Corporate America's Pay Pal
by Gretchen Morgenson
New York Times, October 15, 2006
You may not know Frederic W. Cook, but if you are a shareholder or employee who has watched executive pay rocket in recent years, you are likely to be acquainted with his work.
As the nation's leading executive compensation consultant, Mr. Cook and his colleagues at Frederic W. Cook & Company are probably responsible for creating more wealth for executives over the last 20 years than any other pay advisers.
He and his associates have advised on the $1.1 billion option grant that Computer Associates gave its top three executives in 1998 and the $83 million pension benefit amassed by Hank McKinnell, Pfizer's recently ousted chief executive. And in 2000, court documents show, Mr. Cook's firm provided advice to Tyco International's compensation committee, which heaped a $95 million pay package on L. Dennis Kozlowski, its chief executive at the time.
Mr. Cook also invented "reload stock options," the financial equivalent of perpetual-motion machines, which helped bestow millions of lucrative shares on executives over more than a decade until an accounting change forced them into disfavor. This year, officials at the Business Roundtable, a corporate lobbying organization, hired Mr. Cook to counter critics of executive pay; his study tried to justify rapid increases in the packages.
The soft-spoken Mr. Cook, 65, does not see himself as corporate America's Pied Piper of pay. Instead, he asserts, he is just a "foot soldier" in the army of capitalism. But in any study of executive compensation practices over the last 25 years, the contributions of this foot soldier are more akin to those of a field marshal.
"Fred Cook is the dean of compensation consultants," said Broc Romanek, a former S.E.C. lawyer and editor of CompensationStandards.com, an educational service that provides guidance on pay issues.
An examination of Mr. Cook's career, clients and counseling neatly parallels the explosive growth in executive compensation packages, offering a window onto the mechanics and machinations behind the growing windfalls. From 1970 to 2000, according to a Harvard study, the median compensation awarded to the three highest-paid officers at major American corporations rose to $4.6 million from $850,000. More recently, that figure has settled down to around $4.35 million.
Concerns about shareholder value, corporate governance and the economic and social impact of soaring C.E.O. pay has led to mounting criticism of compensation practices across the nation. Warren E. Buffett, in his annual report to Berkshire Hathaway shareholders this year, decried the role that consulting firms play in awarding lofty compensation packages that have little to do with how well a company performs. Mr. Buffett's generic name for these accommodating firms is "Ratchet, Ratchet & Bingo."
Since its founding in 1973, Mr. Cook's firm has served more than 1,800 clients, including more than half the world's 250 largest corporations. The firm, privately held, employs 50 people; it is based in New York and has offices in Chicago, Los Angeles, San Francisco and London. Cook & Company engineered compensation innovations that other consultants and corporations have emulated, innovations all made palatable by an argument that Mr. Cook propagated to justify this huge transfer of wealth to chief executives: that newfangled pay packages aligned the interests of shareholders and management.
IN corporate boardrooms across America, Cook & Company is renowned and relied upon when pay is in play. When the board of Empire HealthChoice Inc., a nonprofit insurer in New York, set out to increase its executive pay to reflect private-sector practices, it called on Mr. Cook. According to a 2002 examination of the company's pay practices by the New York State Insurance Department, the nonprofit's directors selected Mr. Cook "in an effort to be creative when considering total compensation." After HealthChoice hired Mr. Cook's firm, the insurer's pay packages increased significantly; the insurance department's report questioned assumptions that Mr. Cook's study used to recommend pay raises at the insurer.
Creativity where executive pay is concerned is something in which Mr. Cook takes great pride. On many occasions -- at conferences and before Congress -- he has identified himself and his firm as "the thought leader" on matters involving executive compensation. Although Mr. Cook declined to be interviewed for this article, previous interviews with him, a review of his speeches, writings posted on his firm's Web site and discussions with industry peers displays his singular influence on the development of executive pay practices.
In declining to be interviewed, Mr. Cook said that he could not comment on specific clients that he and his firm have worked with, because of confidentiality policies. But amid concerns about escalating compensation packages, some of those who advise corporations on pay say consultants like Mr. Cook can do more than simply engineer or rubber-stamp outsized salaries and stock options.
"It's not so much that the consultant facilitates, but that the consultant doesn't apply the brakes," said Brian Foley, head of an independent consulting firm in White Plains. "You have to read clients the riot act from time to time -- you have to be willing to walk away to the point of being fired."
It is entirely possible that in recent years Mr. Cook and his colleagues have tried to brake the runaway pay train at some or all of the companies they advise.
On Thursday, Mr. Cook addressed 2,000 compensation professionals at a conference in Las Vegas. Mr. Cook told the gathering that he tried to advise companies to do the right thing on pay but was sometimes rebuffed. He cited two occasions when he encouraged clients to rein in exorbitant executive retirement plans but lost the argument. Asked if he ever thought about walking away from clients with whom he disagreed, he said, "It wasn't a quitting issue."
Even so, Mr. Cook's willingness to attach his formidable name to the Business Roundtable's study exonerating corporate compensation practices suggests that he is friend, not foe, to executives on the receiving end of lottery-sized payouts.
While reasonable people continue to argue both sides of the executive pay question -- some say pay is exorbitant, others say it is justified -- few dispute that consulting firms like Mr. Cook's have given corporations the fuel they needed to put compensation growth on the fast track.
Compensation consulting firms range from smallish, independent shops like Cook & Company to huge conglomerates like Hewitt Associates and Towers Perrin that house sizable pay-advisory subsidiaries. Although nearly 50 compensation consultancies operate nationwide, up from just a handful 20 years ago, they have been largely hidden from investors' view because publicly traded companies have not had to identify them in their pay disclosure filings. That is about to change: the Securities and Exchange Commission has instituted new rules that will require companies to identify their compensation consultants in public filings next year.
The business is very profitable, but analysts say that large firms often use pay consulting as a loss leader so they can snare more lucrative consulting contracts. Any consultant that pushes back on executive pay packages runs the risk of putting other consulting contracts at risk.
A spokeswoman for Hewitt Associates said it had strict policies in place to ensure the independence and objectivity of all its consultants, including those working on executive compensation.
A Towers Perrin spokesman said the firm "rigorously applies policies, safeguards and controls to ensure that the objectivity of our professional advice to clients on executive compensation matters is not compromised by any other consulting assignments we undertake for our clients."
In that context, some consultants say, the new S.E.C. disclosure rules would have been more robust if, in addition to mandating disclosure of the consulting firm's identity, they also required a rundown of other services a firm provides to each of its clients. But they do not. Pressure to do more business with a compensation client, some consultants say, has given advisers an incentive to push the boundaries of executive pay practices.
Consultants and the companies often justify pay packages by relying on comprehensive surveys of compensation practices among peer companies. It is out of these studies that the famous percentiles emerge that keep pay rising. Companies report their executives' pay as landing in a particular percentile of their peer group -- the 75th is common -- to make it seem reasonable.
BUT the data set that these surveys use can be skewed to include, for example, large, one-time stock option grants given to corporate executives for a specific reason -- to reward a promotion, for example, or to induce a top manager to join the company. Though these awards are unusual, they are included in surveys, driving up the pay of every executive who used them.
The bull market in stocks that began in 1982 and ran with some stumbles through the 1990's also gave consultants an opportunity to juice their clients' take by showing them that total compensation across corporate America was rising. Mr. Cook pointed this out in a speech last year. Because option grants were valued at the price of the underlying stock when awarded, he said, in periods of rising share prices, consultants could use the fact that total compensation from options was rising in their studies. For companies whose stock prices lagged behind the market or their peers, consultants recommended increasing the size of the option grants, to remain competitive.
"All the benchmarking data everyone is using has been inflated over the past 15 years so most of that data is useless," Mr. Romanek said. "Everybody should start fresh."
It is easy to see why compensation consultants are so popular -- and powerful -- with top executives today. But that was not the case when Mr. Cook started out. At the time, compensation consulting was usually a small subsidiary at firms like McKinsey & Company and Booz Allen Hamilton, and actuarial firms like Towers Perrin.
After graduating from Dartmouth, Mr. Cook spent four years as an infantry officer in the Marine Corps. He began his career at Towers Perrin in 1966, according to a 2001 profile of Mr. Cook in Workspan magazine, a publication for compensation and benefits professionals.
Mr. Cook struck out on his own in 1973, when he was 32 and, according to the magazine profile, he felt that he had little to lose. He cashed in $25,000 in a profit-sharing account he had at Towers Perrin and rented office space in the Murray Hill neighborhood of Manhattan. Cook & Company's headquarters are still there.
Mr. Cook set himself apart early on, by bringing a keen interest in accounting to executive pay issues. Many companies were concerned about making awards that might prompt tax problems, so a consultant with accounting expertise was in demand. Compensation, meanwhile, was becoming more complex.
According to "Board Perspectives: Building Value Through Compensation," a book by Paul Hodgson, an expert on compensation issues, stock options were popular throughout the 1960's, before federal legislation in 1969 reduced their tax advantages. Then the bear market struck and millions of options were underwater. Other long-term incentives replaced options, and cash bonuses became more popular throughout the 1970's.
During these years, few corporate boards had compensation committees. That changed in the 1980's, when executive pay began to climb at a faster pace. In 1984, the Internal Revenue Service moved to limit the payment of large severance packages known as "golden parachutes." Two years later, when the capital gains tax rate rose to 28 percent, cash and option gains found themselves on equal footing as far as taxes were concerned.
Enter Mr. Cook. In 1988, he came up with a new type of stock option -- the reload -- that put him and his firm on the map. Mr. Cook became the ambassador of reloads, selling them to corporate clients interested in pleasing executives. As he explained them, reload stock options were "enhancements" that allowed executives to increase their stock ownership, aligning their interests with those of shareholders.
IN reality, reloads were awards that were automatically replaced each time they were exercised. For example, if an executive received a grant of 1,000 options carrying a strike price of $10 a share, and later exercised them for $20 a share, he or she instantly got 1,000 more options with a new strike price of $20. Some reloads even had a special feature that covered the tax bills generated by option exercises. In these cases, the replacement option covered a larger number of shares than the original award to pay for taxes due, further diluting the equity stakes of existing shareholders.
Mr. Cook designed the first reload stock option plan for executives at the Norwest Corporation, a Minneapolis bank holding company. The plans soon spread through corporate America like wildfire. In a 1998 analysis of reloads, Mr. Cook noted one reason for their increased popularity. "As executives who have experienced the opportunities of reloads move to other companies or join boards of directors," he wrote, "they are likely to influence the spread of reloads as a tool to obtain the benefits it provides."
By 2001, reloads had become so popular that Mr. Cook told clients that about one in five of the largest United States companies were using them. About half that many were using tax reloads, he said. In 1997, for example, Sanford I. Weill received 20 different option grants, all with reload features, worth an estimated $142 million. Reloads contributed to an estimated $1 billion received by Mr. Weill over 17 years at the head of Citigroup and some of its predecessor companies. Through a spokesman, he declined to comment.
Some analysts eventually blamed reloads for an enormous and, some said, stealth transfer of wealth from shareholders to managers. James F. Reda, an independent pay consultant in New York, was among the first to raise a red flag. In a 1999 article in the Journal of Compensation and Benefits, he and Thomas Hemmer, now an accounting professor at the University of Houston, concluded that reloads were bad for shareholders and that limits should be placed on their use.
"I have a lot of respect for the technical aspects of reloads, but I didn't like that they weren't in the best interests of shareholders," Mr. Reda said. "I was always surprised about how many board members thought it was in the shareholders' interests. I never could figure out how."
Reloads fell out of favor three years ago after accounting changes made them less attractive. But Mr. Cook has found other ways to keep compensation aloft, and his firm's work on pay packages for executives at Computer Associates and Pfizer ended up angering some shareholders at both companies.
Cook & Company advised Computer Associates on a pay plan that in 1998 produced a $1.1 billion stock award for Charles B. Wang, its chief executive; Sanjay Kumar, its president at the time; and Russell M. Artzt, an executive vice president. The award was a result of an employee stock ownership plan approved by shareholders in 1995. Under the plan, the three men stood to share as many as six million options if the company's stock traded above certain preset levels on at least 30 trading days over the following five years. Mr. Wang was to receive 60 percent of the grant; Mr. Kumar, 30 percent; and Mr. Artzt, 10 percent.
Computer Associates' compensation committee told its shareholders that the plan would "promote the creation of stockholder value by encouraging, recognizing and rewarding sustained outstanding individual performance by certain key employees who are largely responsible for the management, growth and protection of the business." The committee also said the plan would help shareholders by retaining key individuals.
The plan generated its first big payment to the executives in 1998. Mr. Wang received shares worth $670 million while Mr. Kumar got shares worth $335 million. Mr. Artzt got a grant worth $112 million. All three executives later returned 22 percent of the shares to settle a stockholder suit.
The company declined to comment beyond saying that the plan was no longer in place.
High-level executives at Computer Associates, now known as CA, were later found to have artificially inflated sales figures in 1999 and 2000. Mr. Kumar pleaded guilty earlier this year to eight counts of fraud and obstruction in the case. Neither Mr. Wang nor Mr. Artzt was named in the case, and Mr. Artzt remains with the company.
Mr. Cook's firm also guided Pfizer on the pension plan that awarded $83 million to Mr. McKinnell. When the company disclosed the value of the plan, shareholders were outraged because their stockholdings had fallen by 50 percent on Mr. McKinnell's watch. The pension became the source of picketing and angry questions at the company's annual meeting in April.
Mr. McKinnell's pension grew so large because it contained a highly unusual element, a Pfizer spokesman explained at the time. While most pension benefits are figured by using a multiple of an executive's salary and bonus, the pension calculation for Mr. McKinnell included the value of Pfizer shares he had received under long-term incentive arrangements from 1993 to 2001. In 2000, Pfizer's compensation committee decided to discontinue that unusual inclusion.
As for the Cook firm's work for Tyco, which related to stock options, a spokeswoman for Tyco declined to comment.
Last year, Mr. Kozlowski was found guilty of looting the company and covertly selling shares while artificially inflating company results.
OF course, it is possible that Mr. Cook and his colleagues have tried to reduce the size of their clients' pay packages over the years and have been overruled by them. Consultants are, after all, just advisers. They cannot force clients to follow their advice.
But in testimony before Congress last year on the subject of executive compensation, Mr. Cook argued that a bill to try to rein in pay -- the Protection Against Executive Compensation Abuse Act -- was undesirable. Mr. Cook used most of his testimony to criticize news-media reports on executive pay. "The media has been flooded with a multitude of distorted, misleading and oftentimes erroneous statistics chosen to portray U.S. C.E.O.'s and board governance in a negative light," he said.
At an executive pay conference last year, attendees were buzzing after James Dimon, the chief executive of J. P. Morgan Chase, delivered his keynote speech. Mr. Dimon took pay consultants to task in his talk, decrying, among other things, the use of peer-group surveys to "ratchet things up."
With Mr. Cook in the audience, Mr. Dimon also described the corporate deployment of stock options as "very capricious" and said that when he arrived in 2000 as Bank One's new chief executive, he immediately cut back on pay items and perquisites -- supplemental retirement plans, company cars and club memberships -- awarded to top executives. It was too much, he said, because well-compensated professionals should be able to pay their own club dues and car bills. And he eliminated supplemental retirement plans at Bank One.
Who designed the plans that Mr. Dimon so happily and proudly scrapped? Cook & Company.
Articles in this series are examining executive compensation. Previous articles in the series can be found at nytimes.com/business.
Eric Dash contributed reporting for this article.
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