A Compensation Guru Pleads for Tightwad Boards
from Spring 1999
by Nancy Perry Graham
“The two overriding issues in executive pay are how much, and how,” sums up Graef “Bud” Crystal, America’s leading expert on executive compensation and its most vocal critic of excessive CEO pay. Chief executive compensation, Crystal says, continues to grow at a wild pace. A study he did last April for the New York Times comparing what CEOs at 279 of the 500 largest market cap companies in the United States earned in 1997 versus 1996 showed a year-over-year pay increase of 38%. That’s about 10 times the rate of increase for the average American worker. The average pay of these CEOs, Crystal points out, was $8.68 million, more than 350 times what the average worker ($24,000) earned.
But, acknowledges Crystal, who edits an Internet executive compensation newsletter called crystalreport.com, “there is more emphasis today in tying pay to company performance than in years past.” While it used to be that salary and bonus comprised the biggest piece of an executive’s compensation package, stock options now can make a CEO’s paycheck almost irrelevant. In 1997, for instance, CEO salaries rose 6.65% while the size of stock option grants rose 53%.
Crystal argues, however, that stock options don’t always have the desired effect; indeed, they may do more harm than good. “The CEO screws up,” he hypothesizes, “so the board cuts his bonus to zero and gives him a small salary increase. But the guilty board then turns around and gives him a million stock option grants. So in reality, his pay goes up 40%.”
In an interview with Corporate Board Member, Crystal talks about the growing use and misuse of stock options to reward top executives; fingers a few well-paid CEOs who aren’t giving shareholders their money’s worth; and applauds corporate boards that have established well-thought-out, performance-based compensation policies.
Why don’t stock options do a better job of improving performance?
Partly because boards ignore the effect of the size of the grant being made. There are two ways for the CEO to make a million dollars. One way is, I give him 20,000 option shares with a strike price of $50. If the stock doubles to $100 a share, he makes $50 a share. That’s a million dollars. But there’s a far easier way: I give the CEO one million option shares and the stock goes up one dollar. Both those outcomes produce a million dollars. But in the second case, I’d be hard pressed to argue I was paying for performance, when the stock rose only 2%.
One intriguing study on your website showed no correlation between incentive-based pay and performance.
Well, say you’re already working as hard as you can and as smart as you can and your kids are grown and you have five cars and three houses and a net worth of 10 or 20 million. Why, then, should I suppose that by announcing that I’m giving you a million option shares, all of a sudden your canine teeth are going to drop down one inch, and you are going to jump on the table and rip the throats out of five directors on your way out of the boardroom to hype the company’s stock? I’m not going to transform Dr. Jekyll into Mr. Hyde under those circumstances. It’s almost insulting. It’s like saying, “CEOs must be the laziest people in the world. We have to give them 100,000 shares just to get them out of bed.”
So why do boards persist in awarding millions of options to top execs?
Options are the one form of compensation not charged to earnings, so the discipline in corporate accounting is lost. Directors hand these things out with abandon. On a single day in 1996, the Disney board gave [Chairman] Michael Eisner options on 24 million shares. Admittedly, he won’t get any more for 10 years. But in December of 1997, he exercised earlier options on 21 million shares for a gain of $550 million. Not one cent of that $550 million ever was expensed against Disney’s income statement.
But in reality there is a cost that comes with issuing stock option grants, isn’t there?
The adage, “There’s no such thing as a free lunch” really does hold true here. There are three ways to handle a stock option economically. One way is to charge the earnings. The second is to do nothing until the option is exercised, and then you run the printing press to issue new shares to pay for it. That, of course, dilutes the earnings per share of the remaining shareholders. And eventually that can cost a tremendous amount. The third way being used by an increasing minority of companies occurs when the executive exercises the options and the company takes cash from the balance sheet and buys in shares. So the net is, they haven’t issued any stock. But they have less cash, which means inevitably in future years they’ll have lower earnings than they would have had with more cash to invest.
Are corporate boards to blame for letting this happen?
The problem with running the printing press or using cash is that those costs most often escape the notice of directors. But directors have to be forgiven for not remembering all the time how many shares outstanding there are, how many there were last quarter, and the quarter before that. Board members for the most part are not CPAs, and they are not asked to work 40 hours a week at this occupation. They meet a few times a year and they can be spun like mad by the CEO.
Can you cite any examples of options excess?
Oh yeah. Foundation Health Systems in Woodland Hills, California. During the year ending December 31, 1996, FHS generated a shareholder return of -23%. Horrible performance. The chairman, Dr. Malik Hasan, received a salary increase of only 3% and no bonus. But he did receive options on 100,000 shares at $35.25 per share, which was the price at the time. He then got another option where the price he had to pay was $40.54, and another 100,000 at $44.06. Those options, by my calculation, had a present value of $3.9 million. So his total pay for 1996 was $5.7 million. Now we go to 1997, when shareholder return was -10.1%. A horrible performance again. But apparently reducing your negative return from -23% to -10% is cause for intense jubilation: Dr. Hasan’s salary increase was only 4.9%, and his bonus was zero, but he received an option on 850,000 shares, three times the size of his grant one year earlier, and all at the market price. So now we end up with a pay package of $12.5 million, over double what he received a year earlier, and yet we have a horrible performance number.
Any other examples of overpriced CEOs? One you mentioned on your website is Stephen Bollenbach at Hilton Hotels.
Well you wonder about this one. When he joined from Disney in February of 1996, he got a huge stock option. That’s par for the course. When you come in from the outside, you’re usually going to get a great big front-end grant. Yet, since then, Bollenbach’s stewardship has not been very good, and still, the board is giving him another six million option shares of Hilton and three million option shares of Park Place Entertainment, a gaming spinoff. It’s like a doctor who, when you came in with a terrible sickness, gave you an injection, and now that you’re sicker than ever, his solution is to double the dosage.
Are there any positive trends in compensation committees or examples of boards that are doing things right?
Certainly there are companies out there that are trying to play the game more fairly. An example is TransAmerica in San Francisco. The market price of its stock was around $105 on the day it granted its CEO, Frank Herringer, options on 645,000 shares, and it said to exercise it he would have to pay $150. But it also said when you go to exercise these options, we will calculate the company’s total shareholder return (stock price appreciation plus reinvested dividends) from the date the grant was originally made until today. And we will compare that total shareholder return to the median shareholder return of a whole bunch of financial companies that we’ve already picked out. If we haven’t beaten the median of these companies, then you can’t exercise. Under this sort of a plan you’d find that about 50% of CEOs wouldn’t have gotten a nickel.
That’s great, but how is a board supposed to retain a brand-name CEO, like a Michael Eisner, if they don’t pay him what he wants?
In a book I wrote some years ago, In Search of Excess: The Overcompensation of American Executives, I argued that every compensation committee ought to have an independent consultant who did nothing but work with the committee. [Editor’s note: Crystal will not serve in a paid consulting capacity for any public company.] The consultant ought to meet with the compensation committee at all times and provide recommendations that are incorporated into the minutes of comp committee meetings that would be available in a lawsuit. That way, the board would have an expert to say, “Wait a minute, have you considered this? What about that?”
And why don’t CEOs have agents? If we had a true arms-length situation where the CEO had his advisers, and the board had its advisers, there would be some vigorous negotiations and alternatives explored. There might even be some angry words exchanged. But what comes out of that is a free-market deal.
How many boards have consultants?
Hardly any.
Why not?
After writing the book, I was talking to a chairman of a comp committee and he said, “I couldn’t disagree with you more. If the company has its consultant and the board has its consultant, you’re going to turn this thing into an adversarial situation.” And I said, “Well what the hell do you think it is? Do you think when the agent for one of those star Yankee players is negotiating with George Steinbrenner, that Steinbrenner is worried about creating an adversarial situation?” This is the attitude in corporate America: that the boards are harmonious places; that we’re not supposed to make loud noises in church. And that’s an unfortunate thing. I wish that boards would be more independent.
What is your opinion of the repricing of options?
I think there is a fair way of doing it, which I might call an economic repricing. Let me give you an example. Let’s say you have 1,000 option shares with a current price of $25 a share, and the price to exercise is $50. With a normal repricing we say: What if we lower the strike price from $50 to $25? Now, what if we did something a little different? Let’s not give you back 1,000 shares at $25. Instead, I’ll give you 425 shares. So you are turning in 1,000 shares with a strike price of $50 and getting back 425 shares with a strike price of $25. I haven’t given you any more money, and if the stock price ends up between $25 and $50, you’ll make more from your 425 shares than you would have from your 1,000 shares. But if the stock price ends up far enough above $50, you’ll wish you hadn’t turned it in.
Are there many instances of this?
Yes. A case in point involves William Anders, the former chairman of General Dynamics. Before Anders took over in 1991, the stock went way down, and he was holding options that were out of the money. So in February of 1991, the board came up with a fair repricing in which Anders turned in 103,746 option shares at $44.94 and got back 51,479 options at $25.56 per share. He then proceeded to perform so well in the next 15 months that he actually lost $3 million, compared to what he would have made had he kept the higher number of shares at the higher strike price.
So is repricing really such a good deal for CEOs?
If you think you’re a real power hitter who can go back and capture the magic again, then you don’t want to reprice. But consider Cendant Chairman Henry Silverman, who on October 14, 1998 turned in 25.8 million option shares that were substantially higher than the market price. One third were cancelled. And another third were repriced with the new price being set at 203% of the market price on the date of the repricing. But one third were repriced, where the new strike price was set to equal 100% of the market price on the day of the repricing. By taking that repricing, is he not admitting to the world that the stock doesn’t have a huge upside?
Let’s talk now about directors. Are they overpaid?
One thing I would quickly observe is that for some reason, institutional investors mounted this crusade against boards having pensions. As a result, company after company is taking away pensions from outside directors and giving them stock options or something else. I think by the time the smoke clears, they will be getting more money than they got before but in a less-objectionable form. Incidentally, I have developed software, available on my website, called Outside Director Pay Simulator, which is based on the pay packages of about 1,000 boards. [Editor’s note: This software is free to Crystal’s subscribers or can be purchased for $195.] You can plug in data about your company’s size, performance, and type of industry, and it will tell you what an average package is for a comparable company. But worrying about directors’ compensation is like a homeowner agonizing over a few strands of crab grass in his lawn when his house is burning down. The CEOs’ and senior executives’ pay is the real issue here.
Any CEOs that are positive models?
The one hero I can think of is James Barksdale at Netscape Communications who, when the company’s stock price plummeted, said, “I made a lot of money going up and I can’t dodge my responsibility going down,” so he cut his pay to a dollar. And the company had given him 300,000 stock options and he gave them back. That’s heroic.
