The swinging pendulum of exec pay (Guest Commentary)

Large base pay, followed by bonuses, stock options and back to bonuses. After all is said and done, it’s transparency that matters

Executive compensation, which some people would say has reached obscene levels, needs to be re-examined.

One of the difficulties with addressing the issue of executive compensation is its ever-changing image. Initially there were complaints about the large base salaries certain executives were receiving. To thwart these complaints, companies began directing a larger segment of compensation packages towards variable or incentive compensation.

On the surface this looked like progress, since it meant organizations were not going to be saddled with large fixed costs. Built into such programs was the assumption that executives would earn the bonuses they received. Unfortunately, these variable compensation provisions produced their own demons. Large bonuses were handed out without any apparent relationship to corporate profitability or improvement in stock prices.

As institutional investors and pension funds complained about offensive behaviour, organizations switched to stock options to compensate senior executives. The theory behind this move was two-fold: stock options didn’t cost the company, and they aligned the interests of the executives with those of the shareholders. However, it would seem that the theory and the practice are not the same.

The extremely large allocation of options assigned to some executives soon raised questions in the investment community and with the public. The investment community challenged the view that stock options did not cost the issuing company any money. This has led to the increasing trend of accounting for stock options on financial statements. This has the potential to lead to increased uncertainty in valuing stocks, but it also draws attention to the magnitude of the compensation of senior executives.

The attractiveness of stock option programs was challenged when the market declined and many options became worthless. To the chagrin of investors, some companies decided to adjust the option price when the issue value of the options slipped below the market level. The investing public took the view that they had suffered losses as stock prices fell, so the beneficiaries of stock options should also suffer.

Another problem that arose in some organizations was that management became greedy. To enhance stock price, and thus their own wealth, they engaged in nefarious practices which both decimated their organizations and had a significant negative effect on the credibility of the whole financial community.

In some organizations where there were no blatantly illegal actions by management, some decisions and practices were undertaken that were designed to enhance short-term profits at the cost of better long-term returns. The short-term enhancement of profits in turn contributed to a better share price but did not always contribute to a better business.

Don Jordan, the former head of a large U.S. energy provider, recently attempted to put forth a shareholder proposal that would put significant limits on stock option grants. He claimed that stock option plans were harmful to shareholders, since they tempt executives to put their interests ahead of what is best for the company. This type of complaint has become a more common refrain with the occurrence of financial scandals in a number of firms.

As the negative aspects associated with stock options have attracted more attention from a variety of stakeholders, it would seem that this form of compensation is starting to wane.

Organizations are beginning to re-examine variable compensation options. The bonus is again taking a more prominent place in executive compensation. The compensation committees of many boards of directors are taking a more active role in determining executive compensation, including bonuses. There are a growing number of instances in which bonus compensation has decreased when earnings have decreased. This would appear to be a progressive move in compensation practice. However, there still seems to be a lack of transparency in the payment of incentive compensation.

In the first place, it’s difficult to find any instances in which incentive compensation is reconciled with the objectives that the board has set. In one recent Canadian case, when the company was challenged on this issue its response inferred that if the company divulged these objectives, it would be divulging its strategy to competitors. This defence is improbable since any details that would be revealed would be so general as to blunt a competitor’s ability to determine what strategy was being targeted. Even if one accepted this argument, it virtually disappears by the time an annual report is published containing executive compensation details.

The credibility of the incentive program would be strengthened if the compensation committee’s report provided a reconciliation of the bonus with the objectives that had been set at the beginning of the fiscal period.

It is interesting to note that the more progressive companies are at least setting out the general parameters of bonus programs in annual reports.

As things stand now, though, there is no check on whether objectives are achieved other than the report of the compensation committee. Since this committee is often made up of outside or independent directors, this should be sufficient support for the justification of the bonuses that are paid to the senior management team. However, as analysts and institutional investors take an increasingly jaundiced view of compensation packages for senior executives, they will be demanding more information about the basis for huge bonuses. Making such information available would provide some defence from the ongoing attacks on executive compensation by the investment community. It would also give greater credence to the job that was being done by the compensation committee of the board.

In this era of increasing shareholder activism, it is important for organizations to clearly set out the criteria used to determine executive compensation. If such action is not taken, companies can anticipate increased attacks — and controls — on their management compensation programs.

Fred Pamenter is managing partner with Pamenter, Pamenter, Brezer and Deganis Limited, a Toronto-based HR consulting and executive search firm. He can be contacted at (416) 620-5980 or [email protected].

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