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Above Board

Regulators and shareholders want compensation committees to explain why CEOs make so much.

1Oct

Any doubts that compensation committees would come under fire were erased this past September, when New York Stock Exchange chairman Dick Grasso was forced to resign over his controversial deferred compensation package of close to $140 million.


The guns were already loaded. Just one month before, Securities and Exchange Commission chairman William H. Donaldson had taken on the issue in the bluntest possible terms. "One of the great, as-yet-unsolved problems in the country today is executive compensation and how it is determined," he told a National Press Club audience in August. True, compensation committees have more independent members—thanks to the Sarbanes-Oxley Act of 2002 as well as proposed reforms issued by Nasdaq and, ironically, the NYSE. But Donaldson also noted that they must now "begin to look into exactly what they're compensating for" and move beyond "simple issues like earnings per share and the increase in earnings per share" when paying executives.


Donaldson's frustration with compensation committees is shared by investors. This year, a record 322 nonbinding shareholder proposals have sought to rein in executive pay, according to the Investor Responsibility Research Center. The issue starts, of course, at the top, where the link between CEO pay and performance remains mysterious. In 2002, CEO total annual compensation (base salary and bonus) actually rose by a median of 10 percent, according to a survey conducted by Mercer Human Resource Consulting, while total return of the S&P 500 shrank by 24 percent. Little wonder, says Barbara Hackman Franklin, former U.S. Secretary of Commerce and a member of five corporate boards, "there's a building public perception that something is out of whack with executive compensation."


This is not really a new observation. In 1997, BusinessWeek magazine named The Walt Disney Co.'s board "the worst in America," a year after its compensation committee awarded CEO Michael Eisner a 10-year contract that included 8 million options. That same week, Eisner scored the single biggest payday for an executive (until that time), earning a $565 million profit from exercising some of his options.


What's upping the ante now, however, is the bright light recent scandals have shone on boards, in particular the workings of comp committees as well as audit committees. Rating systems such as those offered by Institutional Shareholder Services and The Corporate Library are punishing companies with less-than-desirable governance practices. And compensation committees are not only being asked to publicly explain their rationale for CEO pay, they may also soon face personal liability if they approve a flawed package.


In fact, says Edward J. Speidel, Buck Consultants's national executive compensation practice leader, "2002 and especially 2003 should be considered watershed years for comp committees." In response, says Donald Gallo, a principal at Sibson Consulting, companies are instituting reforms designed "to get their houses in order before the next round of [regulatory] assault."



Top Quartile

Historically, a seat on the compensation committee gave members a front-row view of pay and strategic practices. CEOs liked to sit on comp committees of other companies to keep tabs on their peers' compensation, explains Franklin. And since compensation "can influence the behavior of executives," adds Speidel, many directors used their committee assignment to gain influence with the CEO.


What they didn't change was the direction of CEO compensation. Aided by the bull market and the backfiring of several regulatory efforts (the 1992 proxy disclosure requirement drove salaries up, since CEOs could see what their peers were making; the 1993 capping of the tax deduction for executive salaries at $1 million made that figure the de facto standard), CEO pay packages rose 90 percent between 2000 and 2002 alone, according to The Corporate Library. And even as economic times got tougher, executive pay kept increasing. CFOs at the largest public companies saw their median bonuses rise 17.5 percent in 2002, the biggest increase in four years, according to a proxy survey conducted by Mercer Human Resource Consulting for CFO.com.


Part of the problem, says Nell Minow, co-founder of The Corporate Library, is CEOs in America are like the children of Garrison Keillor's mythic Lake Wobegon—all of them are supposedly above average. Most companies want to be able to say that their CEO is in the top quartile of all chief executives. And how do you prove yours is one of the best? Pay him or her in the top quartile. Says Speidel: "All companies want their CEOs to be paid in the 75th percentile; they just never wanted to question whether their performance justified that amount."


The dynamic between the committee and the often hard-charging CEO also led to compensation giveaways. At WorldCom, compensation-committee members reportedly referred to former CEO Bernard Ebbers as "God," "Jesus Christ," and "Superman," and awarded him compensation to match, including a $400 million loan and a $1.5 million annual severance package (amounts they are now trying to recoup). And since traditionally the CEO hires the consultant (or oversees the hiring) who develops the executive-compensation package, it's not surprising that comp committees often received inflated proposals, says Franklin.



Danger from Delaware

These days, compensation packages deemed inappropriate are routinely questioned—even if the CEO's performance is stellar. And in a development that has comp committees shivering, the notoriously business-friendly Delaware Court is holding them responsible for excessive executive pay.


In a January roundtable in the Harvard Business Review, for example, E. Norman Veasey, Chief Justice of the Delaware Supreme Court, said that if directors state 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."


That opportunity may soon present itself. In May, Chancellor William B. Chandler III of the Delaware Court of Chancery allowed a shareholder suit to go forward that charges compensation-committee members at Walt Disney with breach of fiduciary duty in the case of Michael Ovitz. The company's former president famously exited Disney in 1996 after just 14 months of service and pocketed $38 million in cash and options worth an estimated $100 million for his efforts. His efforts were considered so mediocre that Stephen Bollenbach, Disney's CFO at the time, told Vanity Fair magazine that Ovitz "didn't understand the duties of an executive at a public company, and didn't want to learn."


The plaintiffs allege that the Disney compensation committee spent less than an hour debating the Ovitz pay package. Instead, the suit charges, the committee allowed chairman Eisner to steamroll the hire through and negotiate a pricey severance package in order to save face. Disney shareholders now believe committee members should be held personally liable "for a knowing or intentional lack of due care" in overseeing Ovitz's tenure.


"If [the Disney case] goes to trial and the compensation-committee members are found liable, it will be [a landmark decision]," says Franklin. Even allowing the case to proceed, she adds, may mean that all compensation committees can be held accountable for irresponsible pay packages.


Meanwhile, a judgment against Siebel Systems is already altering compensation-committee practices there. As part of a settlement with a shareholder, the Teachers' Retirement System of Louisiana, the San Mateo, California, software maker agreed in August to outline the criteria it uses to determine executives' and directors' pay, and to improve compensation disclosure.


One of the shareholders' main issues: even as the compensation committee awarded the maximum amount of options to CEO Thomas Siebel, it met fewer and fewer times. The plaintiff's lawyers contended that, in 1996, for example, when Siebel received 2 million options, the committee met five times, and that in 2000, when he was awarded 8 million options, it convened only once.



Committee Reform

Increasing the number of meetings is just one of the reforms companies are instituting to quell shareholder and regulator discontent. Compensation committees, says Speidel, are also doubling individual meeting time and "reallocating the meeting schedules so as not to tackle too much at one time." Companies such as Express Scripts Inc. have recently updated their compensation charters. Others, including Credence Systems Corp., have added financial experts to their compensation committees.


Soon, comp committees may also have a detailed guide to best practices at their disposal. A report from the Blue Ribbon Commission on Executive Compensation, sponsored by the National Association of Corporate Directors and chaired by Franklin, is scheduled for release by mid-October. Franklin hopes that if enough companies adopt the proposals, the government will step back from further regulation. "If we do this right and come out with a cogent, reasonable, and practical report, we will have an impact," she says.


The report will likely address a range of topics, including the question of who should sit on a compensation committee. "You can't expect compensation-plan experts to sit on the committee," says Franklin. But, she says, you can expect "people who are truly independent—financially independent, psychologically independent—and who have a little bit of courage to stand up to the CEO when necessary." While having financial expertise may not be as necessary on the comp committee as on the audit committee, "it's going to be helpful" when dealing with such topics as accounting for stock options, says Speidel.


The report, says Franklin, may also recommend changes to some long-standing comp-committee practices. For example, she says, having the committee hire the compensation consultant—much the way audit committees now hire the auditors—would lead to more independent pay proposals. To Ultratech Inc. CFO Bruce R. Wright, such a move makes sense. "Otherwise, management is making recommendations about their own compensation, or board members are doubling as compensation experts, which they aren't," says Wright, the new member of Credence's comp committee. He says firms that don't take such a step "leave themselves open to an added degree of risk."


The Holy Grail for comp committees, of course, is to actually require pay for performance. In assessing performance, Donaldson in his August speech suggested that nonfinancial factors, such as customer satisfaction and product quality, be taken into consideration. Actually putting this idea into practice could prove very problematic, of course, as docking CEOs for failure to attain customer satisfaction or product-quality goals is tantamount to admitting publicly that these goals were not met. Still, says Minow, companies need to develop consistent, accurate, and transparent metrics to explain how they pay executives. "I don't care how they do it as long as they stick with the stated metrics," she says. "And pay should equal performance."



Where the Links Are

Despite the current uproar, few observers expects a big decline in CEO pay. Frank Borelli, the former CFO of Marsh & McLennan Cos., believes that "base salaries will come down a bit" and overall pay packages "will not be so generous." But there are no guarantees—especially if an economic recovery sparks another competitive hiring frenzy.


There are also no guarantees that government regulators will be satisfied with reforms companies make on their own. Even though such advocates of reform as Franklin note that "it's always better to have a private-sector solution" and firmly believe companies are capable of making the necessary changes, some CFOs are not so sure. Says Ultratech's Wright: "There will probably be future legislation."



Lori Calabro is a deputy editor of CFO.

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