Fray on Pay

The battle over executive compensation and what it means for you.

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.

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