Executive "Pay for Performance" Becomes More Than a Slogan For several years now, companies have been generously rewarding their top executives with ever-growing salaries and stock options. Option grants climbed by 20 to 40 percent per year for nearly a decade.
Meanwhile, CEOs at America’s 500 largest public companies received average pay raises of 22 percent in 2003, according to a survey by The Corporate Library research firm. CEO pay increased 10 times faster than the pay of the average American worker, which went up by a mere 2.2 percent in 2003, according to the U.S. Bureau of Labor Statistics.
That disparity has been an issue for many years. Studies have shown that 20 years ago, CEOs were paid 42 times what the average worker earned. Today, CEOs receive more than 400 times the salary of the average worker.
As the Associated Press reports, the CEOs of Apple Computer, Oracle, Yahoo, and Colgate-Palmolive increased their total compensation by at least 1,000 percent in 2003 over the previous year, largely by exercising stock options and getting restricted stock.
Among the 1,794 CEOs who were surveyed, the median compensation was $1.85 million. At the top of the list was Barry Diller, the CEO of Inter/Active Corporation, who took home $156 million, including $151 million in profits on his stock options.
But now, in the aftermath of scandals at Tyco and Enron, instead of automatically granting more stock and options every year, many boards of directors are starting to ask a hard-hitting question: “Do executives really need more pay?”
That’s been the first-hand experience of Donald P. Delves, who is principal of The Delves Group, a Chicago-based compensation consultancy, and author of Stock Options and the New Rules of Corporate Accountability: Measuring, Managing, and Rewarding Executive Performance.
As Delves revealed in a recent issue of Across the Board, many of his consulting clients are approaching executive compensation with a renewed sense of skepticism. At board meetings, directors ask him, “Why should we continue granting more options every year just because somebody else does? Shouldn’t we be more interested in how many options management already has, and how much money they will make if the stock price goes up by 10 or 20 percent? Maybe they already have enough.”
Delves has conceived a new tool, called an “executive wealth analysis,” that considers the entire range of compensation that executives receive. The analysis shows what each individual will earn based on various jumps in stock prices, and its impact on his personal wealth. It might disclose, for example, that if the stock price goes up by $5, the CEO’s personal wealth will increase by $2 million.
Traditionally, the decision about whether top executives are being paid fairly has rested on the competitive survey, which compares the statistics on the compensation that executives receive at several hundred firms. Using this survey, companies can establish the median pay level for each position. Since half of the firms pay above this level and half below, the natural tendency at each company is to want to be in the top half.
It’s easy to see how this practice leads to pay inflation: As each company increases its pay to exceed the median, the median becomes a moving target that always moves higher. Salaries and stock options spiral upward, and there’s no link to the performance of the executive or the firm.
But today’s directors are more aware of their responsibility to shareholders. In compensation-committee meetings that Delves has participated in, directors are issuing ultimatums such as, “If you want us to pay the executives at the 63rd percentile, then the company has to perform at the 63rd percentile.”
It’s about time. It simply doesn’t make sense for a CEO at a poorly-performing company to earn what his peers earn at higher-performing firms. Delves’ solution is to take the following three steps:
Step 1 is to determine the total cost of management. That is, what is the total cost to manage the company, based on the combined pay of the entire executive team? Compare this cost to other companies. At an oil company that Delves consults, the board compares its total cost of management per barrel of oil to the cost at competing companies.
Step 2 is to compare that total cost to the company’s performance. Delves recommends using measures such as changes in revenues, profits, or margins; or return on capital. Many companies keep track of these indicators and compare them to their competitors. By combining Steps 1 and 2, the board can see how much it is paying its executives for how much performance. A simple way of making this comparison is to rank the firm on a list of competing firms on each performance measure, and rank the same firms according to how much they pay their executives. For example, you might find that your company gives its management team the second-highest compensation in the industry, yet its profits rank 11th.
Step 3 is to calculate the “return on management.” This measure is similar to return on investment. It illuminates what the company is getting in return for its investment in management, based on various measures. For example, you could look at the increase in earnings, compared with the total cost of management, over a five-year period. Then you can compare your internal figures to the return on management at other companies, both within and beyond your industry.
We expect Delves’ approach to catch on at many corporations because it takes a systematic approach to what, until now, has been a haphazard process. Companies tend to reward top executives for good performance when the company is doing well, and to console them with more options when performance slips and the stock price falls. Only by carefully measuring compensation and performance and then tying them together can a board truly know if it is getting a good return on its investment in its key people.
This is important not only because it’s wasteful to overpay executives. It’s important because shareholders are becoming increasingly aggressive in demanding that companies rein in CEO pay.
Until now, companies didn’t have to worry that those shareholders would win in court. That’s because the “business judgment” rule stated that the level of a CEO’s compensation is a business decision; as long as the board made a reasonable attempt to make the right decision, it couldn’t be sued for making the wrong one.
But all that is abruptly changing. Last year, the Delaware Court of Chancery refused to dismiss a suit against the Disney Corporation about the compensation it awarded Michael Ovitz. As Geoffrey Colvin points out in Fortune magazine, this is significant because most big companies are incorporated in Delaware, so its court is the most important court for businesses in the U.S.
The suit claimed that Disney’s board of directors overpaid Ovitz, who received roughly $140 million for little more than a year as the company’s president. The court would have rejected the case if the plaintiffs argued that the directors made a poor business judgment. But they used a different strategy: They alleged that the board did not use any judgment.
The suit alleges that the board approved the compensation plan for Ovitz without reading it, without assessing how much it would cost the company, and without analyzing what Disney would have to pay Ovitz if he were terminated.
If those charges are accurate, the board can’t hide behind the “business judgment” rule. The court stated that if the plaintiffs can prove those charges, the directors committed not a lapse of judgment but “intentional misconduct” and their actions were “not in good faith,” which are grounds for a valid lawsuit.
What is even more terrifying for Disney’s directors ? and for boards of all American companies that are paying CEOs without paying attention to the costs ? is that the directors could be held personally liable. According to Delaware law, director’s and officer’s insurance cannot cover any damages assessed against directors who did not act in good faith.
Consider a hypothetical case in which a board of directors failed to act in good faith when they approved a $120 million compensation package for a CEO. Each of the 10 members of the board could be required to pay $12 million in damages.
As we consider the future of this trend, we foresee four developments:
First, boards will react to pressure from investors and regulators and increasingly demand more accountability from CEOs. As Ann Yerger, the deputy director of the Council for Institutional Investors, complained in Newsday, “Pay continues to escalate and in many cases to obscenely high levels. This continues to be the No. 1 issue for our members.” A formal process for linking CEO pay to company performance similar to the one that Donald Delves described will be implemented at many of the largest companies.
Second, boards themselves will need to undergo reforms. Look for institutional investors to use their clout to win the right to select board members who will act in the best interests of shareholders, as SEC chairman William Donaldson suggested recently.
Third, expect more lawsuits to be filed, using the “not in good faith” strategy, against boards that approved outrageous CEO compensation packages. This in turn will motivate directors ? whose own personal wealth will be at risk ? to make more cautious, conservative decisions about executive pay schemes.
Fourth, the increased scrutiny of CEO pay will actually benefit some top executives. Comparing compensation to performance won’t just reveal the cases in which CEOs are overpaid. It will also publicize the performance of CEOs who are underpaid. For example, Business Week used shareholder return to measure CEOs’ performance relative to their pay. The worst offender was Jozef Straus of JDS Uniphase, who oversaw a total shareholder return of negative 91 percent while collecting $152 million in total pay. The best CEO is Warren Buffett of Berkshire Hathaway, who delivered a total shareholder return of 19 percent on a salary of just $1 million.
References List :
1. Associated Press, August 1, 2004, "CEO Pay Rises Nationwide in 2003," by Kendra Locke. ⓒ Copyright 2004 by The Associated Press. All rights reserved.2. Stock Options and the New Rules of Corporate Accountability: Measuring, Managing, and Rewarding Executive Performance by Donald P. Delves is published by McGraw-Hill. ⓒ Copyright 2004 by The McGraw-Hill Companies, Inc. All rights reserved.3. Across the Board, July/August 2004, "How Much Pay . . ." by Donald P. Delves. ⓒ Copyright 2004 by Conference Board, Inc. All rights reserved.4. Fortune, August 9, 2004, "CEO Pay Meets Its Match: Plaintiff Lawyers," by Geoffrey Colvin. ⓒ Copyright 2004 by Time Warner, Inc. All rights reserved.5. Newsday, July 29, 2004, "Report: CEOs Once Again Getting Hefty Pay Raises," by Pradnya Joshi. ⓒ Copyright 2004 by Newsday, Inc. All rights reserved.6. Business Week, April 19, 2004, "Executive Pay," by Louis Lavelle, Jessi Hemple, and Diane Brady. ⓒ Copyright 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
