The Fraud Files

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Tracy L. Coenen

The issue of upper-level executive pay can raise the ire of many, as it might be hard to comprehend salary and benefits in the tens or hundreds of millions. It’s especially easy to rile up the masses if one compares CEO pay to the average pay of production workers. Of course, this exercise in demonstrating disparity can easily make one believe that executive pay and perks are excessive.

For some it’s a matter of equity between upper management and front-line employees. For others, such high pay must somehow be related to fraud and irregularities. But are these valid concerns? Shouldn’t the market decide? Who are journalists and economists to say that upper level executives shouldn’t be highly compensated?

Rules on Executive Pay

The Securities and Exchange Commission changed the rules regarding executive pay in 2006, which should lead to greater disclosure of information by public companies. The rules do not limit executive pay in any way; they just require certain disclosures to be made.

Previously, pension plans and severance packages were used aggressively, as the rules required only limited disclosures about these types of compensation. Now these things must be disclosed, as Pfizer found out last year when the company had to report that CEO Hank McKinnell was entitled to receive a retirement package worth more than $83 million.

Companies must now reveal the three highest-paid employees who are in policy-making positions. The new requirements also force companies to reveal more information about stock option granting practices, partly as a result of backdating practices now apparently used by many companies. Dividends on restricted stock grants must be disclosed in proxy statements, and any executive perks totaling more than $10,000 per employee must be disclosed.

Public companies will also be required to make it easier for people to find total executive pay in SEC filings. There must be a “Summary Compensation Table,” which includes a bottom line number for total pay, making it easy to pinpoint all of the upper level management compensation.

Fraud?

So does excessive executive pay cause more fraud in companies? Maybe, and maybe not.

A 2005 study conducted by the Academy of Management examined 435 companies that restated financial statements. When compared with similar companies that did not have restatements, it was found that companies with a higher proportion of executive pay in stock options were more likely to have restatements.

This study strongly suggests that at least one type of executive pay may lead to more improprieties with financial statements, although it does not appear that the study distinguished between financial statements restated due to fraud versus those restated due to errors.

Clearly, though, this study does not speak to all types of executive compensation, or even the issue of high compensation in general. Definitive causation between high pay and benefits and the propensity to commit fraud has not been proven.

On the other hand, my experience in investigating fraud leads me to believe that an attitude of greed can easily be related to both high compensation and fraud. I see greed as a factor in many corporate frauds, and it’s not too difficult to believe that highly compensated executives could begin to develop greedy tendencies.

So I do believe it’s possible that high compensation can encourage greed, which can in turn lead to fraud. However, there are so many other issues related to the commission of fraud by CEOs, that I am very reluctant to say that there is a direct correlation between pay and fraud. Therefore, any proposal to limit executive pay in order to decrease the risk of fraud should be met with great skepticism.

Excessive?

Over the years, companies have relied heavily on “pay for performance” compensation packages. When companies do well, the executives often receive large bonuses and lucrative stock options. This was meant to give c-level executives a big incentive to keep their companies running well.

Yet pay for performance has plenty of critics, as people wonder what kind of cuts might be made to achieve earnings targets, and whether or not lower-level employees are sacrificed in the interest of executive bonuses. The bottom line is that when a company shows positive earnings growth and rising stock prices, an executive stands to get bigger bonuses and stock options. That doesn’t necessarily mean that the bonus and options are excessive, but some would have you believe it is.

So if pay for performance isn’t the right way in the eyes of some, what is? Since there is always something to complain about, companies that do not tie compensation to a company’s performance get criticized too. This is an especially easy criticism to make when an executive has a more fixed pay structure, and a company does poorly. In that case, the critics would like to see executive pay slashed.

The issue of CEO pay being excessive is very subjective, and it’s not clear who is qualified to make judgments about what is excessive and what is not. The arguments that the pay is too high are easy to fall for, but I’m leery of making a broad judgment about the issue because there are so many differing opinions. After all, my own pay might be considered excessive by some, even though I’m convinced that the market will only pay me whatever my services are truly worth.

None of the Above

Some think that greater disclosures about executive pay will help keep the compensation and benefits in check. On the other hand, ther
e are those who suspect that it may cause executive pay to jump even higher, as companies now have to keep up with the others to compete for talent.

The bottom line is that the free market is at work in hiring, firing, and paying CEOs and other upper level executives. If shareholders object to executive pay, they are free to take action against the boards of directors who authorize such pay.

And shareholders have taken action. Proposals have been set forth to limit pay, to make performance guidelines stricter, and to limit severance packages. While boards may resist these proposals, the shareholders can have an impact by bringing such issues to a vote.

It is easy for the press and business analysts to be critical of executive earnings in the millions of dollars, sometimes even referring to executive compensation as “entitlement” programs. Yet at the end of the day, the market will decide.

If the market dictates that there are few qualified people to lead large companies, compensation and benefits will likely rise to address the supply and demand issue. At the end of the day, pay and benefits for top executives can and should be controlled by the market, rising and falling in response to the need to attract, retain, and motivate management.

If CEOs aren’t doing their jobs, they will lose them. If they are performing at a high level, they will reap the rewards of a job well done.

Tracy L. Coenen, CPA, MBA, CFE, is the president of Sequence Inc., a forensic accounting firm with offices in Milwaukee and Chicago. Coenen can be reached at [email protected] or 414-727-2361.