Drug Industry Is on Defensive as Power Shifts(NYTimes, 11/24/06)

November 24, 2006
Drug Industry Is on Defensive as Power Shifts
By ROBERT PEAR
WASHINGTON, Nov. 23 — Alarmed at the prospect of Democratic control of Congress, top executives from two dozen drug companies met here last week to assess what appears to them to be a harsh new political climate, and to draft a battle plan.
Hoping to prevent Congress from letting the government negotiate lower drug prices for millions of older Americans on Medicare, the pharmaceutical companies have been recruiting Democratic lobbyists, lining up allies in the Bush administration and Congress, and renewing ties with organizations of patients who depend on brand-name drugs.
Many drug company lobbyists concede that the House is likely to pass a bill intended to drive down drug prices, but they are determined to block such legislation in the Senate. If that strategy fails, they are counting on President Bush to veto any bill that passes. With 49 Republicans in the Senate next year, the industry is confident that it can round up the 34 votes normally needed to uphold a veto.
While that showdown is a long way off, the drug companies are not wasting time. They began developing strategy last week at a meeting of the board of the Pharmaceutical Research and Manufacturers of America.
Billy Tauzin, president of that group, a lobbying organization for brand-name drug companies, recently urged Representative Edolphus Towns, Democrat of New York, to seek a position as chairman of a powerful House subcommittee, said Karen Johnson, a spokeswoman for Mr. Towns. The subcommittee has authority over Medicare and the Food and Drug Administration.
Democrats have yet to decide who will head the subcommittee.
Mr. Tauzin, a former congressman, also met with Senator Byron L. Dorgan, a North Dakota Democrat who has been trying for six years to allow drug imports from Canada. The industry vehemently opposes such legislation.
James C. Greenwood, president of the Biotechnology Industry Organization, another trade group, said, “There is a lot of pent-up animosity among Democrats against the pharmaceutical industry.”
Mr. Greenwood, a former Republican congressman from Pennsylvania, said he had a list of 37 Congressional Democrats whom he intended to call in the next month.
Amgen, the biotechnology company, recently disclosed that it had retained as a lobbyist George C. Crawford, a former chief of staff for Representative Nancy Pelosi of California. Ms. Pelosi, the House Democratic leader, is in line to become speaker in January and has said that the House will immediately take up legislation authorizing Medicare to negotiate prices with drug manufacturers.
The 2003 Medicare law prohibits the federal government from negotiating drug prices or establishing a list of preferred drugs.
Amgen is also seeking strategic advice from the Glover Park Group, a consulting firm whose founders include Joe Lockhart, a former press secretary for President Bill Clinton.
Other major drug companies have been snatching up Democratic former-aides-turned-lobbyists. Merck recently has hired Peter Rubin, a former aide to Representative Jim McDermott of Washington, one of the more liberal House Democrats. Cephalon has hired Kim Zimmerman, a health policy aide to Senator Ben Nelson, a conservative Democrat of Nebraska.
The Biotechnology Industry Organization has retained Paul T. Kim, a former aide to two influential Democrats, Senator Edward M. Kennedy of Massachusetts and Representative Henry A. Waxman of California.
A Medicare expert who works for House Democrats said he recently received three job offers in one day from the drug industry, by telephone and in person.
At a dinner last week at the Hotel Monaco here, as part of their board meeting, pharmaceutical executives dissected the midterm election results with experts including Ed Goeas, a Republican pollster, and Stuart Rothenberg, the editor of a political newsletter.
Drug makers have not set a budget for their campaign. They and their trade groups already spend some $100 million a year on lobbying in Washington.
“We have new political realities to attend to,” Mr. Tauzin said in an interview after the board meeting. “We and our allies will do everything we can to defend the Medicare drug benefit, to get out the message that it is working.”
To reinforce that message, drug companies plan to mobilize beneficiaries and urge them to contact Congress.
“I’m putting my trust in beneficiaries,” said Mr. Tauzin, who represented Louisiana in the House for more than two decades, first as a Democrat and then as a Republican. Several recent surveys suggest that at least three-fourths of the people with Medicare drug coverage are satisfied.
But Representative Frank Pallone Jr., Democrat of New Jersey, who hopes to head the health subcommittee of the Energy and Commerce Committee, said price negotiations for Medicare were his priority.
“The 2003 Medicare law was essentially written by the drug industry,” Mr. Pallone said in an interview. “That’s why you don’t have negotiated prices. Republican policies have served special interests like the pharmaceutical industry, and the American taxpayer is paying the price.”
Drug lobbyists believe that the Senate will be receptive to their argument that price negotiations lead inevitably to price controls, and to restrictions on access to drugs, likely to be unpopular with beneficiaries.
Michael O. Leavitt, the secretary of health and human services, said the White House opposed federal price negotiations because they would unravel the whole structure of the Medicare drug benefit, which relies on competing private plans.
Among leaders who attended the board meeting last week were Kevin Sharer, chairman of Amgen; Jeffrey B. Kindler, chief executive of Pfizer; Sidney Taurel, chairman of Eli Lilly; and Richard T. Clark, chief executive of Merck.
Drug lobbyists say they want to work with the new Democratic majority, but that will not be easy. In its campaign contributions, the pharmaceutical industry has overwhelmingly favored Republicans over Democrats. Drug companies infuriated many Democrats in 2003, when they worked closely with Republicans to create the Medicare drug benefit, in a process from which Democrats were largely excluded.
On other issues, Democrats are pushing for stricter regulation of drug safety and for legislation to encourage development of low-cost generic versions of expensive biotechnology drugs. They are determined to allow imports of drugs from Canada, where brand-name products are often cheaper.
They want to investigate drug pricing and profits, drug advertising aimed at consumers and the marketing of drugs to doctors for purposes not approved by the Food and Drug Administration. Democrats may try to repeal some of the liability protections that have been given to vaccine manufacturers.
Outspoken critics of the pharmaceutical industry will gain power as a result of Senate committee assignments made last week. Senators Debbie Stabenow, Democrat of Michigan, and Maria Cantwell, Democrat of Washington, are joining the Finance Committee, which has sweeping authority over Medicare and Medicaid. Three liberal senators — Sherrod Brown of Ohio, Barack Obama of Illinois and Bernard Sanders of Vermont — are joining the Committee on Health, Education, Labor and Pensions, which oversees drug regulation and biomedical research.
The pharmaceutical industry lost one of its most effective defenders when Senator Rick Santorum, Republican of Pennsylvania, was not re-elected. The new Senate Republican whip, Trent Lott of Mississippi, is no friend of the brand- name drug industry. He supports bills to allow imports from Canada and to increase access to generic drugs.
Top pharmaceutical executives are hurriedly planning a response to the Democratic agenda.
“It’s all hands on deck,” said Ken Johnson, a senior vice president at Pharmaceutical Research and Manufacturers of America. “It’s like a hurricane warning flag. You don’t know where it will hit. You don’t know who will be affected. But everybody has to be prepared.”
Drug companies may be open to some changes in the Medicare drug benefit, but they say they cannot accept any form of price negotiation.
“The new Medicare program is clearly benefiting seniors and people with disabilities and has exceeded initial expectations,” Mr. Tauzin said. “But we are open to new ideas that could make it even better. We will propose at the same time we are opposing.”
Specifically, Mr. Tauzin said, drug companies would like permission to fill a gap in coverage that has angered many Medicare beneficiaries.
Many drug companies have programs to provide free drugs to people with limited incomes. When such programs are used to fill the gap in the Medicare drug benefit, they may run afoul of federal law — the anti-kickback statute — because they steer patients to products made by one particular company.
The drug industry is anxiously waiting to see details of the Democratic proposal. Lawmakers are weighing several options. At a minimum, Congress could simply repeal the ban on price negotiations, without requiring Medicare officials to do anything. Many House Democrats want to go further. They would direct Medicare officials to negotiate prices for a government-run prescription drug plan, which would compete with dozens of existing private plans.
The government could negotiate prices for all drugs or just for brand-name drugs that have no competition. Alternatively, Congress could require manufacturers to provide a specified discount, so Medicare would get the “best price” available to any private buyer.
Such details, defining the federal role, are immensely important and could determine the outcome of any votes in Congress.

6 in Germany Settle Landmark Case on Bonuses (NYTimes, 11/25/06)

November 25, 2006
6 in Germany Settle Landmark Case on Bonuses
By MARK LANDLER
FRANKFURT, Nov. 24 — Nearly seven years after he and other board members handed out thank-you checks for $73 million to the departing executives of an acquired German telecommunications company, Josef Ackermann has learned the high cost of his generosity.
Mr. Ackermann, the chief executive of Deutsche Bank, will pay 3.2 million euros ($4.2 million), as part of a settlement Friday with German prosecutors that will end a landmark criminal case. He and three other directors were accused of improperly enriching the managers of the telecommunications company, Mannesmann.
Klaus Esser, the company’s former chief executive, will pay 1.5 million euros. He received the bulk of the disputed bonuses after capitulating to a $183 billion takeover bid by Vodafone of Britain in early 2000.
In return for the payments, prosecutors will drop charges of criminal breach of trust that in the case of Mr. Ackermann could have cost him his job at Deutsche Bank, Germany’s flagship financial institution.
For the bank, the settlement lifts a legal cloud that had shadowed its otherwise prosperous performance in recent years under Mr. Ackermann’s aggressive foray into trading and investment banking.
A state court in Düsseldorf will review the settlement, and legal experts said that would probably happen on Wednesday.
Through six years of investigations, a trial, an acquittal and yet another trial, the Mannesmann case has come to symbolize the abiding resentment of many Germans for the sky-high executive compensation packages that are common in the United States, but still fairly unusual in Europe.
While this case is now almost certain to end without a conviction, legal experts said the size of the financial penalties would make board members at other German companies think twice before giving top executives anything beyond the euros stipulated in their contracts.
“This will sharpen the conscience of board members that they are not the owners of companies, but trustees for the owners,” said Theodor Baums, an expert in corporate governance at Goethe University in Frankfurt. “It takes away a certain discretion from the supervisory boards to reward people.”
Mr. Ackermann said he would pay the settlement out of his own pocket — a penalty that will sting, but only up to a point. During the trial, he testified that his annual income — including salary, bonuses and interest income on investments — was 15 million euros to 20 million euros.
The size of the payments was calculated based on the income of each defendant. Joachim Funk, the former chairman of Mannesmann’s supervisory board, will pay 1 million euros, while Klaus Zwickel, a retired labor leader and former board member, will pay only 60,000 euros.
Legal experts said a financial settlement had been likely ever since a federal court ruled last December that Mr. Ackermann and the other defendants must face a new trial. They had been acquitted of criminal charges in July 2004 after a lengthy trial by the Düsseldorf court.
The blunt and sweeping language used by the federal court in its ruling left little doubt that Mr. Ackermann and the other defendants would face a high hurdle in obtaining another acquittal.
Speaking of the money awarded to Mr. Esser and his colleagues, Klaus Tolksdorf, the court’s lead judge, said: “Such a bonus is nothing other than a waste of money, and that runs against their fiduciary duty. There was no incentive to management as a result of these payments.”
Testifying at their retrial, which began last month, Mr. Ackermann and Mr. Esser said the bonus payments were both a reward for raising the market value of Mannesmann and an incentive for Mr. Esser to see through the smooth integration of the company with Vodafone.
Given Mr. Esser’s fierce opposition to the takeover — which still ranks as the largest — it would have been hard, lawyers said, to argue that he could have played a meaningful role in the integration.
Nonetheless, legal experts said Mr. Esser initially resisted a settlement, since he said he was determined to prove his innocence. On Friday, he noted that the charges were now “off the table.”
Speaking in court on Friday, the prosecutor, Dirk Negenborn, said a settlement was preferable to another lengthy trial in which the penalties might not be any greater than the agreed payments. Six years of legal jeopardy had been a “considerable burden” for the defendants, he added.
Lawyers for Mr. Ackermann agreed, saying that the court would find “no certain answers in this unique case.”
For Mr. Ackermann, a 58-year-old Swiss-born investment banker, the case was a searing introduction to the German judicial system. During the first trial, he spent two days a week in court for six months. He did little for his image when he flashed a V-for-victory sign.
Still, Deutsche Bank steadfastly supported Mr. Ackermann, paying his legal bills and issuing statements on his behalf. But the retrial prompted new questions about whether his legal woes were becoming too big a distraction — not to mention a public relations fiasco.
Deutsche Bank did not issue a statement Friday, though an executive there said the news was greeted with relief.
“It’s a lot of money, but he’s free to carry on as chief executive, and he doesn’t have a criminal record,” said the executive, who spoke on condition of anonymity because of the pending court decision.
Analysts also welcomed the resolution of the case, which has always been viewed outside this country as something of a German curiosity. Mr. Ackermann, they said, could now return full time to the business of running Deutsche Bank.
Under his leadership, the bank has built a hugely lucrative bond-trading operation, based in London. More recently, it has raised its profile in its home market, buying two smaller German consumer banks.
“Ackermann has a good track record,” said Simon Adamson, a banking analyst with CreditSights, an independent research firm in London. “Most of the nervousness about this trial came from the fact that if had been forced to leave the bank, it could have set off a succession battle.”

Dollar Falls Sharply Against Euro and Pound (NYTimes, 11/25/06)

November 25, 2006
Dollar Falls Sharply Against Euro and Pound
By JEREMY W. PETERS and CARTER DOUGHERTY
Correction Appended

The dollar dropped sharply yesterday against a range of major currencies, with the euro breaking through $1.30 for the first time in a year and a half. The fall highlighted concerns about softness in the American economy as economies abroad continue to expand.

The currency sell-off came as investors weighed a number of issues that complicate the prospects of the United States in the coming months, including a huge trade imbalance with China and a slowing domestic housing market. On top of that, economic growth in some European countries is gaining momentum, threatening to siphon investment away from the dollar.

The dollar’s losses came in a thin trading day in which the British pound rose to its strongest value against the dollar in two years. The euro traded at $1.3079 yesterday afternoon, up from $1.2941 on Thursday. The pound was trading at $1.9317, up from $1.9156.

Stocks closed lower on Wall Street yesterday after a shortened holiday trading session that was soured by news of the dollar’s woes.

“To dismiss this as a technical correction is to overlook the structural reasons why the U.S. dollar is having a very hard time these days,” said Hans Redeker, global head of currency strategy at BNP Paribas in London.

Economists say the United States is in a vulnerable position compared with its global competitors. While the most recent data show that the trade imbalance tightened in September, the decline was largely a result of falling oil prices. The deficit between what Americans import and export was a negative $586.2 billion for the first nine months of the year, and it remains on track to break last year’s record of a negative $716.7 billion. The biggest chunk by far represents imports from China.

The trade gap will be one of the major issues that Treasury Secretary Henry M. Paulson Jr. and other top Bush administration officials discuss next month when they travel to China. Mr. Paulson, along with a delegation that will include Ben S. Bernanke, the Federal Reserve chairman, is expected to press Chinese officials on a number of economic issues, from cracking down on piracy to allowing the Chinese yuan to trade more freely in currency markets.

Analysts said that the dollar’s drop yesterday, which was accelerated by orders from traders to sell automatically once it fell past $1.30 against the euro, reflected a growing anxiety over Chinese economic policy. China’s central bank holds a large amount of American currency, and speculation has intensified recently that it could begin selling off dollars to avoid being burned if the dollar collapses.

Also lurking behind the dollar’s depreciation is the rising probability, in the view of some economists and currency investors, that a slowing American economy will force the Federal Reserve to begin cutting borrowing costs next year.

Against the backdrop of a European Central Bank that seems determined to tighten rates further next year, the appeal of dollar-denominated assets is falling as the prospect of higher returns in Europe rises.

“There can be no doubt that the E.C.B. has more shots in its gun,” said Erik Nielsen, chief Europe economist at Goldman Sachs in London. “If the Fed starts cutting next year, then the gap begins to widen.”

Already, the European Central Bank has signaled that it will raise rates by a quarter percentage point, to 3.5 percent, on Dec. 7, and bank watchers have been voicing rising expectations of more rate increases after that.

This week, data on German business confidence, French economic growth in the third quarter and a historically reliable gauge of business sentiment in Belgium all pointed toward stronger growth. All these factors are more likely than not to push the European bank to raise interest rates in a bid to head off inflation, a course of action that would damp the appeal of the dollar in relation to the euro, currency specialists said.

“This drop in the dollar has been justified for some time,” said Chris Turner, head of foreign exchange strategy at ING Baring in London. “The American economy could do more than simply land softly, and Europe is pretty strong right now.”

But there was no single event yesterday to touch off such a sharp drop in the value of the dollar. Rather, economists said, it was a culmination of recent signs of weakness in the American economy that investors found troubling. Some experts said that could suggest that the dollar’s losses would deepen.

Julian Jessop, chief international economist for Capital Economics in London, said in a research note yesterday that the sudden drop in the dollar was “an indication of a much more fundamental lack of support for the currency.” He said this suggests that “the falls will be all the larger once the markets do start to anticipate persistently sluggish growth.”

Jeremy M. Peters reported from New York and Carter Dougherty from Frankfurt.

Correction: Nov. 28, 2006

A front-page Inside summary on Saturday about the sharp drop in the dollar misstated China’s trade relationship with the United States, which was a factor in the currency’s decline. The United States runs a trade deficit with China, not a surplus.

Peer Pressure: Inflating Executive Pay (NYTimes, 11/26/06)

November 26, 2006
Peer Pressure: Inflating Executive Pay
By GRETCHEN MORGENSON
LIKE Lake Wobegon, Garrison Keillor’s fictitious Minnesota town where all the children are above average, executive compensation practices often assume that corporate managers are equally superlative. When shareholders question lush pay, they are invariably met with a laundry list of reasons that businesses use to justify such packages. Among that data, no item is more crucial than the “peer group,” a collection of companies that corporations measure themselves against when calculating compensation.

But according to a handful of pay experts who are privy to the design of pay practices at the nation’s largest corporations, many of these peer groups are populated with companies that are anything but comparable. They also say corporate managers themselves — who have an interest in higher pay — are selecting which companies make it into a peer group. And because these companies are often inappropriate for comparison purposes, their use has helped inflate executive pay in recent years.

“The peer group is the bedrock of the compensation philosophy at a company,” said James F. Reda, an independent compensation consultant in New York. “But a lot of people do it by the seat of their pants, and that is part of the reason why executive pay has really skyrocketed.”

The use of peer groups to calculate executive pay has become ubiquitous in recent years. This is partly in response to the Securities and Exchange Commission’s requirement that companies compare their stock performance with a peer group in tables in the section of their proxy filings devoted to shareholder returns. Theoretically, these tables allow investors to compare their company’s performance against objective benchmarks.

But as is true with much about executive pay, details about exactly how peer groups are compiled have been kept under wraps. The worry among investors, of course, is that executives, consultants and directors simply cherry-pick peer-group members, thereby pumping up pay packages.

Current disclosure rules require neither the identification of companies in a compensation-related peer group nor the rationale behind their selection. Usually, the most a shareholder learns about companies in a compensation peer group is that they are in the same industry or of a similar size.

This ambiguity will change when new Securities and Exchange Commission disclosure rules go into effect on Dec. 15. The rules will require a corporation to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy.

Under the new rules, company officials will also have to certify the accuracy of their pay disclosures. As a result, peer groups are likely to attract increased scrutiny, said Mark Van Clieaf, managing director of MVC Associates International, a consulting firm that specializes in organization design and pay-for-performance standards.

“Is benchmarking pay across companies truly comparing apples to apples?” Mr. Van Clieaf asked. “Failure to have a legally defensible process” can lead to “materially false” disclosures, he said.

POSSIBLE problems with the use of peer groups burst onto the scene in 2003, when the New York Stock Exchange disclosed that it had paid its chairman, Richard A. Grasso, about $140 million in total compensation. Amid a firestorm over the pay, Mr. Grasso resigned.

One reason for the outcry was the makeup of the peer group that the exchange’s compensation committee used to determine Mr. Grasso’s pay. The group included highly profitable investment banks and financial institutions that were far larger and more complex than the Big Board, which, at that time, was a nonprofit organization.

Brian J. Hall, a Harvard Business School professor and an expert on management incentive systems, conducted an analysis of Mr. Grasso’s compensation and provided it to the judge overseeing the case that the New York attorney general’s office filed against Mr. Grasso.

Mr. Hall, hired by the attorney general as an expert witness, found that the companies the New York Stock Exchange board used in its peer group had median revenue of $26 billion, more than 25 times that of the exchange. Median assets of companies in the group were 125 times the Big Board’s assets, and the median number of employees in the peer-group companies was 50,000, or roughly 30 times that of the exchange.

The peer group was flawed, Mr. Hall contended, resulting in unreasonably high compensation for Mr. Grasso. Experts hired by Mr. Grasso concluded that his pay was, in fact, reasonable. But the judge presiding over the case ruled last month that Mr. Grasso must return as much as $100 million to the exchange. Mr. Grasso has continued to defend his pay as appropriate; earlier this month, he asked a state appeals court to block the judge from requiring him to return the money. A hearing on the matter is set for Wednesday .

Some state pension officials have become concerned that certain companies in their portfolios may be relying on peer groups that are flawed. “Peer-group comparisons assume that job responsibilities and job skills of the peer groups are similar and they may not be,” said Denise L. Nappier, the treasurer of Connecticut and fiduciary of the state’s $23 billion Retirement Plans and Trust Funds. “The thing about looking at C.E.O. pay of competitive companies, often companies will want a C.E.O. to be paid in the top quartile of his peers. But not everyone can be above average and this tends to ratchet pay up.”

Peer groups typically appear twice in proxies: first, in portions of the reports disclosing the annual comparison of total stockholder returns at a company versus its peers, and, second, in a section devoted to the calculation of executive pay. In the pay section, shareholders are sometimes told the peer-group percentile in which their top executives’ compensation falls. Typically, the filings state that corporate executives’ pay was in the 50th or 75th percentile of the benchmark group. If an executive is in the 50th percentile, he or she is in the middle of the pack; the 75th percentile means that only one-quarter of the group is paid more.

Compensation experts note that when a majority of companies in any given industry are in the 75th compensation percentile, pay packages may be subject to the Lake Wobegon effect: that all chief executives are suddenly above average. Corporate directors argue that comparing pay practices with those of competitors is only fitting, given that those are the companies they usually look to when recruiting employees and executives. But pay critics contend that an unquestioning reliance on the use of such peer groups is too simplistic and contributes to a one-size-fits-all mentality in pay.

“Sometimes it doesn’t matter what the other guy is doing,” said Brian Foley, an independent pay consultant in White Plains. “First and foremost is what makes sense for this company. If you’re in a turnaround and you are comparing yourself to guys who never had a dip and are quite successful, it’s a question not just of comparison based on size but also based on circumstances. I think these questions are asked sometimes, but sometimes they seem to be glossed over.”

Ms. Nappier said her office was looking at how Eli Lilly used a peer group in its executive compensation practices. According to Lilly’s 2006 proxy statement, the company judges itself against a group of eight companies: Abbott Laboratories; Bristol-Myers Squibb; GlaxoSmithKline; Johnson & Johnson; Merck; Pfizer; Schering-Plough and Wyeth. Lilly’s stock underperformed the peer-group average in 2004 and 2005.

Comparing Eli Lilly with Johnson & Johnson, Ms. Nappier said, shows a stark difference, particularly when you look at the number of profit centers at J. & J. and the complexity of its business.

An official at Lilly did not return a phone call seeking comment.

Sometimes, compensation peer groups include companies that are not even in the same industry or are not of a similar size. An example is the peer group used by the Ford Motor Company, which described its selection this way in its 2006 proxy: “The consultant develops compensation data using a survey of several leading companies picked by the consultant and Ford. General Motors and DaimlerChrysler were included in the survey. Twenty leading companies in other industries also were included.” Ford, however, did not identify those companies.

Ford’s proxy also stated that the peer group it used in the compensation section of its filing was larger than the peer group it used in the stock performance portion of the same filing because “the job market for executives goes beyond the auto industry.” Ford said it chose the companies based on “size, reputation and business complexity” and said that over time, its goal was to peg its pay roughly at the median of the peer group, adjusted for company size and performance.

A Ford spokeswoman, Marcey Evans, declined to comment.

Mr. Reda, the compensation consultant, has a different perspective on how Ford uses peer groups. “That is just not appropriate,” he said. “A peer group should be based on size, profit margin — financial success, perhaps — but you can’t pick a company that has 15 percent profit margins when Ford is doing 8” percent.

Ford is by no means alone in extending its peer group well beyond its industry, Mr. Reda said. He noted that about 10 years ago, big brand-name companies began measuring themselves against other household-name companies, even though they were not in the same industry. Companies that made it onto Fortune magazine’s list of “most admired companies,” for instance, began to compare their pay to others on the roster.

Never mind that the connection was irrelevant, Mr. Reda said. “The result was a lot of pay got jacked up,” he said, “because companies in low-margin industries that didn’t do too well got pay hikes because they were in the ‘most admired’ candy store.”

EVEN companies that have won kudos for corporate governance can fall prey to peer-group traps. Consider the proxy filed last month by Campbell Soup, which provides continuing education programs for its directors. The filing, made after the S.E.C.’s 2007 proxy rules were issued but before they took effect, noted that its compensation committee compared total pay levels at 29 companies “in the food and consumer products industries with which Campbell competes for attraction and retention of talent.” Campbell’s compensation committee approved the companies in the peer group but did not identify them.

In computing Campbell’s total shareholder return, however, the company did not use the 29-company pay peer group as a benchmark. Instead, it used the Standard & Poor’s 500-stock index and the S.& P. 500 Packaged Foods Index, a subset of the S.& P. 500 that consists of only 11 companies, including Campbell. The company outperformed both benchmarks last year.

The use of dueling peer groups — one to measure stockholder return, another to calibrate executive pay — is common in corporate America. But Paul Hodgson, author of “Building Value Through Compensation,” questions the practice. “Best practice would dictate that, if a compensation committee report is to include a graph showing the company’s relative performance to peers, those peers should be the same as the group actually used to test performance,” he wrote in his book.

Anthony J. Sanzio, a Campbell Soup spokesman, said: “In terms of recruitment, we believe the landscape needs to be broader to attract and retain the best talent. For talent, we compete with a much broader group of companies that are much larger.” Mr. Sanzio declined to identify the 29 companies in the peer group but said Coca-Cola, Anheuser-Busch, Procter & Gamble and Johnson & Johnson were among them.

Mr. Van Clieaf, the compensation consultant, said the composition of peer groups is usually more heavily weighted to larger companies, even though corporations typically look to companies smaller than themselves when they are recruiting top executives. This reality calls into question the oft-heard argument that outsized pay is based on market forces and that because companies have to jockey for the very best, enormous compensation deals are reasonable.

“Where would you really go to look for talent,” Mr. Van Clieaf asked. “Either at the second or third layer down at bigger companies or the No. 1 role at smaller companies. Do you really think the C.E.O. of Johnson & Johnson is going to go to work at Eli Lilly?”

Even so, the pay handed out to executives at smaller companies — or to lower-level managers at larger concerns — are rarely included in peer groups, compensation experts and analysts say. Consider the pay awarded to the former Hewlett-Packard chief executive, Carleton S. Fiorina, which was based on a peer-group analysis. Although Hewlett hired Mark V. Hurd, the chief executive of the data processing giant NCR to succeed Ms. Fiorina as chief executive in 2005, Hewlett never included NCR in its peer group when calculating Ms. Fiorina’s compensation, according to Mr. Van Clieaf.

In fact, Mr. Van Clieaf said, Mr. Hurd’s pay while at NCR pay was 40 percent of Ms. Fiorina’s compensation at Hewlett. If Hewlett had included NCR in its peer group — thus adding Mr. Hurd’s lower compensation into the mix — Ms. Fiorina’s compensation would have wound up in a far higher percentile of the peer group than the median percentile that Hewlett reported, Mr. Van Clieaf said.

THIS year, Hewlett-Packard changed its peer group from a so-called blended one that included technology concerns as well as those from other industries, to a group that is limited to technology companies alone. They are I.B.M., Dell, Apple Computer, Cisco Systems, Electronic Data Systems, EMC, Intel, Lexmark International, Microsoft, Motorola, Oracle, Sun Microsystems and Xerox.

“This ensures that the cost structures that we create will enable us to remain competitive in our markets,” Hewlett’s 2006 filing said of its switch.

While Hewlett also noted in the filing that it believed that the design of its compensation plan was appropriate, it — like Campbell and Ford — used a different set of companies to compare its stock performance for shareholders. This shareholder peer group does not contain Intel, Oracle or Cisco. The company declined to comment further.

In the meantime, analysts say, compensation practices continue to be built on the same cheery performance assumptions found at Lake Wobegon.

“I think it is safe to say that in various situations the peer-group analysis has been soft,” said Mr. Foley, the compensation consultant. “And because it’s been soft, the determinations made about pay have been somewhat soft as well.”

Gilded Paychecks Articles in this series are examining executive compensation. Previous articles in the series can be found at nytimes.com/business.

Peer Pressure: Inflating Executive Pay (NYTimes, 11/26/06)

November 26, 2006
Peer Pressure: Inflating Executive Pay
By GRETCHEN MORGENSON
LIKE Lake Wobegon, Garrison Keillor’s fictitious Minnesota town where all the children are above average, executive compensation practices often assume that corporate managers are equally superlative. When shareholders question lush pay, they are invariably met with a laundry list of reasons that businesses use to justify such packages. Among that data, no item is more crucial than the “peer group,” a collection of companies that corporations measure themselves against when calculating compensation.

But according to a handful of pay experts who are privy to the design of pay practices at the nation’s largest corporations, many of these peer groups are populated with companies that are anything but comparable. They also say corporate managers themselves — who have an interest in higher pay — are selecting which companies make it into a peer group. And because these companies are often inappropriate for comparison purposes, their use has helped inflate executive pay in recent years.

“The peer group is the bedrock of the compensation philosophy at a company,” said James F. Reda, an independent compensation consultant in New York. “But a lot of people do it by the seat of their pants, and that is part of the reason why executive pay has really skyrocketed.”

The use of peer groups to calculate executive pay has become ubiquitous in recent years. This is partly in response to the Securities and Exchange Commission’s requirement that companies compare their stock performance with a peer group in tables in the section of their proxy filings devoted to shareholder returns. Theoretically, these tables allow investors to compare their company’s performance against objective benchmarks.

But as is true with much about executive pay, details about exactly how peer groups are compiled have been kept under wraps. The worry among investors, of course, is that executives, consultants and directors simply cherry-pick peer-group members, thereby pumping up pay packages.

Current disclosure rules require neither the identification of companies in a compensation-related peer group nor the rationale behind their selection. Usually, the most a shareholder learns about companies in a compensation peer group is that they are in the same industry or of a similar size.

This ambiguity will change when new Securities and Exchange Commission disclosure rules go into effect on Dec. 15. The rules will require a corporation to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy.

Under the new rules, company officials will also have to certify the accuracy of their pay disclosures. As a result, peer groups are likely to attract increased scrutiny, said Mark Van Clieaf, managing director of MVC Associates International, a consulting firm that specializes in organization design and pay-for-performance standards.

“Is benchmarking pay across companies truly comparing apples to apples?” Mr. Van Clieaf asked. “Failure to have a legally defensible process” can lead to “materially false” disclosures, he said.

POSSIBLE problems with the use of peer groups burst onto the scene in 2003, when the New York Stock Exchange disclosed that it had paid its chairman, Richard A. Grasso, about $140 million in total compensation. Amid a firestorm over the pay, Mr. Grasso resigned.

One reason for the outcry was the makeup of the peer group that the exchange’s compensation committee used to determine Mr. Grasso’s pay. The group included highly profitable investment banks and financial institutions that were far larger and more complex than the Big Board, which, at that time, was a nonprofit organization.

Brian J. Hall, a Harvard Business School professor and an expert on management incentive systems, conducted an analysis of Mr. Grasso’s compensation and provided it to the judge overseeing the case that the New York attorney general’s office filed against Mr. Grasso.

Mr. Hall, hired by the attorney general as an expert witness, found that the companies the New York Stock Exchange board used in its peer group had median revenue of $26 billion, more than 25 times that of the exchange. Median assets of companies in the group were 125 times the Big Board’s assets, and the median number of employees in the peer-group companies was 50,000, or roughly 30 times that of the exchange.

The peer group was flawed, Mr. Hall contended, resulting in unreasonably high compensation for Mr. Grasso. Experts hired by Mr. Grasso concluded that his pay was, in fact, reasonable. But the judge presiding over the case ruled last month that Mr. Grasso must return as much as $100 million to the exchange. Mr. Grasso has continued to defend his pay as appropriate; earlier this month, he asked a state appeals court to block the judge from requiring him to return the money. A hearing on the matter is set for Wednesday .

Some state pension officials have become concerned that certain companies in their portfolios may be relying on peer groups that are flawed. “Peer-group comparisons assume that job responsibilities and job skills of the peer groups are similar and they may not be,” said Denise L. Nappier, the treasurer of Connecticut and fiduciary of the state’s $23 billion Retirement Plans and Trust Funds. “The thing about looking at C.E.O. pay of competitive companies, often companies will want a C.E.O. to be paid in the top quartile of his peers. But not everyone can be above average and this tends to ratchet pay up.”

Peer groups typically appear twice in proxies: first, in portions of the reports disclosing the annual comparison of total stockholder returns at a company versus its peers, and, second, in a section devoted to the calculation of executive pay. In the pay section, shareholders are sometimes told the peer-group percentile in which their top executives’ compensation falls. Typically, the filings state that corporate executives’ pay was in the 50th or 75th percentile of the benchmark group. If an executive is in the 50th percentile, he or she is in the middle of the pack; the 75th percentile means that only one-quarter of the group is paid more.

Compensation experts note that when a majority of companies in any given industry are in the 75th compensation percentile, pay packages may be subject to the Lake Wobegon effect: that all chief executives are suddenly above average. Corporate directors argue that comparing pay practices with those of competitors is only fitting, given that those are the companies they usually look to when recruiting employees and executives. But pay critics contend that an unquestioning reliance on the use of such peer groups is too simplistic and contributes to a one-size-fits-all mentality in pay.

“Sometimes it doesn’t matter what the other guy is doing,” said Brian Foley, an independent pay consultant in White Plains. “First and foremost is what makes sense for this company. If you’re in a turnaround and you are comparing yourself to guys who never had a dip and are quite successful, it’s a question not just of comparison based on size but also based on circumstances. I think these questions are asked sometimes, but sometimes they seem to be glossed over.”

Ms. Nappier said her office was looking at how Eli Lilly used a peer group in its executive compensation practices. According to Lilly’s 2006 proxy statement, the company judges itself against a group of eight companies: Abbott Laboratories; Bristol-Myers Squibb; GlaxoSmithKline; Johnson & Johnson; Merck; Pfizer; Schering-Plough and Wyeth. Lilly’s stock underperformed the peer-group average in 2004 and 2005.

Comparing Eli Lilly with Johnson & Johnson, Ms. Nappier said, shows a stark difference, particularly when you look at the number of profit centers at J. & J. and the complexity of its business.

An official at Lilly did not return a phone call seeking comment.

Sometimes, compensation peer groups include companies that are not even in the same industry or are not of a similar size. An example is the peer group used by the Ford Motor Company, which described its selection this way in its 2006 proxy: “The consultant develops compensation data using a survey of several leading companies picked by the consultant and Ford. General Motors and DaimlerChrysler were included in the survey. Twenty leading companies in other industries also were included.” Ford, however, did not identify those companies.

Ford’s proxy also stated that the peer group it used in the compensation section of its filing was larger than the peer group it used in the stock performance portion of the same filing because “the job market for executives goes beyond the auto industry.” Ford said it chose the companies based on “size, reputation and business complexity” and said that over time, its goal was to peg its pay roughly at the median of the peer group, adjusted for company size and performance.

A Ford spokeswoman, Marcey Evans, declined to comment.

Mr. Reda, the compensation consultant, has a different perspective on how Ford uses peer groups. “That is just not appropriate,” he said. “A peer group should be based on size, profit margin — financial success, perhaps — but you can’t pick a company that has 15 percent profit margins when Ford is doing 8” percent.

Ford is by no means alone in extending its peer group well beyond its industry, Mr. Reda said. He noted that about 10 years ago, big brand-name companies began measuring themselves against other household-name companies, even though they were not in the same industry. Companies that made it onto Fortune magazine’s list of “most admired companies,” for instance, began to compare their pay to others on the roster.

Never mind that the connection was irrelevant, Mr. Reda said. “The result was a lot of pay got jacked up,” he said, “because companies in low-margin industries that didn’t do too well got pay hikes because they were in the ‘most admired’ candy store.”

EVEN companies that have won kudos for corporate governance can fall prey to peer-group traps. Consider the proxy filed last month by Campbell Soup, which provides continuing education programs for its directors. The filing, made after the S.E.C.’s 2007 proxy rules were issued but before they took effect, noted that its compensation committee compared total pay levels at 29 companies “in the food and consumer products industries with which Campbell competes for attraction and retention of talent.” Campbell’s compensation committee approved the companies in the peer group but did not identify them.

In computing Campbell’s total shareholder return, however, the company did not use the 29-company pay peer group as a benchmark. Instead, it used the Standard & Poor’s 500-stock index and the S.& P. 500 Packaged Foods Index, a subset of the S.& P. 500 that consists of only 11 companies, including Campbell. The company outperformed both benchmarks last year.

The use of dueling peer groups — one to measure stockholder return, another to calibrate executive pay — is common in corporate America. But Paul Hodgson, author of “Building Value Through Compensation,” questions the practice. “Best practice would dictate that, if a compensation committee report is to include a graph showing the company’s relative performance to peers, those peers should be the same as the group actually used to test performance,” he wrote in his book.

Anthony J. Sanzio, a Campbell Soup spokesman, said: “In terms of recruitment, we believe the landscape needs to be broader to attract and retain the best talent. For talent, we compete with a much broader group of companies that are much larger.” Mr. Sanzio declined to identify the 29 companies in the peer group but said Coca-Cola, Anheuser-Busch, Procter & Gamble and Johnson & Johnson were among them.

Mr. Van Clieaf, the compensation consultant, said the composition of peer groups is usually more heavily weighted to larger companies, even though corporations typically look to companies smaller than themselves when they are recruiting top executives. This reality calls into question the oft-heard argument that outsized pay is based on market forces and that because companies have to jockey for the very best, enormous compensation deals are reasonable.

“Where would you really go to look for talent,” Mr. Van Clieaf asked. “Either at the second or third layer down at bigger companies or the No. 1 role at smaller companies. Do you really think the C.E.O. of Johnson & Johnson is going to go to work at Eli Lilly?”

Even so, the pay handed out to executives at smaller companies — or to lower-level managers at larger concerns — are rarely included in peer groups, compensation experts and analysts say. Consider the pay awarded to the former Hewlett-Packard chief executive, Carleton S. Fiorina, which was based on a peer-group analysis. Although Hewlett hired Mark V. Hurd, the chief executive of the data processing giant NCR to succeed Ms. Fiorina as chief executive in 2005, Hewlett never included NCR in its peer group when calculating Ms. Fiorina’s compensation, according to Mr. Van Clieaf.

In fact, Mr. Van Clieaf said, Mr. Hurd’s pay while at NCR pay was 40 percent of Ms. Fiorina’s compensation at Hewlett. If Hewlett had included NCR in its peer group — thus adding Mr. Hurd’s lower compensation into the mix — Ms. Fiorina’s compensation would have wound up in a far higher percentile of the peer group than the median percentile that Hewlett reported, Mr. Van Clieaf said.

THIS year, Hewlett-Packard changed its peer group from a so-called blended one that included technology concerns as well as those from other industries, to a group that is limited to technology companies alone. They are I.B.M., Dell, Apple Computer, Cisco Systems, Electronic Data Systems, EMC, Intel, Lexmark International, Microsoft, Motorola, Oracle, Sun Microsystems and Xerox.

“This ensures that the cost structures that we create will enable us to remain competitive in our markets,” Hewlett’s 2006 filing said of its switch.

While Hewlett also noted in the filing that it believed that the design of its compensation plan was appropriate, it — like Campbell and Ford — used a different set of companies to compare its stock performance for shareholders. This shareholder peer group does not contain Intel, Oracle or Cisco. The company declined to comment further.

In the meantime, analysts say, compensation practices continue to be built on the same cheery performance assumptions found at Lake Wobegon.

“I think it is safe to say that in various situations the peer-group analysis has been soft,” said Mr. Foley, the compensation consultant. “And because it’s been soft, the determinations made about pay have been somewhat soft as well.”

Gilded Paychecks Articles in this series are examining executive compensation. Previous articles in the series can be found at nytimes.com/business.

This Fund Is Making a Bundle (NYTimes, 11/10/06)

November 10, 2006
This Fund Is Making a Bundle
By JENNY ANDERSON
How much money is actually made in the fast-growing realm of hedge funds and private equity is often just an informed estimate.
No longer.
A securities filing by a $26 billion investment company provides a rare peek behind the curtain of secrecy that typically governs the world of alternative investments. Late Wednesday, the Fortress Investment Group filed to sell $750 million worth of shares to the public, valuing the company at $7.5 billion.
While the filing does not disclose individual compensation, two things are abundantly clear: money management, when the returns are good, is an extraordinarily profitable business. And the principals will make a killing on the deal.
For the first half of this year, Fortress, which has 500 employees, earned $88 million on revenue of $877.5 million. Fees from its funds totaled $185.8 million.
If finance were more democratic, every Fortress employee, from secretaries to fund managers, would make $673,000 this year on an annualized basis, up 14 percent from 2005, according to data provided by Charles Hintz, a securities industry analyst with Sanford C. Bernstein & Company.
Of course, secretaries and fund managers won’t be taking home the same paycheck. And the offering will make Fortress’s five principals — already wealthy from the success of the fund’s performance — billionaires. They have $500 million invested in the fund. If Fortress sells 10 percent to the public as disclosed, that leaves the five with $6.8 billion to divvy up.
In an effort to minimize the risk that any of those principals will leave, they are restricted from selling shares and face a five-year lockup that requires each to give up from 70 percent of his interests in the first year to 14 percent between the fourth and fifth years.
Like most private equity and hedge funds, Fortress earns huge fees: 1 to 2 percent of assets under management to run the fund and 20 percent of profits in “incentive” compensation. Traditional asset managers make much less: about 1 percent of assets under management.
“I think the compensation is reassuring rather than disconcerting,” said Donald H. Putnam, chief executive of Grail Partners, a merchant bank. “I would not want to own a company that underpaid its people.”
The filing also shows just how profitable hedge funds and private equity can be. Last year, the group had revenue of more than $1 billion, earned $192.7 million and paid out $259.2 million in compensation.
For the same period, BlackRock Financial, the big asset management firm, managed $452 billion in assets, 17 times as much as Fortress. In 2005, it made about the same amount in revenue — $1.2 billion, and slightly more in profit, $233.9 million. It paid out compensation of $595 million to 1,752 employees.
Fortress was founded in 1998 and today is run by its five principals: Wesley R. Edens, Robert I. Kauffman, Randal A. Nardone, Peter L. Briger and Michael E. Novogratz. The company has grown rapidly, from $1.2 billion under management on Dec. 31, 2001, to $26 billion on Sept. 30, 2006. It operates three main lines of business: private equity funds that manage $13.6 billion, hedge funds with $9.4 billion and other publicly traded companies worth $3 billion.
The fund’s returns — high by competitive standards — may be attractive to potential investors. The private equity funds had net annualized returns of 38.8 percent. The hybrid hedge funds that invest in distressed assets, including loans among other things, had annualized net returns of 13.7 percent. The “liquid” funds that invest globally in debt, currency, stock and commodity markets and derivatives had net returns of 13.7 percent. Fortress also manages two “castles,” which are publicly traded alternative investment vehicles. The return for those companies on a net annualized basis is 50.6 percent.
Fortress wants to offer shares to the public, the filing says, to have capital, currency, people and permanence. In other words, it wants money from the offering to invest in the business, a stock to use to make future acquisitions, stock to use as incentive compensation and a ticker symbol on the New York Stock Exchange — FIG — that elevates it from yet another big hedge fund to a permanent institution.
Fortress will use at least $250 million of the proceeds to pay down debt. The remaining money raised will be invested in the business. Other areas it says it could expand into include infrastructure funds, real estate funds, structured debt products, funds focused on industry or geographic sectors and more traditional long-only funds, or those that do not short stocks — a bet that the prices will fall.
Mr. Putnam expects more public offerings of hedge funds and private equity firms will follow.
“It is categorically a trend,” he said. “These companies are easier to float than to acquire. The challenges of an acquisition — it’s the mating of hippos — it’s a rare event.”
As in many mergers, combining the egos, finances and strategies of two money managers can be challenging. “A floatation is much more straightforward and it puts a clear value on the company,” Mr. Putnam said.
Publicly traded hedge funds and private equity funds are not rare abroad. RAB Capital and the Man Group are listed in London, while the Partners Group is traded in Switzerland and the Sparx Group in Japan.
Goldman Sachs is the lead underwriter on the Fortress deal with Bank of America, Citigroup, Deutsche Bank Securities and Lehman Brothers as co-managers. Skadden, Arps, Slate, Meagher & Flom is the legal counsel.