Return to Virginia Business - October 2002

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— Executive compensation chart
— Corporate malaise hits execs' pocketbooks

“A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, ‘I’ll do anything — anything — you want. Just tell me what you would like.’ With no hesitation, he replies, ‘Reprice my options.’”
— Warren Buffett, 2002 Letter to Berkshire Hathaway Shareholders

by John Rubino

All this talk about who made what begs an important question: How much is too much? Is any single executive worth $100 million? Or $20 million? Or even $5 million? During the roaring 1990s, when stockholders were happy and CEOs were rock stars, this kind of blasphemy seldom got beyond the offices of shareholder advocates and the pages of left-leaning magazines. But in the wake of tech’s crash, Enron’s implosion and the general tarnishing of corporate America’s good name, executive pay has become a hot-button issue.

Ironically, just a decade ago, the problem of what — and how — to pay the boss in the corner office seemed to have been solved. To avoid the entrenched, disinterested management that plagued the 1970s and 1980s, companies would tie pay to performance through bonuses and stock options. Then, so went the conventional wisdom, CEOs and CFOs would have shareholders’ interests at heart, winning when investors won and vice versa. Everyone would be on the same, profit-seeking page.

But life didn’t conform to the script. As the bull market evolved into a buying panic, corporate pay packages surged at a pace that would make Tony Soprano blush. According to Boston-based advocacy group Citizens for a Fair Economy, the pay of the average Fortune 500 CEO rose by more than 500 percent in the 1990s, quadruple the growth in corporate profits and about 25 times the gain made by the average worker. The typical CEO now makes about 475 times as much as his lowest-paid employee. Corporate pay has become “a runaway train,” concludes Tim Smith, president of the Washington D.C.-based Social Investment Forum.

What happened? Three things, say observers. First, the structure of some corporate boards was flawed, with ostensibly independent compensation committee members often having consulting deals on the side or relatives on the company payroll. This led them to see managers rather than shareholders as their constituents, and to strive to “make sure that their execs are paid in the top quartile of similar companies around the country,” says Smith. The result was a self-reinforcing cycle of ever-higher pay packages.

Options, meanwhile, turned out to be something less than a panacea for shareholders. Because they’re not taxed, companies soon discovered that they were an essentially cost-free way to pay top people. And they’re hard to value accurately, making it impossible to calculate the worth of a given option package. Inevitably, they came be handed out like penny candy, often on terms that made it possible for executives to get rich while doing a mediocre job.

And finally, the bull market of the 1990s sent most companies’ stocks — and options — higher, regardless of the relative competence of executives. Thus it was possible for a management team to become super rich by pleasing Wall Street, and to lose millions by missing a quarterly earnings target. These higher stakes and lack of board oversight led to earnings manipulation and outright accounting fraud on a scale that must have surprised even Ralph Nader.

But in democracies, it often takes a crisis to force real reform, and this one is spurring changes that offer at least the hope of better things. Recent legislation requires CEOs and CFOs to personally vouch for the accuracy of their companies’ books. A growing number of companies have promised to start expensing options, giving investors a truer picture of the costs of executive pay. And the major stock exchanges have tightened corporate governance rules in an attempt to make boards truly independent. Compensation committee members, for example, can no longer serve as paid consultants or have spouses or cousins on the corporate payroll.

“You’ll see a generational change in boards,” predicts Kerry Moynihan, managing director of the Tysons Corner office of executive search firm Christian & Timbers. Older directors who sit on multiple boards “will look at the extra work that’s now required and decide they’d rather spend the time in the Bahamas.” They’ll be replaced by younger, more engaged directors willing to devote more time to fewer companies — and to hold CEOs accountable. The result, says Moynihan, will be “lower executive pay that’s more closely linked to results.”

Meanwhile, executives who committed actual crimes are being brought to justice. “I am hopeful that there are the equivalent of some public executions. Having a head on a pike outside the town gates sends a message,” says Moynihan.

As for options themselves, they’ll become a smaller part of executive compensation packages, and will come with more demanding terms. Capital One’s plan is a good example, says Moynihan. “Those options vest over time and at higher prices, so for them to pay off, investors have to win as well.”

Other option packages will be indexed, says Paul Hodgson, senior research associate at Portland, Maine-based Corporate Library, a corporate governance consultancy. That is, instead of simply being exercisable at a given price, they’ll rise in value when a company does well relative to its peers or an applicable market average. “An external target injects objectivity into the process,” says Hodgson. “That way, a general bull market won’t make everyone rich, regardless of performance.”

The possible, hopeful result: An era of better corporate behavior, in which conservative accounting attracts rather than repels capital. And where, at last, there’s a clear connection between executive pay and corporate performance.

Return to Virginia Business - October 2002