Practical Guidance On Being Worth One’s “Salt”

The late President Reagan articulated the hope that “people on Wall Street would pay attention to people on Main Street.” This optative was sage when uttered, and remains so even after so many years have passed.

And nowhere is this truer than in the area of executive compensation, where Wall Street is learning—sometimes painfully—to understand the views and perceptions of Main Street. According to CFO Magazine, a record 322 shareholder proposals sought to rein in executive pay last year. The chasm between Wall Street’s perception of what constitutes fair compensation and Main Street’s contrary view is enormous. Yet, CEO pay keeps rising—often at faster rates than profits.

The word “salary” comes from the Latin word for salt, reflecting ancient times when Roman soldiers were paid part of their wages in salt. Salt was a precious commodity then, so being “worth one’s salt” referred to a good worker. Recent events underscore that both executives and compensation committee members must be able to demonstrate why top brass is worth their “salt.”

As noted above and in Compliance Week’s editorial coverage this year, executive compensation has emerged as the primary corporate governance issue in the 2004 proxy season. Shareholder advisory groups are recommending “withhold” votes for compensation committee members where there’s a perceived failure to link CEO pay with corporate performance. Eliot Spitzer has sued Dick Grasso, former NYSE chairman, and Ken Langone, the former chairman of its compensation committee, to recover allegedly excessive compensation. And most recently, CalPERS called on shareholders to oppose the proposed merger of WellPoint Health Networks and Anthem Inc.—not because the merger doesn’t make good economic sense, but because of allegedly excessive pay packages and golden parachutes for WellPoint’s top executives.

In this column, we offer some practical guidance on how to assure that your company’s executives are worth their “salt.” As compensation committees renegotiate packages with top executives, it’s a good time for public companies to revisit their compensation policies and procedures. Here are a few considerations to keep in mind:

Companies Must Appoint A Truly Independent Compensation Committee.

Compensation committees should be small (three to five members), and each member should be independent of management, not only as a “legal” matter, but also as a pragmatic one. Committee members should be selected by the independent members of the board of directors, not the CEO. Of course, the full board should ratify the selection of all committee members. Members should not be close friends of the CEO, or have affiliations, business relations, or interlocking relationships (for example, reciprocal board memberships) with senior management.

Compensation Should Be Linked To Legitimate Corporate Goals.

There are three critical questions that must be addressed when fixing compensation:

For what are the senior officers to be compensated?

How much should they receive? and

In what form should the compensation take?

Compensation should be structured to align management’s interests with those of shareholders. Thus, CEOs should be rewarded for producing growth in fundamental company values, such as market share, markets served, etc., not for achieving some measure of earnings per share. It’s too easy for companies to manipulate earnings per share, at least in the short run. While steady EPS growth can often be a consequence of a well-reasoned, carefully-executed, strategic plan, it can also be achieved by temporarily reducing expenses, such as research and development, or marketing. Yet, the reduction of these expenses can have dramatic long-term consequences. EPS, in essence, is often a fictitious number, and its use as the sole benchmark for setting compensation is inappropriate.

Instilling a proper “tone at the top,” and adhering to good corporate ethics are also appropriate criteria for bonus payments to CEOs.

In a recent survey of Fortune® 500 companies conducted by my firm, Kalorama Partners, we found that over 50 percent of executive compensation comes from options and restricted stock. Yet, too often the rationale for awarding non-cash compensation is different from the rationale used to award cash compensation. Compensation is compensation; irrespective of its form, it must be subject to the same degree of rationality.

Once it’s decided for what compensation is being awarded, the next critical decision is how much each person deserves to make. Thereafter, the decision is what form the compensation should take. Boards must pay heed to the fact that breaking the decision up into its separate pieces may make the pieces seem rational, while the aggregate is not. This is a situation where the total may be greater than the sum of the parts. That’s why it’s important for compensation committee members to step back and look at the entire picture. How would the compensation package look, or reflect on the company, if it were the subject of a newspaper story?

The Committee Should Follow And Document Meticulous Procedures In Determining The Level Of CEO Compensation.

Members of the committee should have access to appropriate expertise to help in determining compensation levels. The members of the committee, however—not senior management—should actually select and hire the experts. It’s also important to keep in mind that, no matter how knowledgeable outside experts may be, it’s inappropriate for compensation committee members to rely blindly on the advice of compensation consultants. Careful scrutiny should be given to all recommendations, and appropriate testing of proffered theories should be pursued.

Great care should also be taken with the package of materials furnished to directors in advance of meetings at which executive compensation arrangements will be discussed. Among other things, the package should contain a complete draft of the proposed agreement, a summary of its key provisions, an analysis of the costs of the proposed compensation over the life of the agreement, information about similar arrangements at comparable companies, and related information.

In addition, the specific factors underlying the recommendation for base salary levels should be enumerated and articulated so each member of the committee understands them. The compensation proposed for the CEO should be compared with that paid to CEOs of corporate peers. Of course, in comparing compensation at comparable companies, it’s also critical to compare performance results achieved.

At the end of the process, the committee members must be able to articulate lucidly why compensation is higher, if it is, than that paid to CEOs of comparable organizations. Similarly, if the compensation is lower, the committee must be able to articulate the reasons for that conclusion. This is often overlooked, for fear of casting aspersions on senior managers, or on the company’s wherewithal to pay higher salaries. Neither concern should preclude candid and full disclosure of any disparities. Finally, factors giving rise to bonus payments should be clearly delineated and understood. Careful notes should be kept of the deliberations.

The Independent Board Members Collectively Should Make All Ultimate Compensation Determinations.

Every independent board member should understand and approve the compensation paid to the five most senior officers. If the full board varies the recommendation of the compensation committee, the reasons for that variance must be articulated and subsequently disclosed with precision.

A Substantial Portion Of A CEO’s Compensation Should Be Placed In An Interest-Bearing Escrow Account, To Be Paid Upon The Successful Completion Of The CEOs Tour Of Duty.

Companies may increasingly be under pressure to recoup severance payments, salary, bonuses, option profits and other payments to executives who bear responsibility for a company’s sub par performance or malfeasance. The use of an escrow account can facilitate this process.

Thus, for example, if a CEO’s base salary were, say, $5 million, perhaps only $2 million should be paid to the CEO, with the remainder withheld until the end of the CEO’s term. All discretionary, or bonus, compensation should also be included in the escrow account. If the company is later compelled to restate its earnings materially, or if the company is accused of fraudulent or other serious illegal conduct, the escrowed earnings would be withheld and remain available to fund any fines the company might be assessed by the SEC, or simply be returned to the company for the benefit of its shareholders.

Companies Should Compensate Senior Executives With Restricted Stock. If senior executives own a significant amount of stock and are required to hold it through their tenure and beyond, they are less tempted to stretch for short-term results. Using restricted stock to compensate senior executives sends a clear message to shareholders that management is not out to make a quick buck.

Limit The Use Of Stock Options To New Or Junior Employees.

Options are best suited for employees who have just been hired or who are just entering into the ranks of employees who receive options. It allows them to gain a significant stake quickly. The use of options primarily for juniors helps eliminate some of the risk of using options. Junior level employees have less ability to affect overall company results and have layers of senior management above them to prevent this from occurring. Directors and officers should also begin acquainting themselves with the various types of performance-based option plans that may become prevalent starting with 2005 financial statements if FASB’s rules on expensing stock options become effective.

Exceptions Make The Rule.

Compensation policies must be flexible enough to handle exceptions. There are always special circumstances that render formulas and rules useless. Compensation policies must allow for this, but the exceptions must be documented in a manner that will stand up to outside scrutiny.

A Lucid And Complete Description Of Compensation Decisions, And All Relevant Details, Should Be Included in Company Filings.

Make sure anyone can understand the disclosure and calculate the compensation. In this context, it is critical for companies to go beyond boilerplate justifications for compensation decisions, such as the need for the company to pay a higher level of compensation in order to “remain competitive.” Compensation committees should be more specific in their disclosures, explaining the strategic rationales that underlie their decisions, the data they examined, and the methodology used to arrive at their conclusions.

Executive Compensation Will Remain A Spotlight Issue For The Foreseeable Future.

Forewarned is forearmed, and perceptions matter. Those who tend to the details now, will reap the rewards later.