http://www.businessweek.com/ AUGUST 21, 2002 NEWS ANALYSIS
CEO Pay Tomorrow: Same as Today Despite the uproar over gargantuan compensation packages, here's why the level of reform is likely to be modest at best During the boom years of the late 1990s, the fact that CEOs made out like bandits may have prompted disgust, but it sparked little outrage. After all, lots of other people were getting wealthy off the bull market, too. Now that actual banditry is being blamed for the collapse of major companies -- and for billions of dollars in shareholder losses -- CEO compensation is being scrutinized as never before. "It seems like every company that had accounting problems also had troublesome compensation practices," says Brandon Rees, a research analyst with the AFL-CIO's office of investment in Washington, D.C. He believes that "executive compensation abuses can be symptomatic of broader corporate governance problems." The two seem to have occurred simultaneously at Enron, WorldCom, Adelphia, and Global Crossing. And this year's scandals have revealed disturbing exec pay quirks even at companies that haven't imploded. Tyco, for instance, showered deposed CEO Dennis Kozlowski with the type of largesse usually reserved for royalty only to see him charged with trying to evade a measly -- compared with his pay -- $1 million or so in sales taxes on high-priced art. LOWER PAY? NO WAY. And you don't even have to be a CEO to come under fire for an outsize compensation package. Who can explain the reported $30 million that superstar telecom analyst Jack Grubman got when he recently resigned from Citigroup's Salomon Smith Barney -- even as he's under investigation for misleading investors in telecommunications stocks? With over-the-top pay and executive misbehavior so closely aligned, it might seem that exec compensation would be facing an overhaul. But the experts see little ahead that will reset the priorities of CEOs -- and certainly nothing that will ratchet down the average $11 million that top executives were paid in 2001. "We aren't going to see CEOs being paid less," says David Aboody, an associate professor of accounting at UCLA's Anderson graduate school of business and an expert in executive compensation. A survey of experts in the field finds a consensus that the reforms from this year's debacles will be exceedingly modest, at best. In fact, they believe that substantive compensation changes will most likely be left to individual companies eager to set themselves apart from the pack. WINDOW DRESSING. CEOs will suffer some, of course. For a while, they'll all be tarred with the same brush as their disgraced peers, some of whom may end up in jail (see BW Online, 8/21/02, "One CEO's Take on CEO-itis"). There's also the indignity of having to vouch in writing for the financial results of their companies because no one wants to rely on their word anymore. But for the most part, the changes being contemplated for stock-option plans and corporate compensation committees have the look of window dressing. Most companies are likely to stick with the status quo, in part because they do business on the up and up. Moreover, it's now obvious that an exec who really wants to cheat can probably find a way to -- at least for a while. "It's tough to legislate integrity," says Steve Hall, a managing director at compensation consultants Pearl Meyer & Partners in New York. Many observers think the only changes likely to be widely adopted are the two the New York Stock Exchange and the Nasdaq may require of companies traded on those exchanges. (Experts say both could be adopted by yearend if approved by the Securities & Exchange Commission.) One would stipulate that corporate compensation committees, which decide how much a CEO is paid, be composed only of independent directors. Today, some 39% of these committees at the country's top 5,000 public companies include either company insiders or outsiders with direct connections to the corporation, according to the National Association of Corporate Directors. Still, independent compensation committees may not do much to improve the moral fiber of execs, because such committees are often populated with CEOs -- active or retired -- who "are from the same old-boys club," notes Rees. And there's nothing in the Nasdaq/New York exchange proposals that would keep boards from loading up compensation committees with the CEO's golfing buddies. THOSE CEO LOANS. The other reform the exchanges have proposed would require shareholder approval of executive equity awards including stock options. (Currently, shareholder approval isn't necessary if the options plan is "broadly based" or results in at least a portion of the shares being distributed to employees.) But greater shareholder oversight of compensation practices may not eliminate executive shenanigans until there's more disclosure of the private dealings between corporation and CEO, says Judith Fischer, managing director of Executive Compensation Advisory Services, a compensation research company in Alexandria, Va. Fischer cites Enron, which disclosed in its public filings that it had granted former CEO Ken Lay a $7 million line of credit. What Enron didn't spell out, she adds, was that Lay borrowed against that line over and over, ultimately accumulating about $70 million in cash -- which he repaid with Enron stock that's now virtually worthless. Another example is WorldCom, which lent former CEO Bernard Ebbers some $400 million to buy company stock. Little of that loan may ever be repaid, now that the company is in Chapter 11 bankruptcy. The government banned company loans to executives on July 30, when President Bush signed the Sarbanes-Oxley Act, which included several corporate governance reforms. Critics argue that it will take more than that to sever the link between executive compensation and corporate scandals, however. It seems clear that at culpable companies, stock options -- which on average account for about 75% of CEO compensation -- failed to align the chief executive's interests with those of the business, as intended. Rather, they seem to have been "an inducement for greed -- for CEOs to find a way to run up the share price, then sell their stock before it fell," says Michael Hoffman, executive director of the Bentley College Center for Business Ethics in Waltham, Mass. PRESERVING TEMPTATION. One way to inhibit that might be to require companies to expense option grants -- which could cut corporate earnings by hundreds of millions of dollars a year in some cases. "If options were expensed, I think companies would be more careful with their awards," says Ann Yerger, research director for the Council of Institutional Investors, a Washington (D.C.) group that lobbies on behalf of large pension funds. Since Coca-Cola said on July 14 that it will expense options, some 80 other companies have announced that they will, too. Yet companies whose execs have enjoyed the biggest gains in recent years -- such as Oracle, which gave CEO Larry Ellison $706.1 million in compensation including stock options in 2001, and JDS Uniphase, whose CEO Josef Straus got $150.3 million the same year -- have yet to follow suit. Until they do, options will likely continue to be a disproportionate part of exec pay, preserving the temptation for unethical CEOs to line their pockets to the detriment of shareholders. One solution would be for companies to change the type of options they grant. The Anderson School's Aboody notes that the bulk of options now granted are fixed options. All that has to happen for a CEO to clean up is for the company's stock to rise above the price at which the options were granted. The problem, notes Aboody, is that this approach fails to correct for stock-price increases the CEO had nothing to do with, such as those caused by a market bubble. LOWER PAYOUTS. It isn't possible to entirely eliminate that effect, of course, but one way to partially offset it, he argues, is to switch from fixed options to variable options, which benchmark a company's stock performance to that of a peer group or to an index such as the Standard & Poor's 500-stock index. A stock would have to meet or exceed the performance of the benchmark for the exec to cash in -- a much tougher test. A few companies are already putting their CEOs to the test. High-speed network company Level 3 Communications grants options that reward top officers only when Level 3's stock outperforms the S&P 500. But there's little sign that variable options will become the norm. CEOs don't like them because they have to be expensed. And for most execs, the payout would be much less than the riches that fixed options deliver. Proponents of reforms offer another approach that might focus CEOs as much on their companies' earnings as their own: Preventing options holders from cashing in until they're done steering the ship. At Citigroup, which has become embroiled in the Enron scandal over loans to the energy company, senior managers must hold on to 75% of the stock or options they accumulate until they depart. "This 'blood oath' ensures that there's never a moment when the long term isn't first and foremost in our minds," Citi CEO Sanford Weill declared in a recent speech. FEELING THE HEAT. It's doubtful that many companies will follow that example, though. Some compensation experts argue that forcing CEOs to keep their stocks until they leave might encourage them to quit early just to cash in. Plus, they note, CEOs should have the flexibility to diversify their holdings. It's likely that CEO compensation will change at least some in the wake of this year's scandals, however. Even if regulators don't push for major reforms, compensation committees will feel the heat as they prepare their CEO goody bags. Among the perks the committees may become wary of are eye-popping severance packages for CEOs who split, even under a cloud. One recent example: Dynegy CEO Chuck Watson was slated to make off with $33 million in severance, or about three years' worth of compensation, after resigning under pressure earlier this year from the energy trader, whose accounting practices are being investigated. "I would think that boards and even execs are very nervous right now about whatever they do," says Yerger of the Council of Institutional Investors. Indeed, compensation committees might be wise not to accept the notion that they're in the clear because the scandals have been limited to a few "bad apples." Notes Bentley College's Hoffman: "That would be like saying you don't need to put any locks on your house because it was just that one crook who robbed you. We've been robbed by people at Enron, WorldCom, and other companies, and we need to feel safe again." That "we" includes not just investors but the markets and the economy, too.
