is a set of books good enough to send a stock price soaring, if only for awhile. If real earnings are not there, they can be manufactured - for long enough, in any case, for executives to cash out. This, in essence, is what happened at Enron, WorldCom, Xerox - indeed, at quite a long list of companies."

In January, in the wake of the Enron catastrophe, a glib Paul O'Neill, the U.S. treasury secretary and former CEO at Alcoa Inc., said, "Companies come and go. Part of the genius of capitalism is people get to make good decisions or bad decisions, and they get to pay the consequences or to enjoy the fruits of their decisions."

That is hogwash, of course. The consequence of failure for 181 executives at the 25 largest U.S. companies to declare bankruptcy since January, 2000, according to recent calculations by London's Financial Times, was total pay of $3.2 billion, largely in the form of stock options cashed in not long before the enterprises slid into the abyss. Never has failure been rewarded so lavishly.

Contrary to the argument of some, options have not advanced the cause of broad wealth generation. Lobbyists for Silicon Valley tycoons and other firms who describe options as a pillar of middle-class prosperity are spouting nonsense. Against their claim that as many as 10 million Americans received options last year, the non-profit National Center for Employee Ownership puts the number closer to 3 million. Options are the preserve of top executives, who receive tens or hundreds of thousands of them. Lower-level employees who qualify for options typically receive only a few hundred.

Another tactic for giving a sheen of social acceptability to brazen CEO greed has been the roping in of rank-and-file workers into the promised stock-market bonanza. That was accomplished in the U.S. largely through the invention of the 401(k), a so-called defined-contribution pension plan to accompany or, increasingly, replace traditional defined-benefit plans. Gaining steadily in popularity since the early 1980s, when the U.S. Internal Revenue Service approved their use for tax-deferred retirement savings, 401(k)s are now the primary source of anticipated retirement income for six of every 10 U.S. workers with retirement coverage. And three-quarters of total 401(k) assets are stocks.

The 401(k) is a corporate treasurer's dream, relieving the employer of the expense of funding traditional pension plans that pay out a fixed, guaranteed sum in each year of a pensioner's retirement. Instead of matching employee contributions to the 401(k) plan with cash, companies match them with their own stock - a freebie for the company.

That's not how the 401(k) has been advertised, of course. It was instead another new-economy innovation, linking retirement to the marvels of an ever-rising stock market so millions of wage slaves could share a portion of the upside that was enriching CEOs.

It hasn't worked out that way. The median 401(k) account shrank to a pitiful $13,493 in 2000, down from $15,246 the previous year. And the erosion of 401(k) assets has only become more severe since 2000, with the collapse of firms like Enron and WorldCom where employee 401(k) plans were loaded with now worthless company stock. What this means, of course, is tens of thousands of people who have lost their jobs at Enron, WorldCom and other casualties of the new-economy collapse have also lost much of their retirement savings. Meanwhile, CEOs and other top executives, not surprisingly, continue to be guaranteed a rich pension payout, having never allowed their own traditional defined-benefit plans to be negotiated away.

Recent pressure for reforms in corporate governance has spurred a growing number of companies in the U.S. and Canada, including some of Canada's Big 5 banks, to report their stock-option expenses as a cost that reduces current-year profits. And a recent directive by the U.S. Securities and Exchange Commission now requires CEOs to vouch for the accuracy of their financial reporting and could make them criminally liable for signing off on profit and loss statements they know to be false.

By far the most significant reform is a new U.S. law that requires the CEO and the chief financial officer to reimburse the company for any incentive-based compensation, including stock-option proceeds, that were received in any 12-month period in which the official reporting of profit and loss is later found to be inaccurate and must be restated. By applying a stiff penalty on lying, that crucial provision is intended to remove the incentive for CEOs to disseminate false or highly suspect information in the hope of profiting from its impact in boosting the stock price.

The American dream of big rewards for honest hard work has been stood on its head. Even T.J. Rodgers, the founder and CEO of Cypress Semiconductor of San Jose, Calif., and regarded by his peers as a straight arrow, was dismayed as he watched CEO pay begin to soar to ridiculous levels. Back in 1991, when his $250,000 pay was near the bottom for the tech sector, Rodgers said, "When I look at overpaid executives I feel like a New England Protestant minister watching Jimmy Swaggart on TV."

Dick Currie now warns against one-shot-wonder CEOs who only briefly seem to merit their extraordinary pay. "I think executive compensation should be related to sustained profit growth," said the former CEO of Loblaw Cos., who boosted the firm's market value from $40 million (Canadian) to more than $14 billion during a 25-year career ending in 2000. "Anybody can hit the ball out of the park once. The trick is to hit out of the park 50 times a year for 10 years in a row."

Roth appeared to be hitting them out of the park in 2000 when Nortel's share price peaked at $124.50. In its 100-year history up to 1995, Nortel's workforce grew to about 60,000 people. Over the next five years the payroll jumped by about 70 per cent, to almost 100,000 employees, with most of the new hires taken on in the last two years before the telecom bubble burst.

Nortel has since shed more than half of its workers. Just as well, Roth said last year, because "there's no reward for being a big company. The complexity is larger than management's ability to deal with it." Problem solved. Nortel's revenues have plummeted by about two-thirds to $11 billion U.S. annually. And the company's shares, which closed Friday at just $1.91 (Canadian), no longer distort the TSE 300 - a formerly frequent complaint among Bay Street analysts that now seems quaint to investors with a sense of irony. Among the latter are Nortel's surviving employees and its pensioners, whose company retirement plan has just posted a loss of $1 billion (U.S.) for 2001 on its holdings of Nortel shares.

Roth is proud of selling at the peak. "When the price/earnings multiple broke through 100, I thought it was a good time to sell," he said. In saner, pre-new-economy times, stocks like Nortel traded at a multiple of just 15 to 20 times earnings. "I never promoted Nortel stock," Roth said, a bit defensively. "But when the p/e hit 110, I just had to sell. I mean, it was an astounding number."

The captain of that Titanic remained on the bridge just long enough to accept induction into the Canadian Business Hall of Fame. Fair enough. Roth was a genius of capitalism, at least by the fun-house rules of the new economy.