12 JUNE 02: CORRUPTION,
2002 CORPORATE STYLE

From the 9 June 02 New
York Times:

Heads I Win, Tails I Win

By ROGER LOWENSTEIN

Every year, in an annual
rite of spring, SBC Communications discloses the

principles that it follows
in setting pay for its top executives.

    As with
all companies, this information is contained in the annual proxy

statement, and as is also
common, SBC purports to follow some basic credos of

American business.

    
A sprawling Baby Bell with headquarters in San Antonio, SBC says its aim
is to

attract and retain high-quality
executives, those who will ”enhance the

profitability” of SBC.
And its foremost principle in achieving this goal is to

”align the financial interests
of SBC’s executives with those of SBC and its

shareholders.”

    This
is an all-American notion, just as SBC is an all-American company. Though

not as well known as AT&T
and MCI, SBC provides the dial tone in the Southwest,

California, the Midwest
and Connecticut — that is, to one in three Americans.

SBC is typically American
in one other respect: somewhere along the way, its

stated compensation principles
became little more than platitudes.

    For the
purpose of examining a single C.E.O.’s compensation, I picked SBC for

its unspectacular qualities.
It is profitable and professionally managed, and

its C.E.O. is well regarded
in his industry. Like many C.E.O.’s, he pursued a

bold growth strategy for
much of the 90’s, had some good early years and more

recently gave back much
of his gains. In the last three years, his stock has

fallen 27 percent — more
than either the Standard & Poor’s 500 or the stocks of

his Baby Bell peers. But
the rate at which the boss was compensated kept

growing.

    SBC’s
chief executive is Edward E. Whitacre Jr. A 60-year-old, 6-foot-4 lifer
in

the Bell system, he was
hired by the old Southwestern Bell back in 1963 for a

job that included hammering
fences. He has been the boss since 1990 and now

rakes in an annual sum that
salaried executives a generation ago could scarcely

dream of. Last year, the
third year in a row in which SBC’s share price

declined, Whitacre received
the largest pay package of his career — one with a

present value of $82 million.

    SBC is
not, by present standards, a compensation horror story. Ed Whitacre’s

record bears little resemblance
to the catastrophes overseen by others in his

industry, like the lavishly
paid C.E.O.’s employed by Lucent, AT&T and WorldCom.

Nor did Whitacre preside
over an Enron-style scandal or pocket tens of millions

before taking his company
into bankruptcy, as Linda Wachner did at Warnaco.

    Whitacre
exemplifies how the system itself is shot through with hypocrisy. And

because his tenure is long,
his collected proxies offer a view of the system’s

gradual corruption. Over
his 12 years as C.E.O., while Whitacre reaped a

fortune, his stockholders
have done precisely average. Their return from

appreciation and dividends
is 11.5 percent a year — a notch below the S&P 500,

at 12.8 percent, and a sliver
higher than its peer companies.

    Executive
pay has been soaring for two decades, but over the last couple of

years, as many big companies
have seen their stock pummeled, the

pay-for-performance rationale
that was supposedly driving these packages has

been exposed as a fraud.
Moreover, as executive pay has grown ever more

dependent on share prices,
the incentive to manipulate earning reports and

thereby boost shares has
also increased.

    The superinflation
of executive wages began in the 1980’s. Following a dismal

decade for stocks, corporate
boards began focusing more on their share prices.

This was largely defensive:
low stock prices spawned a takeover wave. The best

defense against a T. Boone
Pickens or a Carl Icahn was to get your stock out of

their reach.

    ”Promoting
shareholder value” became watchwords of corporate America, as if

that hadn’t been the duty
of management all along. Boards wanted to make

executives think like entrepreneurs.
The model became Silicon Valley, where

companies motivated the
troops by liberally dispensing options (and where many

entrepreneurs became fabulously
wealthy). The beauty of options, to corporate

boards, is that they don’t
count against the income statement. They are like

Monopoly money. Of course,
the more you issue options, the more you dilute the

value of existing shares,
but in the bull market of the 1990s, this was neatly

obscured.

    Ed Whitacre’s
cash take, at first, was relatively stable — in 1992, he got $3.1

million; two years later,
$4.4 million. But as SBC grew, Whitacre was rewarded

with options that gave him
the chance to earn a small fortune over many years.

For instance, in 1994 Whitacre
received options entitling him to buy 161,739

shares, at the price prevailing
in 1994, over the next decade. So if, for

instance, the stock doubled,
Whitacre stood to make $6.6 million; if it tripled,

he would make $13 million.

    That
didn’t completely align his interests with those of cash-paying

shareholders, because Whitacre
had nothing to lose if the stock went down. Also,

a 10-year fixed-priced option
— the standard variety in corporate suites —

entails something of a freebie,
because even if Whitacre did only a mediocre

job, the stock was likely
to rise somewhat. (Even a portfolio of Treasury bonds,

vintage ’94, would have
nearly doubled.)

    So Whitacre’s
options would reward him not just for the part of the stock’s rise

that reflected superior
performance, but also for the part that reflected what

might be termed normal business
progress, or progress at the rate of risk-free

Treasury bonds.

    Meanwhile,
in industry circles, Whitacre was winning a name as a tough and

effective leader with an
L.B.J.-like aptitude for cajoling regulators. He was

especially renowned for
his skill at lobbying to keep long-distance companies

out of local services, a
monopoly. He also pushed SBC into sexy new terrain,

like wireless, long distance
and the Internet.

    Profiles
described Whitacre as hard-working, not given to publicity and

uninterested in corporate
frills. While he maintained a ranch near Marble Falls,

Whitacre wore business pinstripes
to work, not cowboy boots.

    He also
developed a strong interest in stock options. In 1994, SBC’s stock price

was virtually flat. But
the following year, Whitacre got a fresh — and

substantially larger —
batch of options. Though the shareholders received a

poor return, Whitacre was
granted a fresh start.

   
Now that he was getting huge annual grants, the arithmetic subtly changed.
To

become
rich, Whitacre merely had to raise the stock above its level of any

particular
year. Since stocks fluctuate, some of his grants would tend to be at

depressed
prices, meaning that his ”option” to get wealthy became a virtual

certainty.
The frequency of the awards thus undermined the principle of pay for

sustained
long-term performance. By turns, a system designed to motivate became

one
to simply enrich.

    In 1995,
SBC shares rose sharply; in 1996, they fell. And in the following year,

Whitacre got what was then
his biggest option grant ever, 345,000 shares. Those

1997 options didn’t merely
give Whitacre a fresh start; they handed him a golden

carrot for getting the stock
back to where it had been. They were paying him for

treading water.

    The other
way his pay changed was that his board began to grant significant

compensation aside from
options. In 1995, Whitacre got $4.9 million. In 1996, an

off year for SBC, he got
$6.6 million. In 1997, the total rocketed to $15.7

million. Including options,
the total for that year was $21 million. These sums

were distributed over seven
different categories: salary, bonus, ”other,”

restricted stock, options,
long-term incentive plan and ”all other.” This

seven-pocket approach served
two purposes. First, the dollars that Whitacre

received in any one category
were only a fraction of the total, minimizing the

appearance. Secondly, the
board determined the total for each category by

different yardsticks, as
if each were independent of the other. He would get

millions out of one pocket
for overall leadership, millions out of another for

directing some special event
like a merger and still more to ”retain” his

future services.

    In 1997,
for instance, Whitacre got $8.7 million as a ”special retention

grant.” The most curious
aspect of that award was that in 1998 Whitacre

received another retention
grant, this time of $12.5 million. He has received

comparable awards in every
year since, as if he were somehow both an

indispensable captain and
a notorious flight risk.

    Whitacre
also benefited from a permissive redundancy. Every year, he got a

”long-term incentive”
— in 1997 it was $2.2 million — rewarding him for the

rise in the stock over a
three-year stretch. This just duplicated the effect of

his options.

    In 1997
as well, the board awarded Whitacre a $3.3 million ”bonus,” largely

for his ”excellent leadership”
in fashioning a merger with Pacific Telesis

Group. This mimicked a national
trend of awarding bonus pay for work once

considered to be part of
the job. After all, if the Telesis merger turned out to

be a success, Whitacre would
presumably benefit via his stock options. And if

the merger was too new to
bear fruit for stockholders, why was the board

rewarding Whitacre ahead
of the people whose returns his were supposed to

reflect?

    His total
package, including the present value of options, soared to $29 million

in 1998 and $25 million
the following year. But in 2000, the board was forced to

admit that various officers,
including Whitacre, had failed to meet their yearly

targets. Accordingly, his
bonus was cut by 25 percent to a mere $4.5 million.

    Nonetheless,
Whitacre got a 32 percent hike in salary. The multipocket approach,

a staple of the consultants
who design packages for SBC and most other big

corporations, thus put the
lie to the appearance of risk; if Whitacre was

punished from one pocket,
he was promptly redeemed from another. Indeed, the

board doubled his options
award, raising the total compensation for 2000 to a

present value of $29 million.
The total kept on rising.

    Increasingly,
the board’s human resources committee, which deals with

compensation, cited metrics
related to SBC’s size or general reputation but not

necessarily to its profitability
or long-term stockholder returns. Though SBC’s

returns had outpaced those
of other Baby Bells in Whitacre’s early years, in the

last five years they were
20 percentage points lower. And that is the period

when Whitacre has gotten
the bulk of his pay. Boards typically take longevity

into account, and SBC is
no exception-almost as if the board felt it had to make

up for some suddenly felt
neglect when Whitacre was just cutting his teeth.

    In any
case, the proxy has found plenty on which to commend the C.E.O. — for

”transforming SBC from
a regional carrier to a national and global

competitor,” for meeting
”extraordinary challenges,” for becoming ”one of

the leading chief executive
officers in the United States.”

    The directors,
who earn $60,000 a year, no doubt believe this; they have been

close to Whitacre and have
been endorsing his pay for a long time. He has also

been endorsing theirs. Two
of SBC’s nominally independent directors — August A.

Busch III, chairman of Anheuser-Busch,
and Charles Knight of Emerson Electric —

run companies for which
Whitacre is a director. Most of the other 18 directors

have either served with
Whitacre for at least 10 years or were directors of

companies that Whitacre
acquired.

    Certainly
there was much to admire in Whitacre’s bold management. With the world

of telecommunications rocked
by technological change and regulatory upheaval,

Whitacre reckoned that to
sit still was to invite slow decimation. He followed

the Telesis merger by acquiring
Southern New England Telecommunications

Corporation in 1998 and
Ameritech, a giant rival, in 1999 — a blockbuster $62

billion combination.

    It is
not clear that the merger strategy was wrong or that a better strategy
was

at hand. But the telecom
industry was increasingly unattractive. Technology was

reducing the cost of service,
and rivals were snapping up slices of SBC’s former

monopoly. While SBC’s revenues
grew to $40 billion, the empire ranging from

Capetown to Hartford with
nearly 200,000 employees, most of its cash flow was

being consumed by reinvestment,
and its growth was starting to sputter.

    For the
last four years, SBC’s net income growth has been anemic. On closer

examination, the picture
was worse. Corporations with overfunded pension plans

are allowed to book some
of the excess as profit, even though the money never

reaches the shareholders.
In the late 1990’s, as the stock market boomed, SBC’s

plan, like many, became
overfunded, allowing SBC to pad its net income. In 2000,

this contributed $1.1 billion,
14 percent of its total. Then, in 2001, SBC’s

green eyeshades raised the
rate at which they assumed that the pension plan

would appreciate in the
future — by a full percentage point. Since the market

was then in meltdown, this
was a curious decision. In fact, according to a study

of 50 big pension plans
by Milliman USA, SBC raised its rate by more than any

other company (most didn’t
raise it at all). In real dollars, SBC’s plan lost

money last year. But since
its assumed rate of appreciation was higher, so was

the contribution to income.
Last year it equaled $1.45 billion — 20 percent of

SBC’s so-called bottom line.
In setting pay levels, SBC says the board

distinguished between telephone
revenue and pension plans. The stock market

presumably did not.

    SBC’s
proxies have repeatedly cited 1996, the year of the Telecommunications

Act, as the start of Whitacre’s
transformation. In 1996, SBC earned $1.73 a

share (split-adjusted).
Even if you accept SBC’s reported profit for 2001 at

face value, its per-share
earnings, adjusting for a stock split, have grown by

only 4 percent per annum
over that entire span.

    So how
did SBC’s board justify an $82 million package for 2001? The proxy cited

Whitacre’s ”solid financial
results,” as well as SBC’s strong balance sheet,

the ”extraordinarily challenging”
market conditions and Whitacre’s status as a

”leading” C.E.O., deserving
of a salary and bonus in the 75th percentile of

his peers.

    There
is nothing unusual in this. Most companies justify their pay levels

according to peer groups;
all believe their own C.E.O. deserves to be in the

upper echelon; and each
thus helps to ratchet up the scale for all. Until

recently, Verizon, a rival
Baby Bell, had two C.E.O.’s, each of whom received

$14 million last year in
addition to at least $14 million apiece in options

value. Whether SBC or Verizon
got more for the C.E.O. buck becomes a senseless

debate; indeed, at such
levels, all attempts to rationalize pay become

meaningless.

    After
reporting this article from public filings, I called SBC for comment. Jim

Ellis, the general counsel,
took strong exception to the idea that his boss is

overpaid. ”If he’s a poster
boy, it isn’t for abusing the system or being off

the reservation,” Ellis
maintained. SBC’s performance, he said, ranked in the

top third of a group of
20 companies examined by the board, yet his pay was less

than the median of that
group. Ellis added that Whitacre ”has done exceedingly

well in positioning the
company not just for growth periods but for down

periods.”

    The C.E.O.’s
most recent package included a Bunyan-size options grant of 3.6

million shares. That was
partly ”to assure his continued presence,” Ellis

said. The present value
of these options, according to the compensation

consultant Pearl Meyer &
Partners, is $61 million. In effect, the board turned

the stock’s decline to Whitacre’s
advantage,
since it chose a time when the

stock was down (and options
were cheap) to give him four times as many shares as

when the stock was at its
peak. Of course, Whitacre will have to turn the stock

around to cash in on the
award. But if he does, he will reap an immense fortune

— tens of millions of dollars
— merely for recapturing the ground that his

shareholders had already
lost.

 

Roger Lowenstein, the
author of ”When Genius Failed,” writes frequently for

the magazine and is working
on a book about the dot-com bubble.