Paymasters Under Fire
from
September/October 2003
by John R. Engen
Against a backdrop of corporate scandal and a recession-like “expansion” that shriveled the S&P 500 by 24% in 2002, the chief executive stands relatively unscathed. As the tables on the following pages make clear, some CEOs have earned their pay, not only at the 30 top companies in the S&P 500 but also at the top 10 outfits on the Russell Midcap and Wilshire Smallcap lists. But others have continued to enjoy fat compensation while the companies they head were outperformed by competitors.
Regardless of performance, many CEOs got raises. A study of 350 big companies by Mercer Human Resource Consulting shows that the median total compensation (base salary plus bonus) paid to their CEOs rose last year by 10%, to $1.8 million. A more comprehensive measure, “expected overall compensation,” which includes option grants, restricted stock, and the like, jumped 2.2%, to a median $6.1 million for the 350 companies.
A lot of people—shareholders, regulators, lawmakers, and even the courts—are mad as hell about all this and swear they aren’t going to take it anymore. In Britain, angry shareholders of GlaxoSmithKline PLC voted to reject a proposed golden parachute for CEO
J. P. Garnier, who has presided over a shrinking stock price. Although such votes aren’t binding, Glaxo’s board at least postponed its vote on whether to pay Garnier a fat farewell. In the U.S., SEC commissioner Cynthia Glassman warned boards of an apparent “disconnect” between performance and pay. Compensation committees, she said, “seem to be moving rapidly into the spotlight.”
Many believe comp committees are in for more than that. While no lawsuits have yet been filed against boards in respect to CEO pay, E. Norman Veasey, chief justice of Delaware’s Supreme Court, has all but issued an invitation to plaintiffs to go right ahead. “If directors claim . . . that they base [compensation] decisions on some performance measure, and don’t do so—or if they are disingenuous or dishonest about it—it seems to me that the courts in some circumstances could treat their behavior as a breach . . . of good faith,” the judge said in a January roundtable discussion in Harvard Business Review. His advice to comp committees: Hire your own advisers and lawyers to distance yourselves from management as a “guard against anything that might happen . . . in court.”
Are we witnessing a true sea change in attitudes? Diane Lerner, a senior compensation consultant with Watson Wyatt Worldwide, says that a healthy uptick in stock prices and GDP will probably dull the rhetoric. “Attention to executive compensation always drops off in good economic times,” she notes. But Charles Elson, director of the University of Delaware’s corporate governance center, counters that recent scandals have spawned deeper-than-ever mistrust of management, which is playing out in greater “shareholder receptivity” to crackdowns on CEO pay.
One thing is certain: Comp committees seem to be getting the same treatment that was lavished on their audit brethren in the months leading up to passage of the Sarbanes-Oxley Act. In time, they’re likely to face similar restrictions and rules too. Both NASDAQ and the New York Stock Exchange are kicking around proposals that would, among other things, require true independence for comp committees.
Investors are taking note. Patrick McGurn, a vice president of Institutional Shareholder Services, says that during the latest proxy season, more than 40 nonbinding shareholder resolutions targeting executive pay won majority support, vs. just three in 2002. Among the winners: initiatives clamping down on big severance packages at Sprint and Tyco International.
How is the pressure playing out in boardrooms? Deb Thobe, CEO of Thobe Group, a Dallas compensation consulting firm, says she’s already seen several of her clients’ comp committee members resign their posts. “Folks are really worried that they’re going to be held personally liable” for flawed pay packages, she says.
For those who stay on the committee, justifying the CEO’s pay package will be job No. 1. Most companies employ firm guidelines for rank-and-file pay, but apply a different set of rules for top execs. Paymasters use industry comparisons to place individual CEOs in the upper quartile (or at least above the median) vs. rivals. This practice unavoidably escalates pay for the group as a whole, making matters worse.
It doesn’t help that many “pay for performance” packages seem subject to interpretation by boards that just don’t feel comfortable slashing the boss’s compensation. Options repricings, all the rage last year, are only the most blatant of such dodges. Bio-Technology General Corp., of East Brunswick, New Jersey, recently declared that it would pay bonuses even if performance targets weren’t met, provided the comp committee concluded it was “in the best interests of the company.”
Even successful outfits are coming under scrutiny. Share prices at UnitedHealth Group rose 19% in 2002—but that hasn’t stopped some shareholders from grousing about the 13.4 million options, valued at $794.6 million, held by the insurer’s five top executives. “There’s a sense the board has handed over too much of the company’s value to management,” says the Corporate Library’s Paul Hodgson, a senior research associate at the shareholder-watchdog outfit.
Proponents of openhandedness argue that CEOs who can articulate a vision and motivate employees to achieve it are too special to risk losing. Conversely, CEOs face a greater chance of getting axed if their companies don’t perform up to snuff.
Then there are the emotional factors. CEOs, says consultant Diane Lerner, are a sensitive bunch, worried about how their packages stack up against their peers’. “It’s more than numbers. You have self-interest, ego, people’s feelings about how they’ll be perceived,” she says. A more substantial consideration is how investors perceive the matter. Says Thobe, “If you undervalue your CEO’s pay, the Street might wonder if he’s qualified.”
But too often CEOs get the best of both worlds: lofty pay and hefty severance deals, what McGurn calls “pay for failure” packages. When Electronic Data Systems fired CEO Richard Brown in March, after a year during which EDS’s share price dropped by more than two-thirds, he got a lump-sum payment equal to three times his $1.5 million salary, a hefty bonus, immediate vesting of all retirement, restricted-stock, and options awards, and more than $1 million in annual supplemental retirement benefits—all after receiving $6.75 million in cash and a load of equity in 2001. “Either you incorporate the risk [of being fired] into the pay package or the severance,” McGurn says. “Not both.”
To cover their backs, smart comp committees must focus first on independence. The nominating or governance committee responsible for naming directors to the comp committee should make sure it doesn’t choose the boss’s buddies for the assignment.
Expertise is important, too. Some CEOs are known for employing their own experts in salary negotiations and overwhelming comp committee members with lengthy reports that justify their demands. Comp committees should adopt a similar tack, either by employing their own consultants and legal help or by taking over an existing relationship from management. Such efforts can help shield directors from liability if a pay package is challenged later.
Ideally, the result will be a reasonable package that ties the CEO’s pay to overall performance. Equity will remain an important part of the equation, but with the pressure on to expense options, other forms of compensation—such as “performance grants,” which award stock to executives only after certain goals have been achieved—will come into vogue.
Industry comparisons continue to have value. So, too, do measurements against similar-size firms in related industries, and the CEO’s success in achieving strategic goals like operational efficiencies or customer growth. “In the end, CEOs should be rewarded for leading the company where the board wants it to go,” Thobe says. If the company goes elsewhere, a board could be applauded for standing up to a CEO with big-buck demands.
Download the Top 30 Standard & Poor's 500 Companies PDF .
Download the Top 10 Russell Midcap Companies PDF .
Download the Top 10 Wilshire Smallcap Companies PDF .
