Get Ready for the Next Spotlight on CEO Pay
from
September/October 2006
by John R. Engen
To get a feel for the fallout that awaits some boards once the Securities and Exchange Commission’s new compensation-disclosure rules go into effect, consider what happened to Pfizer’s directors when they jumped the gun. The SEC’s new rules are expected to be in force before next year’s proxy season, but the Pfizer board voted to go transparent during this year’s, revealing just how much it was paying the chairman and CEO, Henry A. McKinnell Jr. Shorn of the obfuscation common to proxies in general, Pfizer’s all-too-clear version disclosed that McKinnell’s package included an $83 million lump-sum retirement payout whose true value had been hidden in the complicated formulas reported in previous years.
Powerless to do much about it, angry shareholders vented their ire on the two members of the board’s compensation committee who were up for reelection. They withheld 21% of their votes for the head of Pfizer’s comp committee, Dana Mead, 70, chairman of the Massachusetts Institute of Technology Corp., and George Lorch, 64, chairman emeritus of Armstrong Holdings, a maker of floor and ceiling materials. Mead declined an interview request for this story, and Lorch couldn’t be reached for comment. But George Paulin, the Los Angeles-based chairman and CEO of Frederic W. Cook & Co., a compensation consulting firm that advised the committee, says Pfizer’s directors “decided they were going to have full transparent disclosure and embrace the spirit of the new SEC requirements early.” He admits that the board members “paid a price” for their decision but says they have no regrets.
No wonder the shareholders were riled. Their total return from Pfizer over the five years McKinnell had headed the company was a negative 34%. One investor at the annual meeting chastised the board for signing off on a “pay for failure” program for McKinnell. Defenders say Pfizer’s share-price decline is part of a broader industry trend. They also note that the Pfizer board hasn’t been the only one to approve such rewards. The 11 companies shown at left paid their CEOs handsomely over the past two years even though they produced negative five-year returns for their shareholders, according to the Corporate Library, a governance watchdog. The companies, which all rank in the top half of the S&P 500, also underperformed their industry peers over the same period.
The SEC’s new rules don’t differentiate between CEOs who deliver and those who don’t, but are aimed at shining a brighter light on pay practices and forcing boards to think about how various pieces fit together. Proxies will have to provide a table summarizing the current value of all the components of a CEO’s package, including base salary and bonus, incentives, equity grants, perks, severance arrangements (voluntary or involuntary), and pension. In addition, they must include a detailed “compensation discussion and analysis” section that spells out in lay terms the factors comp committee members considered in putting together each piece of the package, including such things as what results the compensation program was designed to reward, how much weight was given to consultants’ benchmarking data and the CEO’s previous equity awards, and exactly why it’s important that the boss get free personal use of the company airplane. (He spends travel time working, for example.) The SEC rules require similar detail about the total compensation paid to other top executives and to board members. (See the following story for what this means to directors.)
Patrick McGurn, executive vice president of Institutional Shareholder Services, a proxy adviser, says that next year’s proxy season has the potential to be the most contentious ever. “With better disclosure comes the likelihood that shareholders will actually read the numbers and revolt,” he says. “We’ll wind up with more confrontation when the complete numbers see the light of day.” Don’t be surprised if angry investors take board members to court if the numbers appear egregiously generous, warns Michael Melbinger, head of the executive compensation practice at Winston & Strawn. “It’s all about the final number,” he says. His advice to directors: “To protect yourself, you now need to know, review, and discuss every component [of a total comp package] to make sure you’re comfortable with it.”
That might be easier said than done. Few board members possess the technical knowledge to navigate the shifting sands of tax, accounting, and securities-law issues that affect total CEO compensation. Nor do many fully grasp the nuances of establishing truly effective pay-for-performance packages, ones that reward success but levy a price for failure. A director doesn’t have a lot of places to turn for help in getting a better understanding of how compensation packages are put together. While the reporting and documentation requirements of the Sarbanes-Oxley Act offer a relatively concrete road map for audit committee members to follow, there are few such guideposts for their comp committee kin, says Melbinger.
Some boards are trying to solve this by recruiting members with compensation experience. Looking to defend themselves against litigation, others are wisely ridding their comp committees of anybody with the remotest personal tie to the CEO. Compensation committee members are resigning themselves to longer and more frequent meetings too. Marilyn Seymann, associate dean of the Sandra Day O’Connor College of Law at Arizona State University and head of the comp committee at Maximus, a Reston, Virginia, company that administers welfare programs for the federal government, estimates that a typical comp committee chairman must now devote 10 hours per month to the job, about twice the time it took before Sarbanes-Oxley.
To make matters more challenging for comp committees, the best-practices standards of compensation evolve at quite a pace, and today’s bold innovation is likely to be passé tomorrow. Even pay for performance is a moving target and hard to nail down. Suppose a company is going through a tough patch that is beyond the CEO’s control? Methode Electronics, a Chicago maker of electronic systems for cars and other products (2005 revenues: $394 million), is caught up in the slow-growth malaise afflicting automakers. Total shareholder returns have dropped 77% over five years. Even so, CEO Donald Duda has done a good job of keeping the company profitable, and sales may even be up this year—enough to make the board fret that it might lose him to a competitor. Keeping a good CEO is the concern of every board, says non-executive chairman Warren Batts, a former CEO of Tupperware who also serves on Methode’s comp committee. Accordingly, the board approved a 2005 pay package that gave Duda $868,000 in salary and bonus and granted him restricted shares that will vest in 2008, bringing his total package to about $2.4 million. To reach this figure, the committee benchmarked his performance against both direct competitors and companies in associated industries. “We’re trying to find the magic answer to ‘How do we keep the management team motivated and in place while not coming across to shareholders as being extravagant?’” Batts says.
That’s just the explanation that the Methode board will probably have to lay out in next year’s proxy, and maybe it should put it in writing anyway, for practice. Some companies are doing exactly that, in fact—drawing up mockups of next year’s disclosures in anticipation of the new SEC rules, to see how they look. Melbinger, among other lawyers, has been meeting regularly with comp committee clients to walk them through the new requirements, a routine he compares to getting a client ready for a deposition. (See the box on page 41 for some of his tips.)
Boards or committees that don’t like what they see in these dry runs have an excellent opportunity to make adjustments to their compensation programs now so their eventual message to the shareholders will be one they can be proud of, says attorney Laura Thatcher, head of the executive compensation practice in the Atlanta office of Alston & Bird. She has also been advising clients on how to prepare proxies according to the SEC’s new rules. Some boards or comp committees may need to reconsider the size of long-term incentive awards, for example, or persuade CEOs to scale back change-in-control and severance agreements in their contracts before those are detailed in the proxy. “The time to change the underlying facts is before the story goes public,” Thatcher says.
In the course of these mockups, some full boards are getting more hands-on, challenging certain components previously approved by the comp committees. Melbinger tells of a case in which a committee had agreed not only to reimburse its CEO for out-of-pocket health-care expenses but also to “gross up” those payments to cover the extra taxes he’d owe on them. The figure was small, but during the review one director protested against the gross-up arrangement, just as a shareholder might do, and the CEO, says Melbinger, “quickly agreed to relinquish it.”
Boards are trying to come up with better ways to link pay with performance, and many have found that they need to deemphasize the benchmarking data provided by consultants. Critics say benchmarking helps fuel the so-called Lake Wobegon effect, whereby every board believes its own CEO is above average and compensates him or her accordingly. “Every year the benchmark goes way up because everyone gets paid more and boards want to pay their CEO in the top quartile,” says Broc Romanek, editor of CompensationStandards.com, a website that advises boards about pay practices. Diane Doubleday, who heads the executive remuneration business at Mercer Human Resource Consulting, says boards should make compensation decisions based on a variety of data and use benchmarking figures as a final check on their internal calculations.
Talking straight to CEOs and giving them a fair, achievable target, as Methode’s board did, is a good basis for any compensation arrangement, and one that can be laid out forthrightly in a proxy. Doubleday says she has been working with the board of a technology company whose share price used to lag behind that of industry competitors. Some years ago the board observed that better-performing rivals also had consistently higher returns on capital, and decided to tie the CEO’s incentives to that measure. Today the company’s return on capital is comparable to or better than its competitors’, and so is the stock price—and the CEO got his incentive payments. “CEOs are usually pretty competent people,” says Doubleday. “You just have to give them the right goals.” Again, this is a story that could be related in the proxy to explain why the CEO was paid the incentives.
The SEC wants such narrative explanations spelled out in proxies—and some will be more complicated than others. Doubleday posits an example based on cases she’s seen among her clients. Suppose a CEO has deferred some of his compensation over the past 10 years and the company has invested it on his behalf in a 401(k)-type program that has provided a good return. The deferred-comp earnings now might be worth more than his salary and bonus combined, and they have to be reported in the proposed proxy tables. Without a comprehensive narrative to explain this apparent windfall, investors could misinterpret the numbers and get angry. The proxy should describe the source of the deferred amounts, where the money was invested and over what period, and how the value of the investments multiplied, says Doubleday, “with the hope that shareholders buy the explanation.”
Whatever disclosures and explanations they are obliged to make in the future, smart boards have always tried to tie their CEO’s compensation to their specific goals for the company. That means building the right package from the start, with the right base salary and incentives and with reasonable pension and severance benefits. “All your decisions have to meet two simple tests,” says compensation-consultant CEO George Paulin. “Can we justify this as being reasonable in the market? And can we justify it as appropriate to support long-term business objectives that are in the best interests of shareholders?”
It’s nice to imagine an aw-shucks world where CEOs’ pay reflects modest demands that go with their overall humility. Isolated examples of this can be found, though what initially looks like low compensation often doesn’t turn out that way. Richard Fairbank, chairman and CEO of Capital One Financial Corp., has collected no salary or bonus since 1997 but got $249 million last year when he exercised option grants that would otherwise have expired.
Some CEOs agree to a salary that’s equal to a limited multiple of whatever their workers make, but again usually with some kind of stock agreement in the background. At Whole Foods Market, an Austin, Texas-based grocery chain, chairman and CEO John Mackey’s 2005 salary and bonus were capped at 14 times the average cash compensation of the full-time employees, which gave him $436,000. But Mackey cashed in stock options last year too, for a gain of $1.8 million. He has also been granted options to buy 17,000 Whole Foods shares at various prices, which will vest in 2011 and 2012.
Don’t expect “internal pay equity” to catch on everywhere. Consultants say the market for CEO talent is a lot like the one for free-agent baseball players, driven by external forces beyond any board’s control, and that if you want top talent you’ve got to pay for it. As long as boards are forced to go outside the company for a CEO, they’ll face a seller’s market. “The board can try to ignore what’s going on in the marketplace,” Doubleday warns, “but I guarantee that your executives won’t.”
Shareholders won’t be ignoring much either, and certainly not pay for failure. They’re more likely than ever to take note of the CEOs who get the big bucks—and whether they deliver the big bang.
