The endgame in the decade-long debate over stock options is finally playing out. The Financial Accounting Standards Board has an expensing requirement ready to go, although it may delay implementation. The International Accounting Standards Board’s standard on expensing goes into effect in January. And while efforts to derail expensing continue in Congress, resistance will most likely prove futile.
Yet even before the final standard is issued, the stock option controversy itself has dramatically affected compensation for CFOs and their finance departments. “Long-term incentive values have dropped in every study we’ve done,” says Diane Doubleday, a principal at Mercer Human Resource Consulting, which conducted the latest edition of CFO’s biennial compensation survey. Many companies are shifting from options to other forms of compensation, she says, but “restricted stock or performance shares aren’t making up the difference. The total pie has shrunk.”
Of course, that trend isn’t confined to the finance department. Stock option grants are smaller throughout Corporate America, and have disappeared altogether for many rank-and-file employees. The good news for CFOs and their direct reports is that the Sarbanes-Oxley Act and shaky investor confidence have created a very competitive market for finance talent. “Large public companies are paying CFOs more,” says Doubleday.
To be sure, options are not going away. But how companies will change the mix of long-term incentives — and for which executives — remains to be seen. After all, knowing exactly how options will be valued and accounted for will allow companies to better analyze the comparative cost of other forms of compensation. Doubleday argues that a shift is already under way, driven more by shareholder and market demands than by accounting proposals. “Whether FASB postpones this standard for a year or not,” she says, “we are still in the middle of a trend away from options to a diversity of compensation vehicles.”
That diversity is even evident among the rarefied ranks of the 20 highest-paid CFOs. While option exercises put Oracle’s Jeff Henley atop the list, many of those options were granted early in his 13-year career. “I’ve held on to options fairly long,” he explains. “That accounts for why I had a significant gain. It certainly had nothing to do with recent times.”
Indeed, although options still constitute a significant chunk of the pay of the 20 best-paid CFOs, five executives made the list without exercising any options at all. One of the five, Bear Stearns CFO Samuel Molinaro Jr., came in third overall on the strength of a $12 million bonus ($5.3 million of which was cash).
Moreover, 9 of the top 20 received substantial restricted stock awards, including more than $5 million worth for John Hancock Financial Services’s Thomas Moloney (eighth on the list). “We have seen a dramatic increase in the use of restricted stock over the last year,” reports Mercer’s Doubleday. Seymour Burchman, senior vice president at compensation advisory firm Sibson Consulting, agrees. “There is a shift from long-term incentive opportunities delivered through options to service-vested restricted stock,” he says.
While most restricted stock awards doled out today vest based on length of service, says Doubleday, future awards are likely to be based on performance, as compensation committees pursue the perennial goal of tying compensation to performance. “We are still in a transition, and in an uncertain period on accounting treatment,” Doubleday emphasizes.
Still Weighing Options
Nothing illustrates the difficulty of that transition better than the case of Oracle’s Henley. Appointed chairman in January after 13 years as CFO, Henley ended his finance career as the highest-paid CFO in the United States, with $25.3 million in total compensation, despite receiving no bonus, restricted stock, or even a raise since 2001.
Although Henley’s haul was almost entirely the result of a $24.5 million gain on option exercises, he has been among the most pragmatic of software company CFOs, arguing that stock-option expensing is inevitable. Although he has expressed concern about valuation techniques (like other Silicon Valley firms, Oracle does not expense options), he has generally eschewed his industry’s vocal opposition.
In fact, he says, “I think some tech companies did too much of it [awarded too many options]. There was more dilution of their [shares] than probably was warranted.” Henley believes this cumulative dilution, not the pending expensing requirement, is the strongest driver of what he sees as a trend among software firms to give out fewer options.
And Henley puts Oracle in the same camp as mature, large-cap tech companies like Microsoft, which announced it was doing away with options in July 2003. “The days of explosive gains in options are over, because we are just so big,” he says. “That’s one of the challenges for large companies — there isn’t much equity upside.”
Yet, Henley also admits that the compensation package of his successor as CFO, Harry You, differs little in structure from the one he had for years. “We are still giving him a fair amount of options,” says Henley. (The new CFO received a substantial grant of 2 million options, with a strike price of $10.72, five days after being hired. The options vest in four equal annual installments, beginning after one year of service.) “We are contemplating partial substitution or replacement of options using some other type of equity vehicles,” said compensation committee chairman Michael Boskin at Oracle’s annual meeting. “No decision’s been made.” And although Oracle’s latest proxy statement leaves open the possibility of paying directors with restricted stock, the company has yet to issue any.
Indeed, Oracle’s experience illustrates how hard it is for any company in the incestuous technology industry to wean itself off options. “You have to base your compensation on the market,” says Henley, noting that prized employees tend to stay in the tech field. “If everyone got rid of options and went to restricted stock, we probably would, too. That’s not what’s happening. Stock options are still the norm, so far at least.”
Both in and out of Silicon Valley, however, stock options are no longer the norm for everyone. “The broader group of employees is more affected by this shift [away from options] than top levels of the organization,” says Doubleday. “If you are a CFO, you can reasonably expect an annual options grant. But unless you are a star performer [lower] in the organization, you may no longer be eligible.”
Although their base pay and short-term bonuses rose modestly across the board, lower-level finance employees nationwide already appear to be seeing fewer option grants. Over the past three years, Mercer’s survey shows substantial decreases in the percentage of financial-analysis executives, division controllers, cost accounting managers, and payroll managers who are eligible for long-term incentives of any kind. “A lot of the cuts have come from reduced eligibility lower down in the ranks,” confirms Burchman.
As if that weren’t enough to set the rank and file grumbling, the survey also shows slight increases in long-term incentive eligibility among higher-level finance executives — corporate controllers, audit executives, accounting executives, tax executives, and risk-management officers — whose responsibilities have grown in the wake of the Sarbanes-Oxley Act. “The regulatory compliance and control stuff has two effects,” says Burchman. “It significantly increases the workload, and also increases the level of risk.” Ultimately, says Doubleday, that is good news for CFOs and other top-level finance employees. “They are very much now at the center of things, and that has an effect on their compensation.”
For CFOs and other finance executives, though, the 2004 survey is decidedly a mixed bag. On one hand, base pay is up slightly, says Doubleday, and improving market conditions have brought bonuses back at many firms. And companies are funneling a larger percentage of long-term incentives toward top finance executives. “A lot is riding on that CFO,” says Doubleday. “Boards are making sure that if they have a good CFO, they hang on to that person. And if they need a CFO, they are willing to pay.”
The flip side is that even as finance executives garner a larger share of long-term incentives, the total pool is shrinking in size and value. Worse, when it comes to base pay and bonuses, there is no indication that the burdens and risks of Sarbanes-Oxley have substantially elevated the CFO’s relative standing within the C-level suite.
Much has been made of CEO compensation as a multiple of the average worker’s salary. But, says Doubleday, “in the context of corporate governance, observers are also noting the disparity between the CEO and the next level of senior management.” And despite the scrutiny, that gap is huge. Excluding long-term incentives, which vary based on market conditions, this year’s survey shows CFOs took home barely 30 percent of their CEO’s total cash compensation.
Tim Reason is a senior writer at CFO.
Among the largest companies, the regulatory demands of the Sarbanes-Oxley Act have convinced boards to put a premium on keeping or attracting good CFOs. But that’s not the only sort of regulatory strain on a company that can boost a CFO’s fortunes. Take PG&E Corp., whose CFO, Peter Darbee, ranked as the 15th-highest-paid CFO last year. That lofty ranking was largely the result of incentives intended to keep him on board to help the company’s primary utility subsidiary navigate through Chapter 11. (Darbee declined to comment.)
In 2001, Darbee was awarded 230,770 units of phantom restricted stock under a program designed to “retain [executives] throughout the energy crisis” that precipitated the bankruptcy. The entire grant vested at an accelerated rate on the last day of 2003 after PG&E Corp. exceeded its performance targets. On the date it vested, the stock was worth $6,408,483. (Under reporting rules, only about $3.2 million of that — the portion considered contingent on performance — is reflected in his 2003 earnings of $5 million.)
Lavish pay is not unusual in bankruptcy. Although Darbee’s pay and retention incentives were set by the board of the parent company, which remained solvent, creditors early on approved retention incentives for executives at the utility’s subsidiary, says David E. Adante, CFO of Davey Tree Expert Co. and a former member of PG&E’s creditors committee. “It made sense to us to keep that experienced management in place and exit the bankruptcy successfully,” he says.
That’s a common sentiment among creditors, says Seymour Burchman, senior vice president of Sibson Consulting, a compensation advisory firm. “The CFO may be more important than the CEO in the minds of the creditors,” he says. “In some cases, they feel that guy is absolutely critical to getting the company back on firm footing and getting repaid.”
Indeed, PG&E’s creditors ultimately were paid in full, plus interest. And although he didn’t have a say in Darbee’s pay, Adante credits management at both the utility and the parent company for successfully guiding the company through the bankruptcy process. “From my observation post on the creditors committee, you couldn’t have paid me any amount of money to go through the stress they’ve been under,” he says. “Whatever they got paid, they earned it.” —T.R.