February 24, 2009

With Scant Apologies to the Pay Apologists

One of the more disappointing aspects of this market meltdown has been the lack of leadership from the top of Corporate America. So few CEOs have spoken publicly about what can – and should be – done to fix what ails us. There has been panic in the air for over six months, and this may well accelerate if some of our biggest banks are nationalized. Where is the leadership? Hence, the “Slap a CEO” game.

Even more perplexing to me is that a few lawyers are finally speaking up about executive pay – but they are speaking up to defend past practices and urge that they be continued (in comparison, many tell me privately that they agree with our mission to rein in excessive pay). Lawyers have long ago given up the mantle of being perceived as responsible leaders in the community. This surely will not help the profession’s cause.

I’m not saying that Congress’ (and Treasury’s) latest approach to reining in executive pay is without fault. I firmly believe that Congress should not legislate executive pay and have long said that. But I don’t blame them for trying to stem the tide because those involved in setting pay have long ignored the fact that the pay-setting processes are broken (here’s my explanation for how they are).

Change Won’t Happen Until Boards Want Change

Unfortunately, the sad truth is that even if the legislated/regulated pay fixes were perfectly set so that pay would be aligned with performance, etc., the fixes still wouldn’t work until boards and their advisors wanted them to work. They always seem to find a “work around” to keep the excessive practices flowing. Part of the problem is a culture of “all CEOs are deities and couldn’t possibly be replaceable” as well as a failure to recognize that the client is the company, not the CEO. The current state of executive pay remains a huge corporate governance problem – as pay has unintentionally racheted up over the past two decades – and needs to be rolled back.

Unmasking the Myths

These pay apologists continue to argue that CEOs will run to the nearest private equity/hedge fund if they aren’t paid along the lines of the past. I say let’s see. I think most boards will find that their CEOs aren’t going anywhere fast if given the option to depart, particularly given the state of those funds.

Most of the arguments against responsible pay arrangements revolve around the fact that CEOs have amassed so much wealth that they don’t need the company anymore. Which is exactly the point. I hear the argument that hold-through-retirement won’t work because it incentivizes a CEO to retire and collect their accumulated equity now (Note that our approach encourages long-term holding until “the later of” – and Exxon Mobil has shown that it works. Here’s our analysis on how to implement hold-thru-retirement). That may be the case for this generation of CEOs who have amassed ungodly sums of money – but if pay packages are brought back to Earth, this won’t be a continuing problem because your CEO won’t have amassed $100 million in a few short years and will need to keep the job.

There has to be a modicum of common sense in negotiating these pay packages. How can one be motivated to do a better job getting paid $10 million per year versus $5 million? If you earned 5 mil, wouldn’t you give 100% of your effort? Boards need to get off the peer group survey train and do their own homework, starting from scratch and using internal pay equity as an alternative benchmark.

Now that so many responsible tools and processes have been identified, it’s time that companies start using them. Fortunately, some companies have started – as Mark Borges recently identified in his “Proxy Disclosure Blog.”

Compensation Arrangements in a Down Market

Tune in on March 24th for this webcast: “Compensation Arrangements in a Down Market.” Among the important topics, the webcast will cover these types of common situations:

– A company’s stock is down 60% and due to a goodwill impairment, it will report a loss of close to $900 million. The committee decided to exclude the impairment in the annual incentive plan calculation, and now the bonus is being paid at 75% of target. The committee decided to pay the bonus in stock, so the non-equity incentive column for 2008 shows zero, and the stock award shows up in the GPBA table next year. Is that permissible?

– A company is concerned about ISS and the pay-for-performance test, so they are ensuring total compensation is less than for the prior year. What should be considered?

– A company does not want to disclose its business unit performance targets, but it’s afraid that the SEC Staff will reject their competitive harm arguments. What can – and should – it do?

– A CEO does not want to look “grabby,” so she wrote a check for personal use of the aircraft in order to fall below an ISS limit of $110,000. What is there to consider?

In anticipation of Treasury issuing its exec comp regulations in the near future, we have calendared a webcast for March 11th – “New Treasury Regulations and the American Recovery Act: Executive Compensation Restrictions” – so you can get guidance as soon as it comes out.

Nell Minow on Outrageous CEO Pay—and Who’s to Blame

For this BusinessWeek article, Maria Bartiromo recently conducted this interview with Nell Minow of The Corporate Library:

Anger over enormous executive compensation has been rising for years. Are we at a watershed moment?

Yes, I think so. All the scandals I have lived through going back to the savings and loan crisis, insider trading, Enron, and WorldCom seemed very localized—they were about something that everyone could understand. There were people who behaved unethically, and we got to see some very satisfying perp walks. But in this case, because the problem seems so systemic and there has been no indication that anyone has done anything illegal, that has fueled a level of rage I have never seen before.

I used to compare some of these executives to Marie Antoinette, but a better comparison is Nero. When the stories came out about [former Merrill CEO John] Thain and his $1,400 wastebasket and the corporate jets and the bonuses, that makes people feel that not only did the business community create this problem, but they don’t care how bad it gets. I will tell you that the biggest disappointment I’ve had in this mess has been the absolute vacuum of leadership on the part of the business community.

The public may be angry, but don’t stockholders have to get angry, too, for there to be any dramatic changes?

I’m so glad that you brought that up because all the reforms going back to Enron and before always focus on what they call the supply side of corporate governance, which is what the boards must do, what the corporations must do, what the accountants and lawyers must do.

And we have completely failed to address the demand side of corporate governance, which is what shareholders must do. Shareholders have reelected these directors, have approved these pay plans, and have been enablers for the addictive behavior of the corporate community.

The stimulus bill reins in compensation for executives of banks or companies receiving bailout money. Is that fair?

I think there are two important points to make about it. The most important is that this is not the government regulating CEO pay. This is capitalism. This is the provider of capital insisting on some improvement in CEO pay. And whether you are a distressed company that goes to a private equity firm for help or to your Uncle Max for help, those people are going to insist on some kind of a giveback with regard to pay. So this is a business partner negotiating.

Caps don’t really have much of an impact, but they send a powerful message. To me, the interesting part is the restricted stock. The fact that there’s no limit on the restricted stock means that you can earn a zillion dollars under this program as long as you earn it. And the fact that it cannot vest until the government gets [paid back] is very, very good. It really does the best job possible of aligning the interests of the managers with the interests of investors and taxpayers.

Can you explain how compensation contributed to the mess we are in now?

Certainly. With regard to the subprime mess, compensation was structured so that people were paid based on the number of transactions rather than the quality of transaction. And it doesn’t take a rocket scientist to figure out that that is going to lead to disaster.

How has executive pay ratcheted up to such a level?

In part, the answer is that the last time the government tried to fix [outsized executive compensation], there was no limit on stock options. At the time you didn’t have to expense stock options, and they just mushroomed. So we want to have some humility going forward about efforts to correct this problem we helped to create the last time we tried to correct it. And there was a cultural element that led to this as well. I always say that investment bankers are the geishas of the financial world because they sit next to the CEO and laugh at his jokes and talk about what a big strong man he is and wouldn’t it be fun to buy something together.

And so CEOs looked at the investment bankers and said to themselves, “This guy’s making more than I am. I am a titan. I’m the CEO of a great big company. I’m responsible for all these employees and customers, and all this guy does is move numbers around. I should be paid as much as he is.” And then we have what we call the virus directors—directors who move from company to company and bring bad pay plans with them. So you have people like [Home Depot (HD) founder] Ken Langone, and you find him on the compensation committees of GE (GE), approving Jack Welch’s retirement plan, Dick Grasso’s at the NYSE (NYX), and [Bob] Nardelli’s at Home Depot (HD). He personally was involved in three of these outrageous plans.

So compensation committees are at fault?

Yes. I absolutely blame them 100%. I’ve given up on any other reform other than the ability to replace directors who do a bad job. Without that, as long as you still have this very cozy interlocked system of having CEOs control who is on their boards, you’re going to have no incentive for directors to say no to bad pay.

I mean, when Warren Buffett says that he has knowingly voted for excessive compensation because collegiality trumps independence, you know that there’s something really wrong with the system.

– Broc Romanek