Liability in Executive Pay

You can’t read a business magazine or newspaper today without executive compensation being hotly debated. The press is running more and more stories of preposterous termination payoffs to fired CEOs, amazing offers to newly recruited executives, and the rise of professional agents who represent executives in salary negotiations. Absent of any good news to report, the press is having a field day. Nothing seems to rile stockholders as much as “obscene” compensation for the CEO.

The reasons for much of these high blown figures are fairly obvious. The push to put more of the CEO’s compensation “at risk” led to a leveling off of salaries and a sharp increase in the number and quantity of stock options granted. The surge of the economy in 1999 and 2000, with the doubling and tripling of some stock prices, produced unexpectedly high capital gains for a large number of CEOs and senior executives. The new Internet and high-tech companies made dozens of multi-millionaires overnight in shortcut fashion. At the same time, the hot economy created a shortage of executive talent, and companies found themselves in a bidding war to hold and to recruit experienced executives. It’s not surprising that a lot of paychecks went through the roof.

Compensation committees were in a bind. They felt that they had to keep their CEOs competitive (and so did CEOs) and they had to keep their key executives from running off to greener pastures. Some companies were quite successful in doing so. General Electric, for example, gave huge salary packages to its CEO and his dozen or so top executives. But they made equally huge profits and created great stock gains; while the top-producing executives stayed on to keep producing. We have relatively little quarrel with cases like that and neither do the rewarded shareholders.

What gets to us, and to a lot of our fellow compensation watchers, is all the fancy bells and whistles that seem to have no connection to performance. For example:

• Absurdly elaborate contracts with all kinds of arrangements for club memberships, personal use of company airplanes, ownership of office furniture, etc. With big cash salary and bonus, do you have to sweat the small stuff?
• Extravagant termination payouts with no penalty for sub par performance. Sometimes it seems to pay better to be fired.
• Low or no interest loans to buy company stock.
• Substitution of restricted stock grants for underwater options. Repricing is even worse.
• High bonus awards, in stock or cash, granted when competitive corporate performance lagged.

What can be done to bring some common sense to executive pay? The responsibility will fall squarely on the shoulders of the compensation committee. Because of recent accounting malpractices, compensation committees will not only have more responsibility but liability. According to a recent article in the Wall Street Journal, the chief justice of the Supreme Court of Delaware concludes that corporate directors could be held legally liable if they fail to act in good faith when determining executive pay packages.

“The comments are extremely significant,” says Charles Elson, who leads the Center for Corporate Governance in Newark, Delaware and was recently quoted in the WSJ. “It signals that the Delaware courts are ready to begin to review the ins and outs of compensation. If directors are not sufficiently independent of the CEO, it brings their good faith into question.”

The court went on to say, “directors who profess to conducting compensation analysis and fail to do so, could be held liable”. Our advise to directors is clear, hire third party experts in analyzing compensation trends and make sure you do your homework. We don’t think a judge is going to except the excuse that your dog ate your homework.”