Dennis Carey Corporate Strategies

“CEOS ARE PAID a lot to face facts, however unpleasant, so it’s time they faced this one: The issue of their pay has finally landed on the national agenda and won’t be leaving soon. It is now inevitable that someone will do something about it, and one of the fiercer dramas of the next several months will feature Congress, the Securities and Exchange Commission, the accounting profession, and the CEOs themselves battling over who that someone will be. The fight has already begun. Anyone can tell you what the problem is. Just ask your neighbor or cabdriver — then stand back.

Largely unharnessed from corporate performance, the pay of America’s CEOs has been galloping forward faster than the average production worker’s pay, faster than corporate profits, industrial production, the national debt, the population of India, channels on cable TV, or just about anything else on earth but the number of newly independent republics. The CEOs of 282 large and medium-size U.S. industrial companies studied by the Hay Group consulting firm earned, on average, $1.7 million in total compensation last year; in the 30 largest, some $3.2 million. Maybe if the economy were thriving and big employers were hiring, no one would care. Maybe if President Bush hadn’t taken the auto company CEOs to Japan to meet their lower-paid, more successful competitors, or if consumer confidence weren’t in the tank, or if giant companies weren’t still announcing vast layoffs, CEO pay wouldn’t be on the front pages.

But all those things have happened, making Americans deeply, bitterly mad and creating an issue no politician can resist. When a conservative like Dan Quayle rails against ”those exorbitant salaries paid to corporate executives unrelated to productivity,” something’s up. The issue should only get hotter as proxy statements detailing executives’ 1991 compensation go out to shareholders in the next few weeks, about the same time as several of the most important primary elections. The Securities and Exchange Commission, among the first to act, recently reversed its longstanding practice by allowing shareholders a nonbinding vote on corporate pay policies.

The commission is considering requiring fuller disclosure of executive pay in proxy statements, and Washington could go still further. SEC Chairman Richard Breeden says, ”God only help us if the government gets in the business of trying to regulate compensation. It is the board of directors’ job, and I would warmly and strongly recommend them to please do it — because if they do not, then someone will call on us to do it.” Who’s to blame for all this? That’s easy: CEOs. A pedant might insist that boards of directors are the culprits, since they set top executives’ compensation. But in practice most CEOs appoint their own directors, presenting only their nominees to the shareholders for a vote. Besides, 63% of all directors are CEOs. Face it, fellas: You got yourselves into this mess. Now it’s time to get yourselves out.

Fixing CEO pay is a two-level challenge. Level one is devising a pay plan that works; many innovative companies — Georgia-Pacific, Avon Products, Becton Dickinson, and several others — are exploring new ways to link pay and performance. Level two — much harder to reach — is getting boards of directors to adopt those smart pay plans instead of the stupid ones they so often favor. The bedrock principle of paying the chief is aligning his interests with the shareholders’. Sounds simple enough. But the favorite instrument for doing that over the past 40 years, the beloved stock option, turns out to be full of problems. That fact guarantees conflict ahead, because options have been the main engine powering the hypergrowth of CEO pay since the Eighties. In 1985 the typical CEO of a fair-size American industrial received long-term incentives, mainly options, with an estimated value of $58,000.

Last year it was over $527,000. Base salary, bonus, perks, benefits — each figures in, but not like options. They are the form of compensation getting the closest scrutiny from Congress, the SEC,and the accounting profession. A standard option gives an executive the right but not the obligation to buy company shares for ten years at the market price on the day the options were granted, though usually he must wait two to four years before he may exercise them. The incentive seems straightforward: The executive will work like mad to maximize his wealth by raising the stock price, and shareholders get the benefit.

Trouble is, it doesn’t work very well. Options can be employed intelligently and effectively. But because they have built-in flaws and are often abused, their record of linking executives’ interests with shareholders’ is far from good. One reason is that the optionee doesn’t put up any money. For most ordinary investors, the fear of loss is at least as strong a motivator as the hope for gain, but recipients of options face no risk. If the stock rises, terrific; if it falls, they simply discard the worthless things. As compensation consultant James F. Carey puts it, ”From the participant’s viewpoint, the option grant may seem like a no-risk wager in a game of craps called ‘the market.’ ”

The CEO with options has another advantage over the ordinary investor: inside information. Knowing the company’s prospects more intimately than anyone, he has a far better chance of choosing a peak in the stock price to exercise options and take his profit. There’s nothing illegal about this. That’s just the way it is. And that is how options work when companies play fair. Many play otherwise. Suppose a company issues options to a CEO when the stock is at $50, and it then falls to $30. You might think it’s only right for the optionee to be out of the money in that case, but some compensation committees instead take pity on him. They cancel those options and replace them with new ones at $30. America’s champion option repricer is Apple Computer. ”They’re worldclass,” says Ralph Whitworth, president of the Washington shareholder rights group United Shareholders Association, with bitter admiration. Apple has repriced executive stock options six times since 1981, with two repricings affecting options held by CEO John Sculley. As a result, he has earned gains on those options before investors who stayed with the stock earned a dime.

Venture