Since the recent high-profile bankruptcies of Enron, WorldCom and other companies, the public has been bombarded by stories of corporate executives reaping millions of dollars in profits before delivering their companies to the bankruptcy courts and leaving the shareholders and employees holding the proverbial bag.

Other stories have detailed the opulent compensation and retirement packages granted to corporate CEOs. These sensational stories have tarnished the image of corporate America (and corporate executives in particular) and have focused the attention of the public, the investment community and the regulators on the usually low-profile subject of executive compensation.

Although the headlines have focused on the most extreme cases, the factors contributing to the environment that fostered those excesses apply to the compensation systems of many American corporations. Companies that prefer not to repeat the mistakes of others may want to examine their own compensation practices to determine if any changes are in order.

How Did We Get Here In The First Place?

No single factor or practice has brought about the current upheaval. Instead, the problems have resulted from a confluence of factors (termed by some as a “Perfect Storm”). Certainly, the recent (and fondly remembered) long-term bull market played a considerable role, in part by blurring the distinction between general market trends and fundamental corporate performance and in part by magnifying the scale of gains to be reaped by executives from stock options. However, the end of that bull market does not mean that the problems have been corrected. Other contributing factors remain: e.g., an over-reliance on stock options for equity-based compensation, spiraling executive salaries and sometimes lax performance by compensation committees.

Stock Options. Stock options have become the subject of particular scrutiny due to their widespread use and the increasingly large size of grants. The growth of stock options as a component of executive compensation has been dramatic, commencing with the general acceptance of the concept that an equity stake in the company is necessary in order to “align the interests of the executive with those of the shareholders.” The disparity in the financial accounting treatment of a stock grant (which results in a charge to earnings) and an option grant (which generally does not result in such a charge) made options the preferred method for creating that alignment of interests. When faced with a choice between stock grants that reduced earnings and option grants with no earnings reduction, companies generally have chosen the “free money” approach and granted stock options, even though the grant of a stock option is not actually free of economic cost to the corporation. The use of options instead of stock grants was further encouraged by the tax laws in that, unlike service-vested restricted stock, options could qualify for an exception to the $1 million cap on deductible executive compensation imposed by the Internal Revenue Code.

Reliance on options increased during the recent technology boom when start-up dot-coms with little cash for salaries began using large stock option grants to attract workers. The size of those grants and the spectacular rewards they produced in turn led to a perceived need by more traditional businesses to increase the size of their own option grants in order to attract or retain executives. In the process, stock options became an ever-larger part of the average executive’s total compensation package, increasing from about 27 percent of median CEO compensation in 1992 to about 60 percent in 2000.

Somewhat lost in the compensation process has been an analysis of whether stock options are, in fact, effective to “align the interests of the executive with those of the shareholders.” Unfortunately, the answer may be no. A leading executive compensation consulting firm recently examined data from more than 100 companies in 10 different industry groups and found that, while there was a positive correlation between corporate performance (compared to the industry group) and the level of executive ownership of company stock, there was actually an inverse correlation between corporate performance (compared to the industry group) and the ratio of stock options held to company shares owned; i.e., company performance actually declined as the ratio of options held to stock owned by executives increased. Although stock option grants to executives clearly create a performance incentive, the absence of any downside risk that accompanies actual stock ownership may create a management focus on short-term stock price increases (sometimes achieved by cooking the books) rather than long-term fundamental performance. Fortune magazine recently reported (August 11, 2002) that, since 1999, executive and director insiders at U.S. companies whose share price had fallen at least 75 percent from its peak received approximately $66 billion from the sale of company stock, with about $23 billion going to executives and directors of only 25 such companies. Clearly the interests of the executives and the shareholders of those companies were not in alignment.

Spiraling Compensation Levels. During the past several years, the pay for senior corporate executives has been increasing at a rate exponentially higher than that for the average worker. In 1980, average CEO pay at the largest U.S. companies was about 40 times what hourly wage earners at those companies received; today that multiple is closer to 500. The Tax Code’s attempt to discourage excessive executive compensation by denying a deduction for amounts above $1 million instead implicitly sanctioned the $1 million salary and exacerbated the problem by creating an exception for “performance-based compensation” that included stock options. CEOs have gone from relative anonymity to celebrity status, and corporations seeking an executive to lead or turn around the business have agreed to pay huge sums for the best available “free agent.” Consultants have ensured that those figures have gone into executive compensation databases to serve as a reference for other corporations and executives. In a practice reminiscent of Garrison Keillor’s Lake Wobegon (where all the children are above average), corporations have commonly targeted the compensation of their executives at the top quartile level as reflected in those databases, with the result that median compensation levels have continued to rise with each new contract.

Compensation Committee Performance. Based on the recent horror stories of executive compensation excesses (epitomized by the $6,000 shower curtain, $15,000 umbrella stand and hundreds of millions of dollars in other compensation and loans received by Tyco’s Dennis Kozlowski), it appears that corporate compensation committees have not always performed as independent and objective overseers mindful of the best interests of the company. Instead, they have too often been influenced by the very executives whose pay they are to administer or by the recommendations of compensation consultants whose ongoing relationships are with management rather than the compensation committees. Committees which have decided that bringing onboard a free-agent CEO is the answer to corporate problems have been willing to accept whatever demands the target executive has made. Not infrequently, the same committees have then agreed to lucrative separation packages for the same executive when the expected performance was not achieved and bringing in yet another CEO was thought to be the answer.

Where Do We Go From Here?

To some extent the response of corporations to the current state of affairs will be determined by the actions of regulatory bodies. Congress was the first to act, addressing some of the more egregious problems highlighted in the headlines with the Sarbanes-Oxley Act that became law last year. For example, the Act prohibits loans to certain executives and requires those executives to reimburse the company for equity compensation profits if financial results must be restated due to misconduct. (For more information on the provisions of the Act, click here to view the Winter 2002 issue of Trust The Leaders.)

Suggestions for changes to existing practices have also come from a variety of other sources, including the New York Stock Exchange, Nasdaq and the Financial Accounting Standards Board. The NYSE and Nasdaq proposals (expected to be approved by the SEC in the near future) would require, at least for listed companies, that shareholders approve any newly adopted stock option plan and that compensation committees be composed of independent directors.

The NYSE and Nasdaq proposals will increase the opportunity for shareholder input on stock option issues. While institutional investors have been concerned for some time about the dilutional effect and economic (if not accounting) cost of large option grants, the attention on options brought about by recent events has broadened that concern. As a result, shareholder opposition to stock option plans has been on the increase, and stock option issues are expected to be a major subject of shareholder proposals during the 2003 proxy season.

Of even greater potential significance is the move toward the mandatory expensing of options for financial accounting purposes. It is widely expected that proposals from the Financial Accounting Standards Board to require the expensing of options, previously unsuccessful due to loud protests from business and Congress, will soon be implemented. A number of companies (including Coca- Cola and Wachovia) have announced their intention to begin treating option grants as compensation expenses even before that treatment becomes mandatory. Should that accounting rule change take effect as expected, the financial statement bias favoring options over other forms of equity compensation would be eliminated, although the tax incentive for the use of options would remain unless the tax laws are also changed.

However, regulatory actions alone will not be sufficient to prevent the problems from continuing. Corporations will also need to take action on their own, examining their compensation practices and asking difficult but essential questions. What type of incentive are we creating with the present structure and policies? Does the present structure reward short-term performance at the expense of long-term fundamentals? Is the incentive consistent with the interests of the shareholders and effective to advance the goals of the company? Is the company getting value for its money? Is the process objective and independent? Does the process create a competitive advantage or disadvantage for the company? The answers to those questions will determine whether and to what extent changes may be advisable.

The logical starting point for that process would seem to be a review of the corporate compensation committee. Attempts to change or improve the company’s executive compensation system are not likely to have any long-lasting effect if the group administering the program constitutes and remains part of the problem. However, if the members of the committee are knowledgeable and objective, understand the role of the committee and the goals of the corporation, and have access to necessary and appropriate information (including, perhaps, the assistance of consultants and advisors answering to the committee rather than management), problem areas are more likely to be identified, effective solutions implemented and decisions made in the best interests of the company.
In reviewing the appropriateness and effectiveness of existing incentive programs, corporations should keep in mind the recent research indicating that relying too heavily on stock options for the equity component of a compensation program may actually create an incentive for top executives to maintain a short-term focus on option spread, resulting in lower corporate performance. A compensation policy that encourages a meaningful and long-term financial stake in the corporation through minimum stock ownership levels and minimum holding periods for compensatory stock (whether received directly or through option exercise) may be better suited to align the interests of management with those of the corporation. Performance-based compensation tied to specific long-term goals of the company (e.g., return on equity, cost of capital or market share) may also be an effective tool to further the interests of the company by encouraging management to maintain a long-term focus on corporate fundamentals.

Is Perception Reality?

The public’s perception, based on current news stories and headlines, is that the executive compensation system in corporate America is broken and needs to be fixed. The circumstances and events behind those stories and headlines suggest there may be some truth to that perception. Just as no single factor has been responsible for creating the current problems, no single change will fix them, and the appropriate set of solutions will vary from company to company. When the headlines and news stories stop, we’ll know the system is working again, at least for a while.