Next on the Grill: Compensation Committees
from
May/June 2002
by John R. Engen
Audit committee members may have the
hottest seats in town, but their peers on compensation committees
aren’t sitting all that comfortably either. Shareholders are
increasingly angry over the fat pay packets doled out to CEOs and other
top executives. More threateningly, regulators may soon be wading in.
So far, comp committees have escaped the hailstorm of criticism aimed at many directors who serve on audit committees. But that doesn’t mean shareholders aren’t fighting compensation deals. In 2000, three top executives of the Islandia, New York, software corporation Computer Associates, including CEO Charles Wang, agreed to return 4.5 million shares to the company after a judge found in favor of shareholders who’d sued in the wake of a $675 million charge against earnings to cover the grants. The company’s directors escaped being personally sued, though Wang as good as hung a target on their backs. “I know my directors, my comp committee. They’ll make me whole,” he said shortly before the settlement.
As it happened, his board wasn’t so tame that it lavished compensatory raises on Wang the following year, though he did realize a gain of $118 million by exercising past option grants. But his clear assumption that he had a board that would take care of him no matter what didn’t win Computer Associates any fans. “It was a real black eye for the company and the board,” says Ken Bertsch, director of corporate governance at TIAA-CREF, a large institutional investor that owns a stake in the outfit.
Regulators, too, have been scowling at directors who slavishly do their CEOs’ bidding. “Kowtowing to management and blindly signing off on large compensation packages is not a proper discharge of a director’s duties,” warned Laura Unger, then acting chairman of the Securities and Exchange Commission, in a speech last summer. Charles Elson, director of the University of Delaware’s corporate-governance center, predicts that regulators could insist that comp committees, often dominated by the CEOs’ cronies, meet the more stringent independence requirements audit committees already face. Adds Bertsch: “If the investment community continues to lose confidence in compensation committees, you could see a blue-ribbon committee formed by the SEC to look at the problem.”
A crisis of confidence may already be occurring. As of January, TIAA-CREF was pushing more than a dozen companies to reform the ways they calculate compensation, suggesting that many of them get shareholders’ approval for all stock-option plans. The United Food and Commercial Workers, an investor in Citigroup, noted that CEO Sanford Weill has options on more than 32.6 million shares and will reap a windfall even if the stock price merely inches up. Better, said a proxy proposal by the union, to make such grants dependent on significant improvement in earnings.
That’s similar to the chief recommendation of a new, first-of-its-kind report on comp committee practices issued by the Conference Board Inc., a nonprofit research firm in New York City. Comp committees, argues the 50-page treatise, must negotiate tougher contracts that reward executives for meeting key strategic objectives, instead of merely rubber-stamping deals that let their chieftains keep up with the Joneses.
“Compensation has been viewed as being in a little box by itself, separate from other board deliberations,” says Carolyn Kay Brancato, director of the Conference Board’s global corporate-governance research center and principal author of the report. “But it’s really something that needs to be inextricably linked with the strategic direction of the company.”
Achieving that linkage, the report asserts, requires comp committees to be more engaged, independent, and knowledgeable than they are today, and to do a better job of crafting pay-for-performance packages. To that end, members should be selected by nominating or governance committees. Once elected, comp committee members should make sure that the outside compensation consultants report to them.
Investor representatives complain that many comp committees sign off on pay-for-performance packages during good times, only to abandon them when the going gets rough. Moreover, by relying on pay surveys, weak comp committees bring poor performers up to “average” levels of compensation. Strong executives, meanwhile, get outsize rewards, which raise the average for the next year. The Institute for Policy Studies and United for a Fair Economy, two nonprofit research groups, report that the average total compensation of CEOs at 365 major corporations climbed to $13.1 million in 2000, a 571% increase over what they collected in 1990. True, their total comp dropped 10% in 2001, but that counts for little given the largesse of the previous decade.
Richard Koppes, a former general counsel for CalPERS, the big institutional investor, notes that most CEOs are “type A hard-charging personalities” who aggressively seek the biggest pay packages possible. “They’ll come in with a lawyer by their side, armed with statistics to back their case,” he explains. “It can be very difficult to dispute the numbers management is laying on the table.”
An outside consultant hired by the board can help. So can a committee chairman with the backbone to go toe-to-toe with the CEO during tense negotiations. Ideally, this person may be a CEO who has sat on the other side of the table, or a large shareholder with a financial stake in the company. “If the committee is doing its job right, there’s going to be a certain level of friction with management,” says Philip Lochner Jr., a former SEC commissioner and a member of the comp committee at Gtech Holdings in West Greenwich, Rhode Island, which operates lottery systems. “You need a leader who can stand up to the CEO.”
This happened at Apria Healthcare Group, a Costa Mesa, California, maker of home medical equipment on whose comp committee Koppes served. In 2000 Apria flourished, and CEO Philip Carter received not only his $680,000 salary but also another $421,354 in performance-related bonuses and 500,000 stock options. But 2001 proved disappointing to investors, as it was at many other companies, and despite improved pretax earnings the stock languished. Carter argued that in view of the economic slump, less of his pay should be tied to the stock’s performance. The comp committee disagreed. “We said, ‘You’re just going to have to work harder,’” recalls Koppes—and that’s how it was. In this case, the committee had a lot of muscle. Its other two members were David Batchelder and Ralph Whitworth, principals with Relational Investors, an investment firm that owned some 20% of Apria’s outstanding shares. (Postscript: Carter stepped down as CEO in February, just as the company announced a 29% increase in fourth-quarter earnings. Lawrence Higby, who had been president, took the CEO’s job.)
Not only are comp committee members going to have to learn to battle chief executives, they’ll have to work harder at mastering the intricacies of how stock-option plans and the like can affect earnings per share and capital structures. Most companies calculate such numbers with the help of the Black-Scholes model, a system so complicated that it won its creator a Nobel Prize. Not every director can be expected to discuss it with easy familiarity, but, says Lochner, “if you don’t understand in some general way how the Black-Scholes model values options, it’s going to be difficult to make a reasonable decision.”
Don’t think that just because you’ve escaped a comp committee
assignment you’re off the hook, by the way. Responsibility for how much
the CEO and other top execs collect, and how their deals are
constructed, ultimately rests with the entire board.
