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Corporate Board Member, Third Quarter 2009 article


Memo to Comp Committees: Don't Let Investors or CEOs Push You Around

from Third Quarter 2009
Corporate Board Member
by Julie Connelly

  push you around

An uncertain economy is clouding strategic planning, but boards must still grapple with some pretty specific numbers—the ones they’ll have to put together to come up with compensation packages for their CEOs and other top executives. Comp experts have two pieces of advice for those who are looking at the numbers for 2010:

  • Don’t allow yourself to be stampeded by popular opinion. It’s important that you resist any temptation to be punitive just because you sense that shareholders are out for blood.

  • Don’t believe that your CEO will quit if you cut his package. There aren’t that many places for him to go, and besides, CEOs read the papers and if they have any smarts at all they know that pay cuts are where it’s at.

Overall, you just need to be fair-minded and firm. “What I tell everybody is, take a deep breath and relax and try not to make changes in a crisis environment,” says William E. Mayer, 70, lead director of the Midwestern newspaper chain Lee Enterprises and founder of Park Avenue Equity Partners. “You want to be fair to management. If I don’t have any idea of what’s going to happen in 2010, how can I hold management accountable?” Adds Ann Rhoades, 64, president of PeopleInk, a human-relations consulting company in Albuquerque, New Mexico, and chair of the compensation committee at JetBlue Airways: “We had a great year because our people were working very hard, and then the recession came. And now we’re going to penalize them?”


Still, in the current environment there is what shareholder activist Tim Smith of Walden Asset Management describes as “a perfect storm—the hot spotlight of public attention, government regulation, and shareholder pressure to focus on executive pay.” In May, Senator Charles Schumer, the New York Democrat and member of the Banking, Housing, and Urban Affairs Committee, introduced his Shareholder Bill of Rights Act of 2009, a piece of legislation, co-sponsored with Senator Maria Cantwell (D-Washington State), that ties together many of the recent strands of shareholder activism and discontent. The bill’s provisions for proxy access and majority voting—not to mention rules more directly related to executive compensation, such as say on pay—would enable share owners to sweep out entire boards that are deemed to be rewarding failure and replace all the directors with stewards more to their liking.


These forces are pressing boards to rethink what and how CEOs are paid. By the end of 2008, median CEO pay at S&P 500 companies had fallen 6.8%, to $8.4 million, according to Equilar, a Redwood Shores, California, outfit that analyzes executive compensation. A 20.6% drop in the median annual bonus caused most of that downdraft. Frederic W. Cook & Co., a New York City compensation consulting firm, reckons that base salary growth will be negligible this year, annual incentive plans will pay out way below target, and long-term incentive values will drop by 10% to 20%. Myrna Hellerman, a Chicago-based compensation expert at New York’s Sibson Consulting, says that the chair of a compensation committee recently told her, “Well, we just went and took away everything. It was easier that way. It’s what the shareholders expected, and our executives were resigned to the impact of our actions. Now we need to figure out what we’ll bring back and what is gone forever.”


Few will push for directors to abdicate their responsibility to that extent, and certainly not Corporate Board Member. But these are times when boards, and the members of their comp committees, need to work harder than ever to get CEO pay right. And yes, doing so has become particularly difficult. Here are some issues to consider.


Pay for Performance Still Works
Just as the rising tide lifts all boats, the ebbing tide leaves them beached. Equilar analysts recently looked at the accumulated wealth—pension, deferred compensation, all options and stock awards—of CEOs at S&P 500 companies and discovered it was down by 43%. “There you see a very strong link with the shareholder,” says the firm’s research manager, Alexander Cwirko-Godycki. Not that CEOs were exactly impoverished, but the $70.1 million that the median top dog was worth at the end of 2007 had shriveled to $39.9 million a year later. “I don’t mean to compare a CEO to someone who has lost his job in terms of quality of life,” Cwirko-Godycki says, “but CEOs have gotten hit.”


Shareholders want to see clawbacks of CEO bonuses if the chief executives made decisions that turned out badly. Ira Kay, a compensation consultant at Watson Wyatt Worldwide, a global consulting outfit headquartered in Arlington, Virginia, points out that an equivalent move is to make top managers hold a lot of their companies’ shares. “The executives in 80 companies that we surveyed have lost a total of $13.4 billion on their stock. They had a billion-dollar downside,” he says. That is why finance professor David Yermack of New York University’s Stern School of Business says it’s not obvious to him that a permanent change in compensation methods is in order except at financial companies. “We have high-powered incentives that reward people when they succeed and punish them when they fail,” he says. “CEOs are feeling a lot of pain right now, and that’s as it should be.”


There Is No Talent Shortage
For years boards were held hostage by star CEOs who were in such demand that they could write their own employment contracts. Not anymore. With unemployment at nosebleed rates, your boy or girl is most likely staying put. The employment potential of CEOs is directly proportional to how well their companies’ shares performed during their tenures. David Yermack puts it bluntly: “When you run your own stock down 80%, where are you going to go?”


It has taken a little time for boards to realize they have the upper hand. According to Equilar research, at least 40 companies announced that they were paying cash retention bonuses to their top executives between July and December 2008, but fewer than a third included the CEO. Equilar noted that “some special awards, particularly those for chief executives, contain unique performance-based vesting requirements focused on overcoming current challenges.” For example, JCPenney disclosed in a December 8-K filing that it was granting its CEO, Myron E. Ullman III, as many as 500,000 shares “to provide an incentive for performance during the current economic environment and to recognize Mr. Ullman’s willingness to continue his services to the company.” The award caps out at $25 million, and Ullman, who has no employment contract or severance agreement other than one covering a change in control of the company, could get all of that if he sticks around until December 2011—but only if Penney’s annual total stockholder return grows to 29.1% or more by the end of the period. And he’ll get nothing, even if he hangs in there for three years, unless the return is at least 11.3%.


A common worry that the CEO may have wanderlust could be baseless. When Watson Wyatt surveyed 85 outside directors of large U.S. companies in March and April, 68% of them said that their boards or compensation committees were not concerned or were only slightly to moderately concerned about retaining high-performing executives. In fact, there is so much managerial talent around that this might be an opportunity for companies to upgrade. “Dump the dead wood,” suggests J. Richard, who runs his own J. Richard & Co. compensation consulting firm in Half Moon Bay, California. “That’s where boards should be extremely proactive.”


A Dollar a Year Sends the Wrong Message
In a gesture that is supposed to show solidarity with beleaguered employees, or perhaps a mea culpa, CEOs of financial firms like AIG, Citigroup, and Morgan Stanley have renounced their salaries and agreed to work for $1 per year. The Corporate Library, for one, isn’t impressed. In April the corporate governance research firm released a list of 41 CEOs who had served during their companies’ most recent fiscal year for no more than $1 in salary or cash bonus—18 of them voluntarily. What they did have, it turns out, was a combined total of almost $6 billion of stock in their companies. As the Corporate Library pointed out, “A reduction in salary (a forfeiture of typically between one and two million dollars) may be insignificant compared to monies received in perquisites and other arrangements in management contracts agreed upon by the board of directors.” Indeed, more than half of these executives were reimbursed for personal security, airplane travel, a personal car, relocation expenses, and gross-ups offsetting the income tax due on those perks.

“I don’t think anyone is taking a dollar a year who is not wealthy,” says William Mayer. “And when I read that someone is taking that, I’m suspicious.” More to the point, perhaps, Mayer believes that it’s unreasonable to ask a CEO to work for a dollar. “I don’t want him worrying about making ends meet,” he says. “I don’t think he should have a negative cash flow.” A relatively minor pay cut is something else, of course, and boards are having conversations with their chiefs about reducing the CEOs’ base salaries, especially in situations where the companies are freezing or cutting employee pay. Equilar reports that between June 2008 and February 2009, 133 public companies announced salary reductions for executive officers, commonly around 10% to 15%. At JetBlue, CEO (and board member) David Barger voluntarily reduced the base salary he receives as CEO by 50%, from $500,000 to $250,000. (Some directors are also cutting their pay; for more, see the box below.)

In cases where the CEOs aren’t volunteering, boards need to tread with care if they intend to propose a cut. Many employment contracts stipulate that a reduction in salary constitutes good reason for a CEO to quit and collect severance benefits.

But treading with care doesn’t mean that you can’t broach the subject of compensation. In fact, says Michael Melbinger, a partner at the Winston & Strawn law firm who advises boards on compensation matters, “it hasn’t been that hard to speak to the CEOs, because they know circumstances have changed and sometimes they bring it up themselves.” For example, Nabors Industries, a Bermuda-based drilling company, amended its employee agreement with CEO Eugene M. Isenberg—more about him later—in April, on terms “substantially more favorable to the Company than before,” as the proxy dryly noted. Among those terms: Isenberg agreed to donate the after-tax proceeds of his $1.3 million base salary to help employees, their children, and others go to college.

Make Way for Say on Pay
The 400 financial companies receiving federal money under the TARP program have to allow their shareholders to vote on executive compensation. While the vote isn’t binding, it does offer investors an opportunity to sound off on this hot-button topic. In fact, as of early May (the most recent figures available), 22 other companies, including Apple, Motorola, and Verizon, had voluntarily agreed to hold such a vote, according to RiskMetrics, a proxy advisory firm. Of course, the Schumer-Cantwell bill seeks to make a shareholder advisory vote on pay mandatory at all public companies. Clearly life will never be the same for compensation committees—or for CEOs who still think they can command outsize pay and perks. “Say on pay is coming,” says Irv Becker, who runs Hay Group’s U.S. executive-compensation practice, “and it creates a real focus on the CD&A [the compensation discussion and analysis that companies now have to spell out in the proxy] and on how companies communicate with shareholders about how pay is structured.”

So while the board will still be responsible for setting CEO pay, it must explain clearly to shareholders—and shareholder activists—exactly what it is paying for. “I don’t think shareholders will put up with not seeing how the CEO did against specific targets,” says JetBlue comp committee chair Ann Rhoades. The carrier provided that level of clarity in the CD&A it published when making the case for paying CEO David Barger and the other four named executive officers their full bonuses. The CD&A went through eight goals the company had set for these managers and described in hard numbers how they’d performed against each of them.

The executives sometimes fell short. For instance, JetBlue was only seventh instead of the targeted fifth among major airlines in on-time arrivals; passenger revenue per available seat mile grew by 14% year over year instead of 15%; and at year’s end the company had $561 million in cash and cash equivalents instead of the goal of $880 million. Yet that 14% revenue increase enabled JetBlue to place first in the industry. At the same time, even though fuel expenses increased by more than $400 million in 2008 and took a big bite out of its liquidity cushion, the company was able to pay down almost $700 million in debt. Says Rhoades: “In an environment where we don’t control the price of fuel, our biggest expense, you could argue that we should have given management more. But they didn’t ask for it, and we did what we thought was reasonable.” Barger received a bonus of $250,000, half of what it would have been if he hadn’t cut his salary. And at the annual meeting in May, Rhoades says, “our shareholders, even though they lost a lot of value, were very pleasant.”

Coming Soon: the Bungee-Cord Bonus
When CEOs make decisions that turn out badly, shareholders want the bonus back. But being punitive isn’t going to accomplish much. Sixty-four of the Fortune 100 companies have clawback provisions in their employment contracts or other compensation arrangements, and clawbacks are mandatory at companies receiving money under the TARP program. It is also possible that the clawback threat, which can cover a broad range of employees besides the CEO, serves as a warning to overly aggressive managers. Clawbacks look good and shareholders like them. But good-looking is all they are, as two recent cases make very clear.

New York attorney general Andrew Cuomo demanded that 20 employees in AIG’s financial-products unit return the $165 million in retention bonuses they’d received early this year. Although 15 of them did so, only $50 million had come in by March. And then there were the efforts by both Cuomo and his predecessor, Eliot Spitzer, to claw back some of Richard Grasso’s substantial compensation as chairman and CEO of the New York Stock Exchange. Last July, after nearly five years of depositions and lawsuits, all of which placed the directors of the exchange in an extremely unfavorable light, the New York Supreme Court’s appellate division ruled that Grasso could keep the $139.5 million the exchange had already paid him. Warns New York City compensation consultant James F. Reda: “When you institute clawbacks, do you know how many hard-luck stories you’re going to hear? Are you prepared for this and for the legal fees when the executives fight it?”

Obviously it’s better not to pay the money in the first place. What Grasso tried for and didn’t get was an additional $48 million that he believed he was owed but that the exchange had not yet paid him. Holding back some of the reward is the theory behind bonus banking, also known as bonus-malus: Hang on to the dough until you can see whether an executive’s performance is sustainable. The cash held back or banked earns a return, but it is also subject to reductions or even forfeiture—that’s the malus part—if one year’s blowout performance turns out badly later on.

“These things sound good as an immediate reaction, but they can cause problems down the road,” says Equilar’s Alexander Cwirko-Godycki. For one thing, bonuses may have to be larger if a portion is being withheld, and exit packages will swell with yet more deferred pay. Nonetheless, this year UBS, the big Swiss bank, which recorded a loss of about $20 billion in 2008—the largest one-year corporate loss in Switzerland’s history—instituted a bonus-malus system for its senior managers and a group the bank calls “risk-takers.”

Essentially, each year’s bonus has a three-year vesting period. Executives get a third of the money; the rest is held back and reduced in the subsequent two years if results are poor. This might restrain the bank’s more pedal-to-the-metal guys. Alternatively, many others who have labored hard only to watch their bonuses erode will begin thinking about working someplace else when the job market opens up again.

Going, Going…Gone
Perks have seen their day as compensation tools. They have to be disclosed, and they upset shareholders to an extent that far surpasses their monetary value. And with reason: The dirty little secret behind perks is that companies routinely gross up their CEOs for the income taxes due on such things as personal use of the company plane, company-paid life insurance, and the like. Last year 59% of S&P 500 companies paid the tax reimbursement on executive perks, according to Equilar, but so far 50 of those businesses have cut out the practice this year.

Severance agreements are under pressure too. No one wants to justify a big package for CEOs who are already rich from their company stockholdings. So there are more sunset provisions in the agreements, phasing severance out over two or three years. That’s happened at SunPower Corp., a manufacturer of solar cells and panels, says Betsy S. Atkins, 56, CEO of Baja Ventures and chair of SunPower’s comp committee. In addition to cutbacks in severance, Ira Kay of Watson Wyatt predicts reduced perks and ceilings on SERPs, or supplemental executive retirement plans. “These will be permanent changes that will last for the next
half-generation of CEOs,” he says.

There is, however, one disreputable practice that remains—the gross-up of excise taxes due on a CEO’s (often excessive) golden parachute. Some companies, like Reynolds American, the tobacco outfit, are eliminating gross-ups on new contracts but not on existing ones, even though, as Betsy Atkins notes, “gross-ups cost a company a ton of money, and they are hard to defend.” According to RiskMetrics, each $1 of tax that must be grossed up costs a company between $2.50 and $3, because it can’t take any deductions for the gross-up or the expense of the parachute.

There are signs that gross-ups may be ending as well, albeit perhaps on a fitful, company-by-company basis. RiskMetrics published a study of golden parachutes last November and devoted a special section to Nabors Industries, highlighting the enormous gross-up the driller would have to pay on chairman and CEO Eugene Isenberg’s parachute if control of the company changed. Isenberg stood to collect a parachute of $315 million plus another $95.8 million in gross-ups, for a grand total of $411.3 million. That’s more than three times the average amount in the industry. Nabors must have seen the report—or had its nose pointed at it by irate shareholders. Five months later the 2009 proxy announced that the company had eliminated all tax gross-ups, “including without limitation tax gross-ups on perquisites and golden parachute excise taxes.” Isenberg’s basic parachute contracted too. He’d now walk away with a flat $100 million—not chump change, but not $411 million either. Isenberg still gets to pocket an unusual payment that shareholders might also criticize. He collects director fees for serving on the board of the company he heads, $50,000 in 2008.

Cash Is the New Equity
How are you going to reward your CEO when the prizes you used to dole out aren’t motivational anymore? Answer: “I think cash compensation will become more important,” Ann Rhoades says. “What you give will still be performance-related. But cash is as good as restricted stock units over the long term.” In fact, it might be better because many companies do not have enough shares in their stock plans to maintain the dollar value of the equity awards they used to give. So the choice is between paying cash and going back to the unhappy shareholders for authorization to increase the number of shares in the plan. No one is eager to try that. Instead, says James Reda, “you can give long-term cash compensation and index it to your stock price.” Salaries, though constrained by the $1 million cap that companies can deduct from their taxes, may also go up when equity awards start contracting. Irv Becker notes that at comp committee meetings, “you’re seeing discussions around ‘Maybe we need to pay a higher salary.’”

There is a hidden benefit to cash compensation. “Cash is more easily recognized as an expense,” says Reda. “You can’t disguise cash.” Knowing exactly what the company is spending on the CEO will be of great help to boards mulling the next contract. They’ll find it easier to figure out whether their leader is overpaid—or has earned a raise.





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