New federal regulations ushered in by the financial meltdown are changing how--and how much--companies pay their executives.
The spotlight on executive compensation and perks hasn't dimmed, even if the recession is officially over.
The issue vaulted to the forefront during the recent financial crisis, when a public furor emerged over pay practices at banks and other companies that accepted federal bailouts. The situation intensified in November 2008, when the CEOs of the Big Three automakers flew to Washington, D.C. in private jets to lobby Congress for $25 billion in taxpayer-funded help.
Since then, both voluntary guidelines and legislation have emerged to limit perceived excesses in compensation. Both companies and boards of directors are now navigating uncharted waters while negotiating pay packages.
"Executive compensation is under more scrutiny than ever with the slow recovering economy and continuing high unemployment. Congress, the media and the public are pressuring companies, and attacks have come in the courts through shareholder suits. Companies must be very careful in their compensation practices in today's environment," says attorney Jill Kirila, a partner at Squire, Sanders & Dempsey.
The Conference Board, a business research firm in New York City, took on the issue in 2009 and developed a set of voluntary best practices pay guidelines (See "The Guiding Principles," page 20). The recommendations are designed to restore credibility and increase trust in pay practices and oversight. Adherents include AT&T, Cisco, Hewlett-Packard and Tyco International, which became a household name after former CEO Dennis Kozlowski was accused of looting the company and buying a $6,000 shower curtain for his company-owned apartment.
"After the financial meltdown, but before Congressional action, it was clear that the public had lost confidence in businesses. Real and perceived abuses regarding executive pay contributed to this loss of trust," says Bill Ide, chairman of the Conference Board's Governance Center and a law partner in the Atlanta office of McKenna Long & Aldridge.
The voluntary guidelines didn't satisfy everyone, though. President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July. It creates significant changes in corporate governance, securities and executive compensation for all public companies.
"The issue has moved beyond board discussion to a broader public issue. If people are asking the question, ‘Is he or she really worth that much?' it can impact the company's reputation. One headline could entirely change consumers' perception of it," says Eleanor Bloxham, CEO of the Value Alliance, a corporate board advisory firm in Westerville.
Since executive pay initially became a flash point, laid-off employees and frustrated shareholders have continued looking for examples of corporate arrogance. And like it or not, companies need to re-evaluate how executives are paid. Individual performance is now tied to longer-term corporate results. The time horizon for bonus payouts is lengthening. More proxy disclosures are coming.
Navigating the new rules can be tricky, but area experts say it is possible to develop executive compensation packages that are fair to all parties.
The Board's Role
In a perfect world, executive pay packages would be proportional to each individual's contributions and reflect his or her skills, experience and education. They're affordable for the company, yet fair to shareholders and employees. Payouts align with corporate strategy and actual performance, yet discourage excessive risk-taking.
That's a lot of juggling.
"Board involvement is more important than ever. It's not enough to be informed. Directors must take the additional steps to be knowledgeable enough to defend their compensation decisions if they have to," Kirila says.
Executive pay usually involves a combination of base salary, annual incentive bonuses, stock options and awards, and "other compensation," a category that has traditionally included automobile allowances, travel expenses and other perks. Severance provisions and traditional retirement vehicles are common, too.
"Responsible corporate boards look at the individual pieces of compensation, as well as the total. But there's also no doubt that changes to the SEC disclosures require a focus on both, as well as a statement of rationale for the compensation of the CEO and other named executive officers," says attorney Randall Walters, a partner at Jones Day.
In particular, boards are more closely reviewing severance pay. "CEOs used to negotiate severance internally with someone other than the board, such as human resources. Now boards are more aware, and they're starting to negotiate this piece as part of the total compensation package," says John Beavers, a partner at Bricker & Eckler.
While they can be controversial, Walters says severance packages have a legitimate place in the compensation mix. "A severance agreement allows the CEO or other named officers to stay in place during a change of control at the company. These so-called golden parachutes allows him to make decisions that enhance shareholder value, rather than focusing on his own employment situation," he says.
Tread carefully if a job necessitates-or an exec demands-a long list of luxury perquisites. "If you're going to offer club memberships, use of a corporate jet or similar hot-button perks, put the business rationale in the executive's contract," Kirila advises.
More than ever, directors are aware that compensation is reported publicly in a company's annual proxy statement. "Boards are coming to grips with that total number. Many are surprised by it and didn't realize it was so big," Beavers says.
According to research firm Equilar, the median 2009 pay package for a Standard & Poor's 500 CEO was $8.5 million, including salary, bonuses and non-salary income. Whether all those zeroes are justified is often a judgment call.
"The market answers that question. If one company won't pay for his skill, education and competency level, he'll go to a company that will," says Walters. "I recognize the perception that a lot of CEOs are overpaid. To the extent they create wealth for others, though, through increased earnings and stock value, they generally create wealth and shareholder value far beyond their compensation."
Today's trend is to align executive compensation with a company's business plan. "There's a growing recognition of not only what executives are paid, but also what they're paid for. Those can be two very different things," Bloxham says.
"Often, compensation was based on the income statement, earnings and revenue; those things that the CEO and his direct reports had control over. They usually were annual numbers with a short-term look," Beavers says.
The new paradigm more closely links pay to performance. "Public companies are looking at the lower right-hand corner of the balance sheet. Some companies call it shareholders' net worth. Others call it the capital of the company. Boards are focusing now on what's happening there. Is that getting stronger or weaker? And they're assessing it over three to five years, not annually," Beavers says.
Companies should evaluate an executive on more than just financial results, Beavers advises: "Boards should survey and measure employee satisfaction, customer satisfaction and supplier satisfaction. Why those measures? The company should want to be a place that employees want to work for and others want to do business with."
Independent, objective barometers such as surveys are becoming more common. "Boards were trying to measure effectiveness anecdotally and found it to be unreliable," Beavers says. "In the last two to three years, there's been a move from boards using data from company consultants to independent consultants that have no alignment with management. They're benchmarking the executives' peers and making comparisons for the board to review."
Kirila agrees outside compensation consultants can be useful. "Independent approaches to compensation can go a long way in helping a company defend their compensation decisions and assess them objectively," she says. "At the same time, you don't want to lose sight that you may need to pay a certain level to retain or recruit the proper person for the position."
Responsible boards share such measures and results with shareholders. "For too long, executive compensation has been too mysterious," Ide says. "Shareholders should demand accountability. In our work, the Conference Board found there's not enough dialogue between shareholders and directors."
Disclosures and Clawbacks
Congress has addressed executive compensation in several pieces of high-profile legislation.
As part of the American Recovery and Reinvestment Act of 2009, the Troubled Asset Relief Program (TARP) prohibited cash or retention bonuses, or incentive compensation for financial institutions that took bailout funds. It also banned stock options and golden parachute payments for executives at those institutions, and put in place a shareholder advisory vote on executive compensation plans. Those mandates apply until the TARP money is repaid.
This year's Dodd-Frank Act further limits executive compensation. The legislation, which stipulates that every compensation committee member must be independent of the company, applies to all public companies, not just financial services firms.
The new law requires disclosures that outline the relationship between executive compensation and a company's financial performance. Dividend, distribution and stock value changes must be included.
Dodd-Frank also requires a business to disclose the median total pay of all employees other than the CEO, the CEO's annual total compensation and the ratio of the two dollar figures.
That comparison is likely to open a few eyes. Equilar reports the median pay of U.S. private-sector workers was about $30,000 in 2008, the most recent year available. With benefits, the total grows to $36,000. That $8.5 million median pay package for an S&P 500 CEO equates to 236 such workers.
"Boards should know that this new level of comparison clearly can show the company in a good light or a less-than-positive light," Bloxham says. "Board members also need to be aware that compensation at the top impacts workers' morale. Employees will see this information, too. What will the impact be on productivity? It requires boards to be very thoughtful."
Count on some heartburn in the boardroom over this rule. "Before the financial crisis, there was hope among some circles that the issue of pay equity would just go away. That's not the case now. So many people have been hurt in this financial crisis that the issues surrounding it will continue to be important to employee morale and the performance of the corporation for a long time," Bloxham says.
Dodd-Frank also requires disclosure of a company's incentive compensation policy. If financial results must be restated due to material noncompliance, any incentive compensation that was erroneously paid can be recovered for the three years prior to the restatement. "That's regardless of whether the person giving back the money is even responsible for the cause of the restatement," Kirila says.
In 2002, Sarbanes-Oxley implemented a 12-month look back for CEOs and CFOs, but wrongdoing was necessary for a clawback of incentives. "Dodd-Frank dramatically expands clawbacks to include all of the current and former executive officers. And there doesn't have to be any misconduct involved," Walters says.
How can a business collect from the CFO who's no longer on the payroll? "Companies can minimize the negative effect of the clawback by holding incentives in abeyance," Bloxham suggests.
Dodd-Frank includes a nonbinding shareholder vote on executive compensation that's disclosed in the proxy statement. This "say-on-pay" vote must occur at least every three years.
Walters is skeptical the provision will work as intended. "Are shareholders really going to wade through 20 pages of technical compensation details? I don't consider say-on-pay a referendum on compensation. It's a referendum on the performance of the company and on the CEO in guiding the performance of the company," he says. "If the performance is bad, the shareholders will vote ‘no' even though his compensation might be quite reasonable for the situation."
Companies seeking shareholder approval for a merger or acquisition must disclose executive compensation agreements related to the deal in the proxy statement. If the arrangement wasn't included in a prior say-on-pay vote, a nonbinding "say-on-golden parachute" vote is needed.
Even though Dodd-Frank doesn't apply to them, private companies are taking notice. "Litigation is not unique to public companies. Private companies have an incentive to follow the new rules and apply the best practices," Kirila says.
"Very forward-looking private companies always ask if there's a good reason to implement a new provision whether they have to or not." Bloxham says.
Ultimately, even if the Dodd-Frank Act does curb some excesses, Ides says it's not a magic bullet. "You can't have the legislative or executive branch running the boardroom," he says. "Dodd-Frank doesn't get to the heart of doing the right things. Instead it's ‘Here are the rules, and if you don't follow them we'll spank you for it.' Self-regulation is part of the answer, because the law doesn't change the fundamental question: Will the board pay for performance and be transparent in explaining why they pay their executives what they do?"
Lisa Hooker is a freelance writer.
Reprinted from theDecember 2010 issue of Columbus C.E.O. Copyright © Columbus C.E.O.