Fray on Pay
The battle over executive
compensation and what it means for you.
June 1, 2009
When it comes to the public outcry over
executive compensation, the sounds of protest may have faded but the fury
lives on. Bands of placard-carrying citizens have disappeared from lower
Manhattan, but efforts to rein in what many perceive as outrageous paydays
are, if anything, intensifying. From Capitol Hill to boardrooms across the
country, efforts are under way to restrict the compensation of executives
of all publicly traded companies, even those far removed from any form of
bailout.
"People have been excoriating
executive-pay practices for decades, and this is their 'pitchfork' moment,
with mobs literally taking to the streets to protest the bonuses at AIG,
Merrill Lynch, and other firms," says Ira Kay, director of executive
compensation consulting at Watson Wyatt.
Already the repercussions are being felt
far and wide, from Silicon Valley, where Apple shareholders pushed through
a "say-on-pay" proposal despite board members advocating for its
rejection, to The Netherlands, where the CEO of ING made a "moral appeal"
to executives to return their recent bonuses. A Watson Wyatt survey found
that nearly two-thirds of board members believe companies need to change
their executive compensation plans in response to current political and
market pressures.
A Volatile Mix
It is political pressure in particular that has many observers, not to
mention CFOs, seeing red. Soon Congress is expected to unveil a slate of
executive pay legislation that could extend the government's recent rules
for companies receiving federal dollars from the Troubled Asset Relief
Program to other publicly traded companies. "The sad thing about AIG and
the TARP regulations on executive pay is that successful, careful
companies will be painted with the same broad brush, affecting their
ability to compete in the global marketplace," says Jeffrey A. Burchill,
senior vice president and CFO of FM Global, a large business-property
insurer.
If the remarks coming from the two
primary movers in Congress House Financial Services Committee chairman
Barney Frank (DMass.) and Senate Banking, Housing, and Urban Affairs
Committee chairman Christopher Dodd (DConn.) are any indication,
companies can expect substantive changes, although the full scope is
anyone's guess. "Specific caps on compensation are not very likely," says
Alexander Cwirko-Godycki, research manager at compensation benchmarking
firm Equilar Inc., "but there is definite momentum behind say-on-pay
provisions, mandates for wider clawback policies, and increased
compensation disclosure requirements, among others." It remains to be seen
which of these, if any, will become law, but in Cwirko-Godycki's view,
"there has certainly never been a stronger case for these proposals to
become reality."
"Situations of excessive pay are not
rampant," says Brent Longnecker, chairman and CEO of Longnecker &
Associates, a Houston-based compensation consultancy. "Only about 2% of
companies have rewarded failure, but the government is keen to do
something to appease the public's outrage." He is not alone in this view.
"Nobody knows what the rules will be or how the Treasury Department will
write the regulations, but they're coming," says Patrick McGurn, special
counsel to the institutional shareholders services unit of RiskMetrics.
In a worst-case scenario, some or all of
the compensation provisions in TARP would be extended to all public
companies (see "Laying Out the TARP" at the end of this article). While
that's a long shot, even the possibility has many people raising a battle
cry. "If companies don't get out in front of this issue now, with their
compensation committees leading the charge, the government will get in and
make things worse," says Ben W. Heineman Jr., former General Electric
senior vice president and general counsel and currently a senior fellow at
Harvard University's schools of law and public policy. "This is not the
time to go into the bunkers."
"The question is how far Congress will
go," says Claudia Allen, chair of the corporate-governance practice at
Chicago-based law firm Neal, Gerber & Eisenberg. "You have politics and
the law getting stirred in the same pot, and it is a volatile mix."
Many observers fear the law of unintended
consequences, and point to the 1993 creation of Section 162(m) of the
Internal Revenue Code as Exhibit A. The regulation forbade corporate tax
deductions for salaries exceeding $1 million, but made an exception for
performance-based incentive compensation, such as stock options vesting at
a particular date. Not surprisingly, or so it seems now, companies shifted
from high salaries to high stock options and bonuses, while also lifting
the salaries of many seemingly underpaid CEOs and other senior executives
to $1 million. Now the Obama Administration is considering revising 162(m)
downward, disallowing tax deductions above $500,000 and closing the
loophole for stock options. "As we've seen happen in the past with respect
to executive pay, the government has a way of making things worse,"
Longnecker says.
CFOs React
CFOs certainly seem disinclined to burrow into the bunkers. "This
country was built on capitalism, on people wanting to better themselves,
working long hours to achieve cherished dreams of success," says Marc
Rosenblum, CFO of cosmetics company Clarins USA. "Unlike socialist
societies, people could become rich if their companies became successful.
We have to be very careful not to make this country a place where dreams
can no longer be realized."
"If the government begins setting
bright-line tests limiting compensation and enacts one-size-fits-all
regulations," says Holly Koeppel, CFO at Midwest utility American Electric
Power (AEP), "it may change the perception and motivations of managers,
ultimately rendering the organization less competitive."
Rosenblum, however, concedes that some
reforms are needed. "You cannot reward someone for sales volume without
regard for whether or not it's good for the business," he says, taking a
swipe at AIG. "I don't blame traders there for getting bonuses they
should be compensated for bringing in volume. But it's the CFO's job to
make sure that what they're selling is not too risky." He suggests, in
fact, that CFOs should play a key role in bringing sanity to bear on
compensation. "Abolishing bonuses isn't the answer: managing risk is. As
long as finance has a say, everybody wins."
Koeppel agrees. "The issue is risk and
how to align it with executive reward," she says. "We lost our way when
reward was linked to financial metrics that did not translate into cash
flow."
In Search of Better Metrics
There may be a lesson in that for compensation committees, which are
now on a collective hot seat from which they are unlikely to extricate
themselves any time soon. "The typically light agenda of summer committee
meetings will be a distant memory," says Myrna Hellerman, senior vice
president at Sibson Consulting. "Committees will have to make [vital]
decisions about what stays and what goes in 2010 compensation plans."
RiskMetrics's McGurn agrees, adding that "AIG and other egregious examples
of 'pay-for-failure' have served as a consciousness-raising exercise for
boards and compensation committees."
"I think that compensation committees
should be in the crosshairs on this issue," says Lester A. Hudson,
chairman of the Human Resources Committee of AEP's board (which also
addresses executive-compensation policies), "and not the executives
receiving incentive compensation. The problems reside with the directors;
many just don't understand the implications of their plans. It is their
responsibility to ensure that incentive compensation doesn't increase the
risk level of the company, and some committees failed to grasp this."
As for what such committees might do,
Bruce Ellig, a compensation adviser and author of the revised and updated
Complete Guide to Executive Compensation, echoes Koeppel's comments
on metrics in general and cash flow in particular. "There are a number of
ways that boards can address these issues before the government [steps
in]," he says. "For example, they may want to use both net income and cash
flow as pay-for-performance measures, as opposed to just net income. Cash
flow is much harder to fudge you either have it or you don't."
FM Global's compensation program links
incentive compensation to three key metrics: profitability, customer
retention (measured as revenues from the existing customer base), and new
customers (measured as additional revenues). If profitability falls
precipitously and the other two metrics rise, executive compensation
suffers the reverse of the equation used by AIG. "Of the three key
metrics, profitability is the one weighted largest, accounting for 50%,"
Burchill says. "Customer retention is 40%, and only 10% is new business.
You have to have company results before you pay incentive compensation."
Despite the uncertainty regarding
legislation, many companies are addressing compensation issues already.
The Watson Wyatt survey found that fully 55% have frozen salaries 34
percentage points higher than the consultancy's December 2008 survey
recorded. Thirty-eight percent of respondents also are making changes to
their annual incentive-plan performance measures and 30% are making
changes to their long-term incentive-plan measures. About one-third have
already shifted to time-based restricted stock and performance-based
shares, and another third have changed or are considering changes to their
executive-pay programs to address excessive risk.
Tensions and Checkpoints
Given that companies seem to be taking action, however belatedly, on
this hot-button issue, many argue that no government intervention is
needed. "I'm a firm believer that the current system is working," says
Mylle Harvey Mangum, chairman and CEO of IBT Holdings, a designer and
builder of retail environments for bank branches. Mangum sits on several
boards and currently chairs two compensation committees, at Haverty
Furniture and Collective Brands (owner of Payless retail shoe stores).
"Compensation committees are in the best and most knowledgeable position
to address the perceived abuses," she says. "Directors today are chosen by
other board members and voted on by the shareholders. Nobody slips by
anymore."
To assure that executive pay is aligned
with company performance, she says, compensation committees should
consider scenario-planning exercises in which the key metrics governing an
executive's pay are put through different circumstances. On the two
compensation committees she chairs, "we use tally sheets to plot the
financial metrics against salary and performance-based compensation to see
where things might end up down the line. Each company is different, which
is why one-size-fits-all regulations just don't work. You want to set up
healthy tensions and checkpoints that encourage salespeople to sell like
crazy, but then have a finance person who has to approve the pricing and
margins before things get out of control."
Such checks and balances also are in play
at AEP. Koeppel assists the board in linking business outcomes with
compensation metrics. "We take the board through new scenarios every
year," she says, noting that finance provided "a wider range of possible
outcomes this year in light of the economy."
AEP's board has the discretion to make
adjustments to the compensation plan if they perceive it to have negative
unintended consequences. Directors did that earlier this year, when the
company lowered its 2009 earnings guidance. The board changed AEP's
methodology for annual incentive compensation by increasing the threshold
earnings per share needed to fund the program, moving it to the midpoint,
rather than the low end, of the company's earnings guidance. The board
decided that "requiring employees to work harder to achieve incentive
awards more-appropriately balanced employee and shareholder interests,
since shareholders would be negatively impacted by the lower anticipated
earnings," Koeppel says.
Such best practices may be moot, however.
"The die has been cast," says Kay. "We're in a deep recession and people
are looking for victims. Executive compensation is number one on that
list. The government is getting high marks from the public. For the time
being, Corporate America cannot defend itself."
Russ Banham is a contributing editor
of CFO.
Putting More Claws in Clawbacks
One of the less controversial aspects of
executive-compensation reform concerns clawbacks, or procedures for
retrieving bonuses from executives whose managerial prowess was evident
only for the very short-term, if at all. But current laws can make
retrieving undeserved bonuses tricky. There isn't much case law on the
subject, with only one successful clawback to draw from a 2007
settlement with William W. McGuire, former CEO of UnitedHealth Group, who
was required to repay $468 million of his bonus for allegedly backdating
stock options.
A spate of pending litigation may change
that. In April the SEIU Master Trust, a consortium of pension funds with
approximately $1.3 billion in assets, demanded that the boards of
directors of 29 major companies in its investment portfolio investigate
more than $5 billion of incentivized executive pay alleged to have been
tied to poorly understood derivatives and other financial instruments.
Since 2005, the top five most highly paid executives at the 29 firms,
which include AIG, Wells Fargo, Citigroup, American Express, Goldman
Sachs, and McGraw-Hill, received more than $3.5 billion in cash and equity
pay and more than $1.5 billion in stock options. During that same period,
the share prices of the 29 firms plummeted.
Meanwhile, corporate antipathy toward
"say-on-pay" shareholder provisions seems likely to fade even though many
experts say such policies lack nuance. "It's a blunt instrument," asserts
Russell Miller, managing director of Executive Compensation Advisors, a
division of executive search firm Korn/Ferry International. "Shareholders
will be asked to vote either yes or no. It doesn't give them the ability
to vote on the merits or detractions of various elements within
compensation programs, or to engage in any kind of meaningful discussion
with management." Then again, most such provisions are nonbinding anyway,
which once again puts compensation committees on the line as they debate
whether to act on such votes. R.B.
Laying Out the Tarp
Notable executive-pay rules within TARP legislation include:
A prohibition on cash bonuses and
incentive compensation other than restricted stock for the top five
officers and others
A prohibition on bonuses to these top
executives in excess of one-third of their annual compensation, until the
TARP loans are repaid
Stringent "clawback" provisions
requiring TARP recipients to recover performance-based compensation
awarded to the top executives if the bonuses were based on statements of
earnings, revenues, gains, or other criteria that are later found to be
materially inaccurate (The new rule stiffens the clawback provisions of
the Sarbanes-Oxley Act of 2002, which addressed only CEO and CFO pay.)
A "say-on-pay" provision permitting
shareholders to vote "for" or "against" a public company's
executive-compensation program
An end to "golden parachutes," as well
as other restrictions on severance payments
The effective banning of such executive perquisites as free country-club
memberships and chic office remodels R.B.
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