The summer slide in the Dow seems to have reinforced growing skepticism about the whole system of remuneration for senior executives. For months, the business pages echoed to the sound of gurgling as corporate officers going underwater began to think that they needed a snorkel in the form of stock options repricing. That generally means lowering the purchase price of worthless options to make them worth something again.
In fact, the evidence was mostly anecdotal, and second-hand anecdotes at that. Consultants and academics alike report that many companies checked out the possibility of repricing, but were either frightened off by obdurate hostility from institutional holders, or they had their heads dry and back above the surface by October, and decided it was not worthwhile.
Institutions were usually prepared to sanction options repricing for employees but, as in the case of Reebok, only where executive officers on the board were excluded. For senior officers, the message was clear: if you take credit for a bull, you should grin and bear it when the market goes down.
Shareholders faced with shrinking portfolios seemed to join in a growing public mood, reinforced by headlines about payouts like Michael Eisner’s $550 mn, that this was not the right time to pass the hat round for corporate officers. According to Claude Johnston of compensation consultants Pearl Meyer & Partners, options now make up half of the average CEO’s paycheck. However, when they surveyed 90 of the largest American companies, they found that although CEOs’ salaries outpaced their companies’ market cap when riding a bull, they also went farther underfoot when mauled by the summer bear.
Until the high point of the market on July 17, CEO holdings increased by 34.5 percent compared with their companies’ market cap growth of 20.7 percent. But as stock prices went down, the CEOs suffered – up to a point. By the end of September, they had lost 17.7 percent since July 17. In fact, before anyone passes the collection plate, both companies (11.2 percent) and executives (10.7 percent) were still up over the year by October.
Eroding orthodoxy
Growing shareholder skepticism about repricing was also reflected in the New York Stock Exchange’s September decision to curb covert executive schemes by insisting that employee share options go to a shareholder vote unless at least 45 percent of employees are to benefit from such a scheme. And that will be tightened even further by next year.
The buzz about repricing may well have eroded the orthodoxy that options tied to stock price are a real and effective incentive for executives and other insiders. It also led some compensation experts to question whether stock price is an accurate reflection of corporate performance. For example, the downward slope accentuated voices like that of Conference Board compensation expert Charles Peck, who is skeptical that ‘share prices necessarily are symptomatic of corporate performance.’ He concludes: ‘What it all comes down to is that executive compensation never goes down. The composition may change, but the amount never goes down.’
And some investors – retail and institutional – are beginning to discover there is, in fact, no hard evidence that incentives are related in any way to corporate performance. Still the prevailing view among academics has been echoed by the institutional investors who have maintained heavy pressure on boards to adopt stock option incentives.
You could argue that executives and their friends on the boards were gracefully succumbing to pressures to adopt measures that ratcheted up their pay. Compensation committees insisted they be paid above the peer group average – thus perennially and collectively raising the average – or by taking credit for the bull market with stock-price based incentives.
In time for the change of attitude, Professor Michael Beer from Harvard Business School interviewed several hundred executives who, anonymously of course, admitted to practices such as ‘low-balling’ – setting low targets for incentive schemes that they could easily exceed. He found little evidence of an incentive factor. ‘This is a huge wave, mostly based on myth. Succumbing to the pressure doesn’t make it right. You can cite some high-performing companies that have incentive schemes, and some that don’t, so it seems that incentive schemes don’t make a difference. Something else is making a difference here, and the only relationship with performance was whether they had a team-based culture. When people put incentive systems in, they don’t really put them in to make them performance-based, but to give people an upside. And when there’s a downside, they usually redesign the pay system by repricing options or redesigning the bonus system.’
Beer concludes that if the market were to stay down, we would see a shake-out of these schemes that ‘look great on the way up but not so good on the way down.’ The clincher for some boards is that executives can reprice on a personal basis, by crossing the road to work for someone else. As Beer puts it, ‘These systems don’t motivate people, they move them.’ In contrast, he suggests that companies should ask themselves: Do we want to attract people to our firm who are motivated by money? ‘The answer is no. You won’t get much value from them because they spend their time arguing about pay, and then go to a better offer.’
Chink in the armor
Pearl Meyer’s Johnston has had some inquiries from clients about repricing and sees the need to attract personnel as the weak link in the armor against it. ‘It’s going to be a very difficult thing for boards to deal with. I think that there is a shortage of executive talent, so they’ll pay what they have to pay.’ But he also thinks most boards will still decide that repricing is a bad thing, not least because of institutional pressure. ‘We’ve always advised our clients that they should be looking at other forms of longer-term compensation, based on revenue growth earnings or assets over some three-to-five year period.’ With wry satisfaction, he suggests, ‘We may now find companies more receptive to longer-term forms of compensation instead of relying solely on stock prices.’
Pat McGurn of Institutional Shareholder Services, the proxy advisory firm, agrees. ‘Broad-based plans don’t retain, and they don’t provide incentive. But they do attract, and they do encourage people to jump to the next best bid at the first opportunity.’ He has spoken to Silicon Valley companies who are against an IPO because of their horror at having to ask shareholders for approval for option-based compensation plans. And he suspects there are lots of shadow plans which don’t cover top executives going into place without shareholder approval. ‘The catch is that when they go to the shareholders for a high executive plan, there would be a day of reckoning, because shareholders would learn about it and take it into account.’
McGurn foresees shareholders turning to alternative mechanisms to keep their stewardship, not just in the form of compensation plans but in their overall use of capital. ‘For example, there may be more votes against directors, especially against compensation committees. It would be a form of capital punishment: some shareholders may retaliate against new issues if they feel that companies have not given them a voice on compensation plans. New issues are usually charter items that need a majority of votes outstanding. It’s going to be a hot season this year with a lot more boards being held accountable.’ He can make the prediction with some confidence, since in October ISS decided to vote against what it considered the ‘trend toward skyrocketing pay-outs’ from option schemes.
Options may also come under pressure from another front. There is a growing move to put the dilutive effect of stock options into the main accounts and out of the footnotes where it has hitherto been hidden. American accounting practices, pretty much unchanged since 1972, and only slightly modified in 1995, allow the cost of the options to be banished to the footnotes so that they do not seriously affect the published bottom line. One effect of current shareholder dissatisfaction may be to strengthen the hand of the Financial Accounting Standards Board in the changes it is currently introducing in, for example, costing stock option repricing as a compensation expense. Currently, US accounting practices favor options compared with countries like Japan and the UK, where options have been more recently introduced – not always to universal acclaim.
Protecting the eggs
The other aspect is that executives themselves may react against having so much of their remuneration in such a volatile form. Kathy Buxton of the Investor Responsibility Research Center, who authored a report on rising CEO pay levels, predicts, ‘If we have a very turbulent stock market, and if enough executives experience a decline in total pay as a result of the fluctuations, it could be the case that they won’t like them any more, and may not want to put all their eggs in this basket.’ They may already have their defenses prepared, she suggests. ‘Many people will tell you that the growth in pay is directly the result of pressure from institutional investors.’
Corporate Management Solutions, based in Shelton, Connecticut, develops software that drives those incentives, calculating the options and evaluating them for employees. Founder Mike Brody reports very little repricing activity among the firm’s 2,200 corporate clients. ‘When there’s something like repricing involved, we normally get a call because it is our software that does the calculations – and we are getting very few calls. That’s encouraging: Chicken Littles aren’t running round saying that the sky is falling in. We were surprised by how little commotion there was out there. We thought there would be a lot more panic, a lot more repricing, a lot more people questioning the plans. We were expecting quite a bit more given the market, even though it’s come back.’
However, Brody does not expect instant conversion away from stock price-based options. ‘It’s very difficult to turn that kind of philosophy round in the short term. Out in the compensation consulting world, the word is still that equity-based plans are the way to go. If something happened in the market, everyone would share the burden.’
Professor Kevin Murphy of the University of Southern California has seen the same pattern of interest in repricing – expressed but not acted on. He also expects that the present flurry of interest in restructuring executive pay will blow over. ‘The companies that were thinking about repricing probably aren’t any more. It’s obvious why they were considering it. The executives come in with a dejected look on their face and say, ‘The market’s down. It’s not my fault, and I don’t have any incentives left.’ Boards will find that quite convincing. If the market had continued to fall, you’d see a lot more interest, but as long as this recovery sticks for the end of the year, then they’ll stick with options, for tax and accounting reasons – and because they get lots of money from them.’
What goes up…
However, there is an alternative. Waxing Churchillian, Murphy declaims, ‘Stock price-based schemes are the worst systems, except when compared with all the others.’ He suggests that repricing deserves serious consideration, if it’s also reversed on the upside. ‘Reprice your options when the market goes down, as long as you can reprice them the other way, when the market goes up.’ However, as he admits, ‘A compensation consultant wouldn’t last five minutes if he suggested that.’ Even so, Murphy suggests, this is already ‘almost the case with the indexed options, so that the option price goes up and down with, say, the S&P 500. It would be like continual repricing, based on the market.’
Harvard’s Brian Hall has a similar proposal. First, he thinks CEO salaries are not out of line with sports people and Wall Street, so his problem is with the structure, not the amounts. ‘Executives aren’t just motivated by money. But it does take their mind off other things, like empire building. When bonus plans are complicated, executives spend too much time gaming them to manipulate the figures, so unless you get them right, you’re better off not having them at all. Keep them simple and straightforward – that’s why I like stock options. If you have a bunch of shares that haven’t been vested, think of the incentive to keep from going underwater with them. A zero pay-off is a big stick to go along with the carrot.’ He concludes: ‘I hope the stock market blip pushes companies to consider indexing some of their options to the market. Not all, because indexing means that half will be under the median. But a third gets you around that problem. Then, with a good company, you can still be in the money – even in a bear market.’
So, even if Chicken Little has stopped clucking, a lot of people will be looking more apprehensively at the sky than hitherto. Executive stock options will doubtless be around for some time but shareholders and institutions will scrutinize them more harshly – and executives will be a little less sold on them. Astute compensation consultants would be well advised to have ready a new set of mixed or non-stock price-based incentives for the next time the sky looks a little unsteady.
