The Economic Times Friday, April 19, 2002
Executive elation G ANANDALINGAM The 2001 executive compensation information hit the news wires a couple of weeks ago, and caused a lot of commotion. Nothing seems to derail executive compensation in the United States, not the sagging economy, nor the slumping corporate profits, not the widespread layoffs, and certainly not the second consecutive down year in Wall Street. While the median CEO salaries and bonuses fell by 7.7 per cent between 2000 and 2001 to $1.32 million, the total overall compensation including stock options rose by 24 per cent to $10.2 million. One would have imagined that senior management would be compensated less in the years in which their companies do badly, whether measured by profitability or by shareholder value. But, in fact, there was widespread and significant enhancement in executive pay. Take a few examples: Cisco lost $1 billion in value, and yet John Chambers made $154 million for the fiscal year that ended June 2001. Coca Cola's shares fell 23 per cent, but the CEO Douglas Daft's pay and bonus increased by 17 per cent. Daft was also awarded more stock options worth over $45 million. The shares of SBC Communications fell 18 per cent, while CEO Whitacre's total compensation package increased by 163 per cent. Tyco International, a company in the news for nefarious activities saw a loss in share value of 12 per cent. Yet, CEO Dennis Kozlowski's salary and bonus jumped by 36 per cent to $5.7 million, not to mention the value of his shares. American Express missed all the goals set by the CEO Kenneth Chenault; the board, however, voted to pay his bonus. Industries that have done terribly during the past two years like telecommunications, and consumer products saw CEO compensation increased by 100 per cent and 140 per cent respectively. With the exception of financial services, drugs, and aerospace, executive compensation increased across the board in almost all industries. Over the past twenty years or so, senior management of companies has received stock and stock options as a significant part of their overall compensation. In many cases, stock-related compensation is more than 75 per cent of total compensation. Even Jack Welch, the CEO of a well-established company received 89 per cent of his total compensation in stock-related payment. People like John Chambers of Cisco and Ralph Ellison of Oracle have more than 95 per cent of their compensation tied to stocks. Thus it is not surprising that short-term impact on the stock price is of paramount importance to CEOs who pay a great deal of attention to what analysts say about their companies in Wall Street. Stock options became an important mechanism for compensating executives due to an influential study by Michael Jensen of Harvard University. He studied companies during a period 1974 to 1988, and concluded that the pay of top executives was unrelated to the performance of companies stock. He concluded that so long as the executives were paid like bureaucrats, the self interest of executives would be fundamentally different from that of their shareholders. Given the premise that the shareholders own the companies, tying share values of companies to the pay of senior management makes sense because it should provide incentives to increase shareholder value. The question then is why did senior management, especially CEOs, have drastic increases in compensation while shareholder value declined. The board of directors of these firms is mostly to blame for this disconnect between performance and pay. On the face of it, these boards may have a difficult task. Although all boards are supposed to have a policy of paying executives for performance, if we give them the benefit of the doubt, you could say that they have to take into consideration a number of complex factors when determining both "performance" and "pay". Variables that go into performance might include strategic ones such as changing technology and product mix, and operational ones that involve keeping key personnel within a company, or increasing market share in potentially lucrative markets, none of which may be reflected immediately in annual profit numbers. The boards also have to ensure that they attract and retain people considered to be the cream of the crop among executives, and ensure parity with the compensation of executives in rival firms. However, it is also clear that the boardrooms are beset by a clubby culture, and many of the board members have had long term-professional and personal relationships with the CEO and other senior executives they are supposed to oversee. Many executives know that they could convince their directors to overlook the bottom line, if the directors had not already taken it upon themselves to look the other way. There has also been a phenomenon recently that is best captured in a joke that Warren Buffett sent in a newsletter to his Berkshire Hathaway shareholders. A gorgeous woman slinks up to a CEO at a party, and purrs "I'll do anything - anything - you want. Just tell me what you like". With no hesitation, the CEO replies "Reprice my [stock] options" The boards in many companies have kept changing the stocks and stock options given to executives and also some employees. Even when stock options are "under water", i.e., the option price is above the price at which the stock is being traded in the stock market, the boards have acquiesced to the demand of many executives to either "reprice" the options, or compensate them for the loss on paper by issuing more stocks at a lower option price. Changing the compensation scheme then drastically changes the rules of the game that started by trying to align executive compensation with shareholder value, thus providing incentives for them to perform. Whenever one asks the question: "what is the primary objective of the CEO", most business students provide a number of answers like, "increase shareholder value", "increase the market share", "create an innovative firm" , "recruit and retain excellent employees" and so on. But, clearly, in most companies in most parts of the world, the main objective of the CEO seems to be to keep the senior executives elated. (The author is the Ralph Tyser Professor of Management Science at the Smith School of Business at the University of Maryland). Copyright � 2002 Times Internet Limited. All rights reserved.
