Fray on Pay
The battle over executive compensation and what it means
for you.
Russ
Banham, CFO Magazine
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 (D–Mass.) and Senate Banking,
Housing, and Urban Affairs Committee chairman Christopher Dodd (D–Conn.) — 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.
© CFO Publishing Corporation 2008. All rights
reserved.