Executive Compensation:
More Bang for your Buck
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Introduction
Executive compensation is of growing concern today. In the wakes
of corporate scandals such as Enron and WorldCom, executives are being
scrutinized more than ever and companies want assurance that
executives will live up to their large payment packages. Recently, there
has been a disconnect between executive payment packages and the
company’s desired mission which executives are supposed to work
towards. Due to the SEC’s increased disclosure requirements, index stock
options are now a very real solution to aligning executive compensation
and company objectives. Compensation Committees, a unit of the board
of directors, are the crucial factor to the success of such an initiative.
Their governance and disclosure of the payment process can assure that
CEO’s are paid fairly and are working towards the stated company
mission.
Ethical Framework
I will explain my argument using duty ethics as well as a fairness
and justice approach to executive compensation. The fundamental
understanding of justice was derived by Aristotle more than two thousand
years ago and is still widely accepted today: “equals should be treated
equally and unequals unequally.” 1 In other words “individuals should be
treated the same, unless they differ in ways that are relevant to the
situation in which they are involved.” 2 For example, if two people that are
working for a company are doing work that is equivalent in terms of the
amount of work and the mental capacity that the work requires, than I
think we would all agree that it would be unjust to pay one of these
workers more than the other. This idea is the ethical basis upon which I
am basing my argument for a change in the governance and issuance of
executive compensation.
There are three different kinds of justice which are very important to
executive compensation and in cases where compensation is unjust
and/or unfair different forms of justice are being used to compensate for
unjust actions.
• The first type of justice is called distributive justice and this is
what all employee compensation is based on; distributive justice
is the extent to which our corporations ensure that benefits and
burdens are distributed among employees in ways that are both
fair and just. This means that an individual is paid based upon the
physical and mental capacity their job requires. 3
• A second important form of justice is retributive justice.
Retributive justice refers to the extent to which punishments are fair and just. For example, the punishment for an
underperforming CEO would be job termination and a loss of
severance pay. 4
• The third kind of justice is known as compensatory justice, which
means that people are fairly compensated for their injuries. In the
case of executive pay the only way to compensate stockholders
who have been hurt by underperforming executives is to change
the pay scale to better align managerial and owner goals. 5
CEO Expectations
To understand why current CEO compensation is so unjust we
must define what company’s expect from a CEO. Also, it must be made
clear that the problem is not the amount of money that CEOs are being
paid, but rather the ways in which the money is awarded to CEOs. CEO’s
are hired for a variety of reasons: for a specific goal such as to increase
new product development, further penetrate an existing market, or to
save the company from a previous underperforming CEO. So, CEOs can be
viewed as multi-headed monsters, the CEO is the big head and it is their
job to listen to all of the other heads and use their information in making
wise judgments that guide the body of the beast where to go: down the
sunny trail with rabbits and deer next to a river or down the dark alley
filled with scary eyes and eerie noises.
Unfortunately it is not this simple; there are many voices to listen
to and even more roads that a CEO can choose to take. But the intangible
abilities of successful CEOs to make sound decisions and guide their
prospective companies down the right paths is the risk reward scenario in
which CEO’s are deserving of very high compensation. 6 One task alwaysremains the same when it comes to performance; provide long term
growth and sustainability. Who says that this is the one task that exists
throughout all corporations? The stockholders are the members that say
this and it is their funds that make public corporations possible,
executives are managing the company for these shareholders and as such
should have their best interests in mind. Short term gains that will cause
long term problems are never viewed as the right direction of the
company by the stockholders, but this is exactly what many executive
compensation packages promote. Executive compensation needs to be
changed so that CEO’s are paid based upon the execution of their duties:
which primarily is to provide long term growth and sustainability which
will result in a rising stock price.
Three Elements of Bad Executive Compensation
Three elements that we must confront in regards to executive
compensation to realign payment with performance are large base pay,
severance packages, and misuse of stock options that have become
standard practice. These three elements promote poor performance and
are always unwarranted. The problem is that companies are paying CEO’s
based on the wrong measures. A person’s base pay is for their day to day
work it is time spent in the office writing memos, talking to clients,
working with different departments, attending meetings etc. These are
tasks that all executives do and although they do require a level of
expertise they are inherently no different from person to person.
Therefore, since I have defined base pay as that which pays for routine
duties there should be no reason for the Chief executive officer to receive
substantially more than any other executive in the company.
Severance packages have lost sight of their original intent.
Severance packages are pay and benefits for employees who have been
fired or have resigned from a company. So why would your employer
negotiate your severance package with you after you have quit or been
fired? “You’re selling a release, an end to the possibility of a legal
proceeding and expense for the company. You’re promising to go quietly.
The employer benefits by avoiding possible damage to workforce morale
and the time and expense of disruptive litigation.” 7 This seems to
contradict the circumstances under which many CEO’s are being fired and
are being paid large severance packages. A major part of this problem
that contributes to the negotiation of out of proportion severance
packages as part of the contract terms is a company’s desire to hire out of
house. Companies often times hire very well known former CEO’s of other
successful companies that are able to bargain for a much more extensive
payment package (including a severance package) when in fact they
should be promoting management and giving current executives an
opportunity to run the company that they have been working for, for
many years. There are many good reasons why company’s should do this:
first someone who has already worked for a company for a number of
years knows the industry very well and understands the competition very
well, second someone who has already been working for the company
understands the company’s culture, and third promoting management
gives the company a lot more leverage. Management wants the
opportunity to prove that they can successfully manage the company.
Therefore, they are willing to work for a lot less money; they don’t have
the negotiating power that a CEO from another company has. 8
The third element to discuss is the misuse of stock options. When
used properly stock options can be a great way to pay-for-performance, unfortunately in the past there has not been proper governance and
disclosure of this information for stock options to be used as intended.
Stock options are granted by the board of directors to executives and are
a guaranteed number of stock shares at a set price and time that an
executive can option to receive at some point in the future. Stock option
back dating is a very common misuse of stock options. It is when
executives back date the time for when the option was granted so if the
stock price was significantly lower than the grant date. 9 This is of course is
illegal because it is diluting the returns that shareholders make on stock
gains. It is clear that all three of these forms of compensation are
unwarranted and it makes you wonder how such blatant disregards for
company resources can go unnoticed, the answer is a lack of transparency
and communication to the stockholders. The board of directors oversees
and must sign off on all final stock options before they are paid out to
executives. If the board of directors were doing its job there wouldn’t be
the backdating scandals that there are in the corporate world today.
Unfortunately, in cases where there have been admissions of stock option
back dating “The decision-making process has been to bypass the
compensation committees completely. In other words, they have simply
been asked to rubber-stamp decisions that have already been made by
management.” 10
These committees, which are a selection of the board of directors,
are failing their duties; the problem is that the board is selected by a
nominating committee that usually includes the CEO who is often the
chairman of the company as well as current board members. These
directors already have a comfortable relationship with the CEO and hence
are less likely to elect a truly independent director who would be brave
enough to stand up against management and stock option back dating.
Many times the CEO is also a board member of another company so there
are many mutual favors being conceded by CEOs on different boards, the
you scratch my back and I’ll scratch yours mentality. Furthermore,
shareholders are not given the direct privilege of nominating a director
and voting on directors. The current system is under what is known as a
plurality standard, this means that shareholders are allowed to vote on
the slate of candidates that management has assembled. However;
“There’s seldom a contest, and, under the plurality standard, if a director
gets one vote and a million and a half other votes are withheld against
that director, it doesn’t matter-that director is elected with one vote.” 11 To solve this problem the SEC must make all information available to
stockholders. Providing clear and precise information of compensation
terms that owners can understand would regulate the issuance of stock
options and prevent backdating.
Why Performance Based Pay?
Why should a CEO’s payment be based on performance? Some
people say that executives should be paid entirely by salary. This
however, is not true because the only companies that pay their top
executive by salary are private companies. However; this is entirely
different since the majority of private companies cannot afford to pay the
CEO through private stock only because they have a very small number of
shares and the returns generated from stock gains would not provide a
sufficient income. Also private companies do not have public money to
pay out of proportion sums to their executives and therefore executive
payment is regulated through economic means. Outside of private
companies virtually every other professional level job is paid based upon performance: lawyers are paid by billable hours, doctors by clients
treated, athletes by competitions won (individual sports such as golf and
tennis; other sports such as basketball and baseball are private
enterprises in which it is up to the team owners to negotiate player
contracts which are based on performance).
Public Corporations are the only businesses that make it more
enticing for CEO’s to seek short term gains that produce stock price spikes
and then walk away with multimillion dollar severance packages; so by
intentionally harming the corporation CEO’s are paid millions of dollars.
“How can anyone justify Home Depot’s (HD) former CEO Bob Nardelli
receiving a $200 million termination settlement after declines in market
share and shareholder value?” 12 The answer to this is you can’t. When
CEO’s like Bob Nardelli are given these outrageous severance packages,
employees are fired to account for these funds, investor confidence is
ruined, which in turn sends sends the stock price plummeting as investors
sell their stake in the company and remaining owners have lost a large
amount of money and continue to be hurt by smaller dividend returns
which they may rely on as a means of income. If a CEO’s job is to provide
long term growth and sustainability for investors then surely protecting
the jobs of the company’s employees who are often shareholders and are
one of the few sustainable advantages a business can have are equally
important to a company.
The Problem with Stock Options
As I have stated, stock options used as performance based
payment methods can realign shareholder and management goals and
they can also greatly improve executive performance. Stock options are granted by the board of directors. They are the right to a given number of
shares at the current market price when the option is granted. So,
executives make money on these options when the stock price rises and
then after a certain time period they are able to exercise the option and
can sell the stock for a profit. 13 Unfortunately, these options are often
misused by executives with the knowledge of the board of directors.
“The bull market of the 1990s brought substantial value to stock options,
but when the market began a downturn, investor value dropped
substantially. Although investor value dropped with share prices, the
average CEO total compensation in American companies was higher in
2002 than in 1999. In other words, executive-owners continued to
benefit from huge pay packages while investor-owners suffered from
the downturn in the value of their stock portfolios. At least some
decrease in portfolio values was a direct result of the market's reaction
to the financial scandals created by the executive-owners of
corporations.” 14
This is the result of back dating stock options which is the major
issue why so many people are against them as a means of executive pay.
It is the board of directors job to govern these options and unfortunately
they allow backdating to happen which is why it is so important for the
compensation committee to be completely separate from management.
Back dating stock options occurs when executives adjust the option grant
date to a previous time when the stock price was lower to create a better
gain for them. This practice is illegal and in no way benefits the company
although boards of directors have often argued that this practice is
necessary to retain valuable employees.
“Boards of directors have defended the re-pricing of executive stock
options by stating that it helps retain executives who are essential to
company performance. The authors believe that the issue that must be
addressed in the face of this logic is how essential such executives
actually are if they were the people in charge during the market decline.
There is some evidence that the performance and retention rationales
behind repricing are flawed.” 15
The logic behind the acceptance for back dating stock options is
greatly flawed and this problem stems from the connection between the
board of directors and management, they must be separate units to
function properly. “Second, three separate studies indicated that over the
two-year period after repricing, CEO turnover was approximately twice as
high for repricing firms compared to a matched group of firms that did not
reprice" 16
Compensation Committee Responsibilities
The compensation committee is made up of members of the board of
directors. As members of the board of directors it is important that this
unit be completely independent of management so that the group is able
to create an unbiased compensation plan that is fair to both executives
and stockholders. Since the inception of the SEC’s new executive
compensation disclosure rules there have been several positive effects on
compensation committees.
• First of all many committees have been engaging in preparing the
compensation discussion and analysis, which explains the rationale for each pay element which holds the committee
accountable for unjust pay. 17
• Second this analysis has provided detailed information on pay
levels allowing for better assessment of a company’s pay-for-
performance strategy 18
• Last the in depth preparation that is required in disclosure
statements will help these committees to better understand
executive payment programs and will enable index stock options
to be used properly and effectively. 19
Furthermore, to improve disclosure, investor confidence and to
control pay-for-performance measures compensation committees must:
• Share disclosure targets; this measure will increase investor
confidence and ensure that the compensation committees are
living up to their responsibilities. 20
• Explain how incentive payouts are determined and, 21
• Last is to make sure that all of these disclosure statements are in
plain English. These documents do investors no good and appear
deceptive if the people it is meant to benefit can’t understand the
document. 22
Index Stock Options
With improved compensation committee oversight and better
disclosure to investors these committees are now able to implement pay-
for-performance methods that before were not governed sufficiently to
work effectively. The method of performance based pay that I am talking
about is index stock options. Index stock options are when
“The board of directors selects a group of companies, such as industry
rivals, to serve as a benchmarking peer group. The option-issuing
company indexes or ties the exercise price to the benchmark group. In
theory, economic and industry factors should affect similar companies in
similar fashion. Thus, if share prices for the benchmark group rise by an
average of 10% in a given year, then the option-issuing company's shares
should rise comparably. If instead the company's shares rise 15%, then
an assumption can be made that the executives provided a positive 5%
controllable organizational impact and, as such, deserve additional
performance-based pay. Indexed options cannot be exercised at a profit
unless the issuing company's stock price either outperforms, or falls less
steeply than, its peer comparison companies.” 23
This is the most just way to compensate executives for the
additional benefits they provide and best aligns executive and company
goals because it prevents managing for self interests because of improved
compensation committee oversight and disclosure. Furthermore, tying
the stock option to a industry index means that executives have to work
harder to assure that their company has the best strategy possible so that
they are able to reap the benefits of this form of pay-for-performance. 24
As with any type of performance based pay it can always be
manipulated, the key is to make sure that compensation committees have
proper oversight and disclose all relevant information to ensure that
payment measures like index stock options are used properly and
effectively. Index stock options are the most effective form of pay-for-
performance because it prevents managing for self interests by tying the
option to an industry index. Executives must manage to the best of their abilities and outperform competitors to reap the benefits of these
options. Also, other aspects of executive pay such as severance packages
and out of proportion base salary must be diminished to better motivate
today’s executives. These are people who are motivated by money and as
such it is crucial that the members that govern executives (Board of
Directors: compensation committees) must make sure that the payment
packages are set up in a way that promotes executives to manage for
company interests.
Works Cited
1. Velasquex, Manuel, Claire Andre, Thomas Shanks, and Michael J. Meyer.
(1990). Markkula Center for Applied Ethics. Santa Clara University.
Retrieved November 22, 2007 from http://www.scu.edu/ethics
2. Ibid 1
3. Ibid 1
4. Ibid 1
5. Ibid 1
6. Paying for performance. (2002, November). Sales & Marketing
Management.
7. Tobias, Paul H., and Susan Sauter. (2007). How to Negotiate a Fair
Severance Package. Careerjournal.Com: The Wall Street Journal.
Retrieved October 28, 2007 from
http://www.careerjournal.com/jobhunting/negotiate/
8. George, Bill. (2007). Nonperforming CEOs. Business Week Online. 3.
Retrieved from Business Source Complete, EBSCO.
9. Ethics of options repricing and backdating: banishing greed from
corporate governance and management. (2007, October 6). The CPA
Journal.
10. Ibid 9
11. Ibid 9
12. Lewin, Rivkah. (2007). Illegal Stock Option Timing: It's Your Move, SEC.
Financial Trends. 57-60. Retrieved October 10, 2007 from
Business Source Complete, EBSCO.
13. Ibid 9
14. Ibid 9
15. Ibid 9
16. Ibid 9
17. First Year Wisdom for Next Year’s Disclosure. (2007, December).
Directors&Boards.
18. Ibid 17
19. Ibid 17
20. Ibid 17
21. Ibid 17
22. Ibid 17
23. Ibid 9
24. Ibid 9
25. Mark, Hamstra. (2007). Earned Income. Supermarket News 55. 14-21.
Retrieved October 10, 2007 from Business Source Complete, EBSCO.