![](img_CBMaglogo_v2.gif)
Memo to Comp Committees: Don't
Let Investors or CEOs Push You Around
from
Third Quarter 2009
Corporate Board Member
by Julie Connelly
An
uncertain economy is clouding strategic planning, but boards must still
grapple with some pretty specific numbers—the ones they’ll have to put
together to come up with compensation packages for their CEOs and other top
executives. Comp experts have two pieces of advice for those who are looking
at the numbers for 2010:
-
Don’t allow yourself to be stampeded by popular opinion. It’s important
that you resist any temptation to be punitive just because you sense that
shareholders are out for blood.
-
Don’t believe that your CEO will quit if you cut his package. There aren’t
that many places for him to go, and besides, CEOs read the papers and if
they have any smarts at all they know that pay cuts are where it’s at.
Overall, you just need to be fair-minded and firm. “What I tell everybody
is, take a deep breath and relax and try not to make changes in a crisis
environment,” says William E. Mayer, 70, lead director of the Midwestern
newspaper chain Lee Enterprises and founder of Park Avenue Equity Partners.
“You want to be fair to management. If I don’t have any idea of what’s going
to happen in 2010, how can I hold management accountable?” Adds Ann Rhoades,
64, president of PeopleInk, a human-relations consulting company in
Albuquerque, New Mexico, and chair of the compensation committee at JetBlue
Airways: “We had a great year because our people were working very hard, and
then the recession came. And now we’re going
to penalize them?”
Still, in the current environment there is what shareholder activist Tim
Smith of Walden Asset Management describes as “a perfect storm—the hot
spotlight of public attention, government regulation, and shareholder
pressure to focus on executive pay.” In May, Senator Charles Schumer, the
New York Democrat and member of the Banking, Housing, and Urban Affairs
Committee, introduced his Shareholder Bill of Rights Act of 2009, a piece of
legislation, co-sponsored with Senator Maria Cantwell (D-Washington State),
that ties together many of the recent strands of shareholder activism and
discontent. The bill’s provisions for proxy access and majority voting—not
to mention rules more directly related to executive compensation, such as
say on pay—would enable share owners to sweep out entire boards that are
deemed to be rewarding failure and replace all the directors with stewards
more to their liking.
These
forces are pressing boards to rethink what and how CEOs are paid. By the end
of 2008, median CEO pay at S&P 500 companies had fallen 6.8%, to $8.4
million, according to Equilar, a Redwood Shores, California, outfit that
analyzes executive compensation. A 20.6% drop in the median annual bonus
caused most of that downdraft. Frederic W. Cook & Co., a New York City
compensation consulting firm, reckons that base salary growth will be
negligible this year, annual incentive plans will pay out way below target,
and long-term incentive values will drop by 10% to 20%. Myrna Hellerman, a
Chicago-based compensation expert at New York’s Sibson Consulting, says that
the chair of a compensation committee recently told her, “Well, we just went
and took away everything. It was easier that way. It’s what the shareholders
expected, and our executives were resigned to the impact of our actions. Now
we need to figure out what we’ll bring back and what is gone forever.”
Few
will push for directors to abdicate their responsibility to that extent, and
certainly not Corporate Board Member. But these are times when
boards, and the members of their comp committees, need to work harder than
ever to get CEO pay right. And yes, doing so has become particularly
difficult. Here are some issues to consider.
Pay for Performance Still Works
Just as the rising tide lifts all boats, the ebbing tide leaves them
beached. Equilar analysts recently looked at the accumulated wealth—pension,
deferred compensation, all options and stock awards—of CEOs at S&P 500
companies and discovered it was down by 43%. “There you see a very strong
link with the shareholder,” says the firm’s research manager, Alexander
Cwirko-Godycki. Not that CEOs were exactly impoverished, but the $70.1
million that the median top dog was worth at the end of 2007 had shriveled
to $39.9 million a year later. “I don’t mean to compare a CEO to someone who
has lost his job in terms of quality of life,” Cwirko-Godycki says, “but
CEOs have gotten hit.”
Shareholders want to see clawbacks of CEO bonuses if the chief executives
made decisions that turned out badly. Ira Kay, a compensation consultant at
Watson Wyatt Worldwide, a global consulting outfit headquartered in
Arlington, Virginia, points out that an equivalent move is to make top
managers hold a lot of their companies’ shares. “The executives in 80
companies that we surveyed have lost a total of $13.4 billion on their
stock. They had a billion-dollar downside,” he says. That is why finance
professor David Yermack of New York University’s Stern School of Business
says it’s not obvious to him that a permanent change in compensation methods
is in order except at financial companies. “We have high-powered incentives
that reward people when they succeed and punish them when they fail,” he
says. “CEOs are feeling a lot of pain right now, and that’s as it should
be.”
There Is No Talent Shortage
For years boards were held hostage by star CEOs who were in such demand that
they could write their own employment contracts. Not anymore. With
unemployment at nosebleed rates, your boy or girl is most likely staying
put. The employment potential of CEOs is directly proportional to how well
their companies’ shares performed during their tenures. David Yermack puts
it bluntly: “When you run your own stock down 80%, where are you going to
go?”
It
has taken a little time for boards to realize they have the upper hand.
According to Equilar research, at least 40 companies announced that they
were paying cash retention bonuses to their top executives between July and
December 2008, but fewer than a third included the CEO. Equilar noted that
“some special awards, particularly those for chief executives, contain
unique performance-based vesting requirements focused on overcoming current
challenges.” For example, JCPenney disclosed in a December 8-K filing that
it was granting its CEO, Myron E. Ullman III, as many as 500,000 shares “to
provide an incentive for performance during the current economic environment
and to recognize Mr. Ullman’s willingness to continue his services to the
company.” The award caps out at $25 million, and Ullman, who has no
employment contract or severance agreement other than one covering a change
in control of the company, could get all of that if he sticks around until
December 2011—but only if Penney’s annual total stockholder return grows to
29.1% or more by the end of the period. And he’ll get nothing, even if he
hangs in there for three years, unless the return is at least 11.3%.
A
common worry that the CEO may have wanderlust could be baseless. When Watson
Wyatt surveyed 85 outside directors of large U.S. companies in March and
April, 68% of them said that their boards or compensation committees were
not concerned or were only slightly to moderately concerned about retaining
high-performing executives. In fact, there is so much managerial talent
around that this might be an opportunity for companies to upgrade. “Dump the
dead wood,” suggests J. Richard, who runs his own J. Richard & Co.
compensation consulting firm in Half Moon Bay, California. “That’s where
boards should be extremely proactive.”
A
Dollar a Year Sends the Wrong Message
In a gesture that is supposed to show solidarity with beleaguered employees,
or perhaps a mea culpa, CEOs of financial firms like AIG, Citigroup, and
Morgan Stanley have renounced their salaries and agreed to work for $1 per
year. The Corporate Library, for one, isn’t impressed. In April the
corporate governance research firm released a list of 41 CEOs who had served
during their companies’ most recent fiscal year for no more than $1 in
salary or cash bonus—18 of them voluntarily. What they did have, it turns
out, was a combined total of almost $6 billion of stock in their companies.
As the Corporate Library pointed out, “A reduction in salary (a forfeiture
of typically between one and two million dollars) may be insignificant
compared to monies received in perquisites and other arrangements in
management contracts agreed upon by the board of directors.” Indeed, more
than half of these executives were reimbursed for personal security,
airplane travel, a personal car, relocation expenses, and gross-ups
offsetting the income tax due on those perks.
“I don’t think anyone is taking a dollar a year who is not wealthy,” says
William Mayer. “And when I read that someone is taking that, I’m
suspicious.” More to the point, perhaps, Mayer believes that it’s
unreasonable to ask a CEO to work for a dollar. “I don’t want him worrying
about making ends meet,” he says. “I don’t think he should have a negative
cash flow.” A relatively minor pay cut is something else, of course, and
boards are having conversations with their chiefs about reducing the CEOs’
base salaries, especially in situations where the companies are freezing or
cutting employee pay. Equilar reports that between June 2008 and February
2009, 133 public companies announced salary reductions for executive
officers, commonly around 10% to 15%. At JetBlue, CEO (and board member)
David Barger voluntarily reduced the base salary he receives as CEO by 50%,
from $500,000 to $250,000. (Some directors are also cutting their pay; for
more, see the box below.)
In cases where the CEOs aren’t volunteering, boards need to tread with care
if they intend to propose a cut. Many employment contracts stipulate that a
reduction in salary constitutes good reason for a CEO to quit and collect
severance benefits.
But treading with care doesn’t mean that you can’t broach the subject of
compensation. In fact, says Michael Melbinger, a partner at the Winston &
Strawn law firm who advises boards on compensation matters, “it hasn’t been
that hard to speak to the CEOs, because they know circumstances have changed
and sometimes they bring it up themselves.” For example, Nabors Industries,
a Bermuda-based drilling company, amended its employee agreement with CEO
Eugene M. Isenberg—more about him later—in April, on terms “substantially
more favorable to the Company than before,” as the proxy dryly noted. Among
those terms: Isenberg agreed to donate the after-tax proceeds of his $1.3
million base salary to help employees, their children, and others go to
college.
Make Way for Say on Pay
The 400 financial companies receiving federal money under the TARP program
have to allow their shareholders to vote on executive compensation. While
the vote isn’t binding, it does offer investors an opportunity to sound off
on this hot-button topic. In fact, as of early May (the most recent figures
available), 22 other companies, including Apple, Motorola, and Verizon, had
voluntarily agreed to hold such a vote, according to RiskMetrics, a proxy
advisory firm. Of course, the Schumer-Cantwell bill seeks to make a
shareholder advisory vote on pay mandatory at all public companies. Clearly
life will never be the same for compensation committees—or for CEOs who
still think they can command outsize pay and perks. “Say on pay is coming,”
says Irv Becker, who runs Hay Group’s U.S. executive-compensation practice,
“and it creates a real focus on the CD&A [the compensation discussion and
analysis that companies now have to spell out in the proxy] and on how
companies communicate with shareholders about how pay is structured.”
So while the board will still be responsible for setting CEO pay, it must
explain clearly to shareholders—and shareholder activists—exactly what it is
paying for. “I don’t think shareholders will put up with not seeing how the
CEO did against specific targets,” says JetBlue comp committee chair Ann
Rhoades. The carrier provided that level of clarity in the CD&A it published
when making the case for paying CEO David Barger and the other four named
executive officers their full bonuses. The CD&A went through eight goals the
company had set for these managers and described in hard numbers how they’d
performed against each of them.
The
executives sometimes fell short. For instance, JetBlue was only seventh
instead of the targeted fifth among major airlines in on-time arrivals;
passenger revenue per available seat mile grew by 14% year over year instead
of 15%; and at year’s end the company had $561 million in cash and cash
equivalents instead of the goal of $880 million. Yet that 14% revenue
increase enabled JetBlue to place first in the industry. At the same time,
even though fuel expenses increased by more than $400 million in 2008 and
took a big bite out of its liquidity cushion, the company was able to pay
down almost $700 million in debt. Says Rhoades: “In an environment where we
don’t control the price of fuel, our biggest expense, you could argue that
we should have given management more. But they didn’t ask for it, and we did
what we thought was reasonable.” Barger received a bonus of $250,000, half
of what it would have been if he hadn’t cut his salary. And at the annual
meeting in May, Rhoades says, “our shareholders, even though they lost a lot
of value, were very pleasant.”
Coming Soon: the Bungee-Cord Bonus
When CEOs make decisions that turn out badly, shareholders want the bonus
back. But being punitive isn’t going to accomplish much. Sixty-four of the
Fortune 100 companies have clawback provisions in their employment contracts
or other compensation arrangements, and clawbacks are mandatory at companies
receiving money under the TARP program. It is also possible that the
clawback threat, which can cover a broad range of employees besides the CEO,
serves as a warning to overly aggressive managers. Clawbacks look good and
shareholders like them. But good-looking is all they are, as two recent
cases make very clear.
New York attorney general Andrew Cuomo demanded that 20 employees in AIG’s
financial-products unit return the $165 million in retention bonuses they’d
received early this year. Although 15 of them did so, only $50 million had
come in by March. And then there were the efforts by both Cuomo and his
predecessor, Eliot Spitzer, to claw back some of Richard Grasso’s
substantial compensation as chairman and CEO of the New York Stock Exchange.
Last July, after nearly five years of depositions and lawsuits, all of which
placed the directors of the exchange in an extremely unfavorable light, the
New York Supreme Court’s appellate division ruled that Grasso could keep the
$139.5 million the exchange had already paid him. Warns New York City
compensation consultant James F. Reda: “When you institute clawbacks, do you
know how many hard-luck stories you’re going to hear? Are you prepared for
this and for the legal fees when the executives fight it?”
Obviously it’s better not to pay the money in the first place. What Grasso
tried for and didn’t get was an additional $48 million that he believed he
was owed but that the exchange had not yet paid him. Holding back some of
the reward is the theory behind bonus banking, also known as bonus-malus:
Hang on to the dough until you can see whether an executive’s performance is
sustainable. The cash held back or banked earns a return, but it is also
subject to reductions or even forfeiture—that’s the malus part—if one year’s
blowout performance turns out badly later on.
“These things sound good as an immediate reaction, but they can cause
problems down the road,” says Equilar’s Alexander Cwirko-Godycki. For one
thing, bonuses may have to be larger if a portion is being withheld, and
exit packages will swell with yet more deferred pay. Nonetheless, this year
UBS, the big Swiss bank, which recorded a loss of about $20 billion in
2008—the largest one-year corporate loss in Switzerland’s history—instituted
a bonus-malus system for its senior managers and a group the bank calls
“risk-takers.”
Essentially, each year’s bonus has a three-year vesting period. Executives
get a third of the money; the rest is held back and reduced in the
subsequent two years if results are poor. This might restrain the bank’s
more pedal-to-the-metal guys. Alternatively, many others who have labored
hard only to watch their bonuses erode will begin thinking about working
someplace else when the job market opens up again.
Going, Going…Gone
Perks have seen their day as compensation tools. They have to be disclosed,
and they upset shareholders to an extent that far surpasses their monetary
value. And with reason: The dirty little secret behind perks is that
companies routinely gross up their CEOs for the income taxes due on such
things as personal use of the company plane, company-paid life insurance,
and the like. Last year 59% of S&P 500 companies paid the tax reimbursement
on executive perks, according to Equilar, but so far 50 of those businesses
have cut out the practice this year.
Severance agreements are under pressure too. No one wants to justify a big
package for CEOs who are already rich from their company stockholdings. So
there are more sunset provisions in the agreements, phasing severance out
over two or three years. That’s happened at SunPower Corp., a manufacturer
of solar cells and panels, says Betsy S. Atkins, 56, CEO of Baja Ventures
and chair of SunPower’s comp committee. In addition to cutbacks in
severance, Ira Kay of Watson Wyatt predicts reduced perks and ceilings on
SERPs, or supplemental executive retirement plans. “These will be permanent
changes that will last for the next
half-generation of CEOs,” he says.
There is, however, one disreputable practice that remains—the gross-up of
excise taxes due on a CEO’s (often excessive) golden parachute. Some
companies, like Reynolds American, the tobacco outfit, are eliminating
gross-ups on new contracts but not on existing ones, even though, as Betsy
Atkins notes, “gross-ups cost a company a ton of money, and they are hard to
defend.” According to RiskMetrics, each $1 of tax that must be grossed up
costs a company between $2.50 and $3, because it can’t take any deductions
for the gross-up or the expense of the parachute.
There are signs that gross-ups may be ending as well, albeit perhaps on a
fitful, company-by-company basis. RiskMetrics published a study of golden
parachutes last November and devoted a special section to Nabors Industries,
highlighting the enormous gross-up the driller would have to pay on chairman
and CEO Eugene Isenberg’s parachute if control of the company changed.
Isenberg stood to collect a parachute of $315 million plus another $95.8
million in gross-ups, for a grand total of $411.3 million. That’s more than
three times the average amount in the industry. Nabors must have seen the
report—or had its nose pointed at it by irate shareholders. Five months
later the 2009 proxy announced that the company had eliminated all tax
gross-ups, “including without limitation tax gross-ups on perquisites and
golden parachute excise taxes.” Isenberg’s basic parachute contracted too.
He’d now walk away with a flat $100 million—not chump change, but not $411
million either. Isenberg still gets to pocket an unusual payment that
shareholders might also criticize. He collects director fees for serving on
the board of the company he heads, $50,000 in 2008.
Cash Is the New Equity
How are you going to reward your CEO when the prizes you used to dole out
aren’t motivational anymore? Answer: “I think cash compensation will become
more important,” Ann Rhoades says. “What you give will still be
performance-related. But cash is as good as restricted stock units over the
long term.” In fact, it might be better because many companies do not have
enough shares in their stock plans to maintain the dollar value of the
equity awards they used to give. So the choice is between paying cash and
going back to the unhappy shareholders for authorization to increase the
number of shares in the plan. No one is eager to try that. Instead, says
James Reda, “you can give long-term cash compensation and index it to your
stock price.” Salaries, though constrained by the $1 million cap that
companies can deduct from their taxes, may also go up when equity awards
start contracting. Irv Becker notes that at comp committee meetings, “you’re
seeing discussions around ‘Maybe we need to pay a higher salary.’”
There is a hidden benefit to cash compensation. “Cash is more easily
recognized as an expense,” says Reda. “You can’t disguise cash.” Knowing
exactly what the company is spending on the CEO will be of great help to
boards mulling the next contract. They’ll find it easier to figure out
whether their leader is overpaid—or has earned a raise.
|