Berkshire Hathaway's (NYSE:BRK) Warren Buffet offered his views on executive compensation in his annual letter to shareholders. In the letter, he explains how Berkshire comes up with their compensation and expressed his disappointment with pay consultants who have allowed such excessive compensation to take over. Buffet insists that the solution to the problem would be for a few large institutional shareholders to team up and take on the problem by taking a fresh new prospective.

Here's what the Oracle of Omaha had to say:

Berkshire employs many different incentive arrangements, with their terms depending on such elements as the economic potential or capital intensity of a CEO’s business. Whatever the compensation arrangement, though, I try to keep it both simple and fair.

When we use incentives – and these can be large – they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance. If a CEO bats .300, he gets paid for being a .300 hitter, even if circumstances outside of his
control cause Berkshire to perform poorly. And if he bats .150, he doesn’t get a payoff just because the successes of others have enabled Berkshire to prosper mightily. An example: We now own $61 billion of equities at Berkshire, whose value can easily rise or fall by 10% in a given year. Why in the world should the pay of our operating executives be affected by such $6 billion swings, however important the gain or loss may be for shareholders?

You’ve read loads about CEOs who have received astronomical compensation for mediocre results. Much less well-advertised is the fact that America’s CEOs also generally live the good life. Many, it should be emphasized, are exceptionally able, and almost all work far more than 40 hours a week. But they are usually treated like royalty in the process. (And we’re certainly going to keep it that way at Berkshire. Though Charlie still favors sackcloth and ashes, I prefer to be spoiled rotten. Berkshire owns The Pampered Chef; our wonderful office group has made me The Pampered Chief.)

CEO perks at one company are quickly copied elsewhere. “All the other kids have one” may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees. Irrational and excessive comp practices will not be materially changed by disclosure or by “independent” comp committee members. Indeed, I think it’s likely that the reason I was rejected for service on so many comp committees was that I was regarded as too independent. Compensation reform will only occur if the largest institutional shareholders – it would only take a few – demand a fresh look at the whole system. The consultants’ present drill of deftly selecting “peer” companies to compare with their clients will only perpetuate present excesses.

Rep. Barney Frank proposed additional legislation aimed at providing shareholders with additional powers when it comes to executive compensation. The Massachusetts Democrat's proposed bill would give shareholders a chance to cast a nonbinding confidence or no-confidence vote on executive pay plans, allowing them either to ratify or disapprove of them. Similar provisions are already present in Britain, Sweden, and Australia where pay packages are rarely voted down but rather kept pay in check through fear of shareholder retribution. While no Republicans have yet endorsed the representative's bill, the Democrat-controlled Congress could pass the provision as soon as April. Given recent shareholder concerns over executive compensation, it would not be surprising to see this bill passed quickly into law.

The House Financial Services Committee has scheduled a hearing on executive compensation for March 8, 2007. U.S. Rep. Barney Frank, D-Mass., organized the hearing, which will focus on legislation designed to give shareholders more power in setting executives' compensation. Political pressure to increase oversight in Corporate America hit a high recently after shareholder outrage against Home Depot and Pfizer CEOs combined with President Bush's speech earlier this month demanding that companies tie pay to results. Notably, however, Bush stopped short of calling for either new federal rules or fresh congressional action; but, Barney Frank said he plans to go ahead with his plans to move legislation that would greatly expand shareholder powers in the Board room. On the topic, he said, "I agree with President Bush that excessive executive compensation has become a problem, but disagree with his view that we should do nothing about it." No witnesses have been listed yet; however, the hearing is scheduled for March 8th of this year.

The SEC's new executive compensation disclosure rules may have a new set of flaws after an accounting loophole for stock options and an 11th hour rule change may cloud the compensation of top executives. The loopholes, which were discovered by compensation analysts hired to draft these new filings, may undermine the SEC's ultimate goals and end up simply costing company's more money without seeing results. How so? Let's take a look...

The problems stem from a stock options accounting rule known as FAS 123R, which changed the way company's reported stock options expenses. Previously, stock options were not reported as expenses. FAS 123R changed this by saying that if companies gave stock options to executives, they had to subtract the total value of those grants from their earnings that year. This would obviously result in a huge windfall for companies issuing a lot of stock options - particularly in healthcare and technology. To avoid the huge windfall, some 900 companies changed their options vesting dates to occur before the rule went into effect. This enabled the companies to erase an estimated $8 billion of future expenses from their books - they could award these options without cost. Then right before Christmas, the SEC changed the rules again. Now allow companies to report the amount of stock options that vest per year rather than the total value of the options granted to an executive. Without the total value being reported, the summary tables on the new compensation disclosures can be extremely misleading, often changing the order of executives by compensation significantly. Since the new rules require only the top five executives in each company to report in the summaries table, there is room for many top executives to completely hide their compensation from shareholders.

One of the most popular executive perks during mergers and acquisitions is the so-called tax gross-up, which is a payment made by company's to cover taxes on an executive's severence package. Given today's tax law, these gross-ups can end up costing shareholders almost as much as the severence packages themselves! For example, when SBC boughtout rival AT&T in 2005, CEO David Dorseman received not only a $29 million severence package but an additional $11 million gross-up to cover taxes. These gross-ups often go under the radar, unnoticed by the majority of shareholders. Many shareholder rights groups call these gross-ups the most costly part of a golden parachute and an extremely inefficient use of shareholder money. Consequently, it will likely be a popular topic during this years proxy season.

Gross-ups first gained their popularity during the 1980's merger frenzy after the government imposed new tax penalties on executives aimed at preventing them from cashing out million by quickly selling their companies and unloading all of their shares. Companies then began offering gross-ups as an incentive to help keep and retain executives. According to an article on BusinessWeek, only 10% of companies in 1987 had gross-ups compared to about 77% now. It is becoming increasingly apparent that government regulations intended to help reduce executive compensation are simply costs that are passed on to shareholders...

Aflac, Inc. (NYSE:AFL) became the first company to offer shareholders a non-binding vote on executive compensation packages. The move came in response to a 2006 shareholder proposal aimed at increasing corporation transparency and accountability. "Our shareholders, as owners of the company, have the right to know how executive compensation works", commented the company's CEO. "The board's action is in keeping with Aflac's longstanding pay-for-performance compensation policy and our commitment to transparency at all levels."

The company created an offer last week that will give shareholders the ability to cast their votes on the company's 2009 proxy. While the shareholder vote on pay packages serves only as an advisory vote as of now, it creates an important venue for shareholders to communicate on the issue of executive compensation. And with over forty companies are facing shareholder resolutions on executive pay this 2007 proxy season, this may become a new trend to help satisfy the increasing concerns over compensation packages.

A new study by the University of Texas has found that CEO’s at companies whose directors sat on numerous other boards were paid 13% more than CEO’s whose directors did not sit on other boards.  The study is a reflection of sorts of outside directors, most of whom often sit on several boards.

There are several possible explanations.  Some argue this is evidence of the power of "friend of friend" networks that facilitate mutual back-scratching.  Others argue that it is evidence of a viral spread of self-serving practices.  Simply put, it allows a board member, with a reputation for supporting CEO’s, to get other jobs.  An outside director that is friendly to CEO’s on one board gets selected by other CEO’s for other board positions. 

This study, involving 3,000 companies, shows that companies lavishly pay CEO’s even while performing below expectations for such high pay.  This has also been noticed by more than 80% of Americans (evenly divided between the well-off and those making under $100,000-a-year) who agree that CEO’s are paid too much.  The greater the bond between CEO’s and board members creates greater compensation packages, plain and simple.  

Grants of restricted stock are not inherently performance-based. This is due to the fact that the executive may receive compensation even if the stock price decreases or stays the same. A grant of restricted stock is treated like cash and does not satisfy the definition of performance-based compensation, unless the grant of the restricted stock is solely based upon the attainment of a performance goal or standard (set by the compensation committee and/or shareholders). While not overly common, restricted stock is one way in which many executives are "quietly" compensated by effectively tendering stock into cash.