Executive Pay
After years of watching the top echelons of corporate management take home billions, shareholders want to know: Will inflated pay packages get slashed?

By David S. Hilzenrath
Washington Post Staff Writer
Sunday, December 21, 2008; F01

Angelo R. Mozilo, whose Countrywide Financial came to symbolize the failings of the mortgage industry, took home more than half a billion dollars from 1998 to 2007, including $121.7 million from cashing in options last year alone. Charles O. Prince, who led Citigroup to the brink of disaster, was awarded a retirement deal worth $28 million. Now, in a show of purported restraint, top Wall Street executives are going without bonuses.

What are we to make of all this?

If you're angry that so many executives got paid so much for screwing up so spectacularly, you might take solace in the fact that shares they still hold have lost value, too. But if you think executive pay is finally succumbing to the force of gravity -- if you'd like to believe that an epic destruction of investor wealth will fundamentally and permanently change the way chief executives are paid, or that you, dear shareholder, have the power to join forces with others just like you and create a more rational order -- don't bet on it. The nation's financial crisis could change the rules of executive pay, but if history is any guide, you'll have a lot more to complain about in the years ahead.

Through nearly two decades of tinkering, each new twist in executive pay has proved flawed. Incentives meant to reward good management have done just the opposite, and efforts to reform the system have in some respects made matters worse. From the bursting of the dot-com bubble to the collapse of companies like Enron and WorldCom, from the rampant backdating of stock options to the current meltdown of the global financial system, the so-called pay-for-performance movement has led to colossal windfalls, reckless risk-taking and fraud.

At a time when the government is using taxpayer funds to rescue financial titans -- when ordinary Americans are watching their retirement savings evaporate -- announcing that top executives will forgo bonuses has obvious public-relations benefits. But unless a bonus was warranted, it's a hollow gesture. And it does nothing to alter certain underlying realities.

For the most part, executive pay is set by executives. Executives dominate corporate boards, and corporate boards are self-perpetuating. As a practical matter, shareholders have little say in the selection of directors, and once directors are in the compensation boat, they have little incentive to rock it.

If you're a director and you go along with generous chief executive pay, "you get to sit on more boards," said Fabrizio Ferri, an assistant professor at Harvard Business School who studies executive compensation.

According to one school of thought, the scale of executive pay, if not the particular form, is unlikely to change substantially unless the balance of boardroom power changes.

There are several ways the crisis could shake things up.

First, short of a revolution in the way corporations are governed, there are efforts afoot to make it harder for executives to profit from mismanagement while investors are left holding the bag.

Some shareholder activists are calling on boards to hold incentive pay hostage to a company's long-term fortunes, and investor anger could put pressure on directors to comply. The American Federation of State, County and Municipal Employees plans to ask shareholders to vote next year on resolutions urging boards to take two steps: stretch out the payment of annual bonuses over multiple years and hold on to a significant portion of equity awards until the executive has been gone from the company for two years.

The resolutions are purely advisory.

Second, through its bailout programs, the government can set conditions for companies that accept federal funds. For example, the government is requiring participating firms to eliminate incentives for executives to take "unnecessary and excessive risks that threaten the value of the financial institution." It's unclear how companies will apply such a nebulous standard. In the spirit of both the AFSCME proposal and the Treasury mandate, the investment firm Morgan Stanley recently said it will make a portion of annual bonuses subject to recapture by the company.

Third, either Congress or the Securities and Exchange Commission could make it easier for big shareholders to put their own candidates for board seats on the corporate ballot. In theory, that could make directors much more accountable. For it to work, shareholders, especially institutions like pension and mutual funds, would have to take a more active role than many have had the stomach to play in the past.

The plan could backfire. If executives are forced to confront shareholders with real power, would they be any less motivated to deliver short-term results, or the illusion of short-term results -- even if those compromise the company's interests over the long run?

* * *

Outrage about executive pay is far from a new phenomenon.

Back in 1990, two professors warned that something very bad was taking place in America's boardrooms: Executives were being paid too little.

"On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets?" professors Michael C. Jensen and Kevin J. Murphy wrote in the Harvard Business Review.

Executives, not surprisingly, embraced the idea. In a way, so did their toughest critics. At the time, some shareholders were up in arms about million-dollar executive salaries. They demanded that pay be based on performance, and they bought into the notion that chief executives should be able to make more money as long as they earned it.

President Bill Clinton and Congress got into the act in 1993, dictating that companies could no longer take tax deductions for executive pay packages of more than $1 million -- unless the pay was performance-based.

What followed was a massive proliferation of stock options, making it possible for executives and workers alike to attain fortunes that were previously unimaginable. Options give the holder the right to buy shares of stock at a fixed price -- ordinarily, the price at which the shares are trading when the options are granted. If the market price of the stock climbs, the holder can exercise the options and sell the shares at a profit.

If the executive is awarded options to buy 500,000 shares at $10 each and the stock price climbs to $100 -- well, you do the math.

Corporate boards claimed that they were aligning the interests of executives with those of shareholders. They were wrong.

Options can reward any increase in the share price. That became painfully clear in the bull market of the 1990s when executives benefited from rising share prices even if their stocks lagged behind competitors or market averages.

Then came an epidemic of accounting scandals, which showed that options gave executives powerful incentives to cook the books and kite their stocks. More recently, many companies were found to have secretly manipulated the terms of options. By backdating the awards -- in other words, falsely claiming that the options were granted when the stock price was especially low -- companies lowered the performance hurdle and made the options much more valuable.

As an alternative to options, or in addition to options, many boards shower executives with stock that vests over a period of years. But those awards are widely mocked as "pay for pulse" because they have value even if the stock price falls. Some boards layer on additional requirements -- for example, the executives can't collect the stock unless the company's profit or share price hits certain targets. If the targets aren't easy to hit, they can introduce more incentives to cheat.

Meanwhile, boards have a history of openly changing the rules to benefit the boss. When performance targets proved too hard to meet last year, a bunch of companies dispensed with their criteria and awarded bonuses anyway, according to a report this month by the Corporate Library.

Government efforts to reform executive pay have had mixed results.

When the government limited the tax-deductibility of executive salaries, many boards stuck shareholders with the added taxes instead of capping the salaries. When the government mandated clearer disclosure of executive pay, it gave shareholders fresh ammunition to complain -- but it also gave executives more information about their peers, which gave them new leverage in pay negotiations, Joseph E. Bachelder III, a lawyer for top executives, wrote in the New York Law Journal last year.

In 1992, after the SEC adopted some of the most significant reforms, one leading compensation critic suggested that the actions could put him out of business. "I may be like the Maytag repairman, with nothing to do, sitting here waiting for somebody to be overpaid," Graef Crystal joked. Sixteen years later, Crystal is still fulminating.

At last check, the chief executives of companies in the Standard & Poor's 500-stock index received pay packages valued at an average of $10.5 million, which was 344 times the pay of the typical American worker, according to a study by the Institute For Policy Studies and United for a Fair Economy, which says that "concentrated wealth and power undermine the economy."

Murphy, a co-author of the 1990 Harvard Business Review article, predicted that executive pay will resume its upward climb.

"I think we have a history that shows that uproars over executive compensation at most create short-run changes in pay. And then what usually happens is the government enacts some knee-jerk reactions that at the end of the day end up increasing executive pay," he said.

Chief executives "prefer to play a heads-I-win, tails-you-lose game with shareholders, and so far they've been successful," said Jensen, the other author of the 1990 article. "It's changing, but compensation committees [of corporate boards] still tend to be under the control of the CEO," he said.

Though it may be counterintuitive, the current crisis could plant the seeds for a new bumper crop of executive riches.

As compensation committees ponder their next round of pay decisions, one of the questions they are trying to answer, board advisers said, is how to factor in the decline in stock prices when determining how many shares to award executives. They could give out the same number of shares as in past years, delivering much less value. Or they could give out many more shares to make up for the reduced value of each individual share, setting executives up for huge gains if stock prices recover.