E*Trade: CEO Pay Isn't the Only Problem


Investors cried foul on Apr. 30 when E*Trade Group Inc. (ET) disclosed it had paid out a $77 million compensation package for Chief Executive Christos M. Cotsakos in 2001 -- a year in which the financial-services company lost $242 million. When Cotsakos pledged on May 10 to return $21 million to E*Trade, the din hardly subsided. After all, his remaining $56 million compensation still topped the combined pay of the CEOs of Charles Schwab, Goldman Sachs, J.P. Morgan Chase, and Merrill Lynch -- all vastly larger and more profitable firms.

Perhaps Cotsakos' pay package shouldn't have been that shocking, for it could well be a symptom of greater corporate-governance issues at E*Trade now coming to the fore. Start with the question of director independence: It turns out director David C. Hayden, chairman of E*Trade's compensation committee and most responsible for Cotsakos' pay package, has close business ties to the CEO. Plus, Cotsakos is a general partner at a venture-capital firm bankrolled in part by E*Trade, positioning him to personally profit from E*Trade's investments and influence.

These new questions may be having an impact on E*Trade stock value. Its shares have dropped 9% in the six days since the CEO compensation disclosure, closing at $6.88 on May 15 (see BW Online, 5/10/02, "How Valuable Is E*Trade's Crown?"). And one of E*Trade's larger shareholders says Cotsakos' decision to return a slice of his compensation package should be the beginning of several changes. "We would hope that the corporate governance would improve. If it doesn't, we will have to reevaluate our outlook," says Brian McMahon, president of Thornburg Investment Management, which owned a 2% stake in E*Trade as of December.

NO INFLUENCE? E*Trade insists that it's a well-governed company. Chief Communications Officer Connie Dotson says the board instituted a corporate-goverance committee in early 2002. Of the Hayden-Cotsakos relationship, Dotson says: "I don't think [the compensation] is biased at all by their relationship." Hayden also says he wasn't influenced by a close relationship to Cotsakos: "The way I run the compensation committee...is the way it should be run."

Hayden notes that some of the biggest compensation decisions, such as forgiving a $15 million loan to Cotsakos, were made by the entire board. Furthermore, E*Trade's venture-capital endeavors are geared to help the firm spot new technologies and maintain its edge, says Dotson. Cotsakos wasn't available for comment for this story.

The relationship between Cotsakos and Hayden, however, appears to be too close for comfort for some shareholders and analysts. E*Trade was largely responsible for the early success of Hayden's Internet company, Critical Path. In 1998, two years before Hayden joined E*Trade's board, the online brokerage firm invested $15 million in Critical Path, a provider of e-mail services. When Hayden filed to take his company public in 1999, Cotsakos was on his board. E*Trade initially accounted for 62% of Critical Path's business, and it owned 13% of the startup. Cotsakos would see his personal stake in Critical Path quickly grow to $35 million.

A "KEY" PERSON. Because E*Trade was so involved in the early success of Critical Path's business, some question Hayden's ability to be independent as an E*Trade director. Moreover, E*Trade has remained a customer of Critical Path, where Hayden served as chairman until his resignation on May 13. "It's a conflict," says Stephen Fowler, founder of BoardSeat, a board search and consulting company. "Key committees should be comprised of completely independent board members."

That's not all. Hayden, who joined E*Trade's board in August, 2000, also founded Archipelago LLC, a venture-capital firm. Archipelago's Web site lists Cotsakos as one of the "key people" involved with the entity, and Dotson and Hayden both describe Cotsakos as an "adviser" to Archipelago without any financial stake. Says Dotson: "He or E*Trade never invested in [Archipelago]."

Nevertheless, a CEO assisting the business of the person who determines his salary creates an opportunity for conflict, critics say. "It could be problematic," says Thornburg's McMahon. "You keep coming around to this not-so-independent relationship between the board and Cotsakos."

"NOTHING IMPROPER." Archipelago's ties highlight more potential conflicts between Hayden and Costakos. In early 2001, the venture firm committed to invest $1 million in another venture outfit called Vectis Group, according to a Critical Path document filed with the Securities & Exchange Commission. Vectis Group was one of three companies that gave Hayden's Critical Path a much-needed cash infusion in late 2001.

Hayden dismisses any connection. Not only did Archipelago eventually withdraw its investment commitment to Vectis, according to Hayden, Cotsakos never advised him on specific investments, including the potential Vectis relationship. "There's nothing improper here," says Hayden.

Hayden's role isn't the only one that troubles investors and watchdogs, however. They're also concerned about ArrowPath Venture Capital, a firm that E*Trade partially funds. Cotsakos serves as a general partner, and E*Trade frequently partners with or becomes a customer of ArrowPath's portfolio companies. This can put Cotsakos' CEO responsibilities in direct conflict with his duties as a venture capitalist, say governance experts.

CHARITABLE GIFT. Moreover, Cotsakos stands to benefit personally from the clout E*Trade brings to ArrowPath investments. "This is a conflict because it puts the CEO on both sides of the transaction," says Charles M. Elson, director of the Center for Corporate Governance.

E*Trade says ArrowPath has yet to make money and that any profits it generates for Cotsakos would be given to charity. But corporate-governance experts say it represents a conflict nonetheless. "He still gets credit for giving it to charity. It's still a benefit to him," says Elson.

These myriad issues have become sources of concern for E*Trade shareholders. And it will likely take more than a pay cut to deal with them. Cotsakos and E*trade would be best served to address their critics' questions head on. Elgin covers Internet companies from BusinessWeek's San Mateo, Calif., bureau


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