BUSINESSWEEK ONLINE : OCTOBER 16, 2000 ISSUE
MANAGEMENT CEO Pay: The More Things Change... Facing a tight market for talent, even independent boards richly reward mediocre performance The compensation committee at Dominion Resources Inc. (D), a Virginia utility, is squeaky clean: five members, no insiders. But last year it did something that used to be seen only on insider committees. It turned a bad year for shareholders into a good year for the boss. While Dominion shareholders lost 10.9% on their stock, the committee handed CEO Thomas E. Capps a 192% pay hike, including options valued at $8.9 million that brought his 1999 compensation to $11.3 million. In its proxy, Dominion said the big paycheck was awarded because net income of $363 million exceeded Capps's goals. Indeed, for an electrical utility, Dominion's 9.5% increase in operating earnings for the year represented strong growth. But there was another reason Dominion wanted to reward Capps: It didn't want to lose him. ''You have to recognize what's being done in the marketplace,'' says committee Chairman Kenneth A. Randall. ''Otherwise, you just have your head in the sand.'' Dominion is no longer the exception, it's the rule. A BUSINESS WEEK study of companies in the Standard & Poor's 500-stock index finds that independent committees are now more likely to dole out raises when the stock tanks than committees stacked with insiders. Nearly a decade ago, that wasn't the case. Compensation committees with insiders--such as current and former employees--were twice as likely to reward underperforming CEOs with fat paychecks, option grants, and bonuses, according to a study by Fordham University Associate Professor Harry A. Newman, who looked at 49 large companies with negative shareholder returns in 1992. But since then, a lot has changed: A tight market for executive talent has made the best boards as forgiving as the worst. Says Newman: ''The good guys have caught up with the bad guys.'' Companies say there are better indicators than stock price for judging CEOs --such as long-term performance relative to peer groups, earnings and revenue growth, and success in achieving strategic objectives. Those benchmarks become even more important in a market that frequently doesn't reward old-economy companies, even those that perform relatively well. But governance experts say that part of the CEO's job is communicating the company's success to the market. Besides, they say, rewarding yeoman-like performance with princely paychecks is at the very least unseemly when shareholders have taken it on the chin. UNDER THE RADAR. A decade of reforms to prevent insiders from giving CEOs the key to the company vault has had some impact. Internal Revenue Service rules designed to create independent compensation committees have helped, although critics maintain that the IRS definition of independence allows a lot of insiders in under the radar. Still, in 1999, 57% of committees with insiders hiked CEO pay despite negative returns, compared with 65% in Newman's 1992 study. But when no one was looking, the independent committees--extolled by both regulators and shareholder activists--have overtaken their insider counterparts. In 1999, 62% rewarded CEOs whose companies racked up negative returns. That's almost double the 32% Newman found in 1992. What's more, CEOs whose companies had positive 1999 returns but still trailed the S&P 500 got bigger raises from independent committees, which increased pay 116%, compared with 45% for insiders. LACK OF TALENT. Corporate governance leaders say pay and performance are diverging because the supply of the most desirable CEO candidates--those already at the helms of large companies--is limited. Meanwhile, demand, fueled by the profusion of Internet start-ups, has shot up. ''There's a lack of talent out there,'' said Drew Hambly, senior research analyst for the Investor Responsibility Research Center, a shareholder watchdog group. ''These compensation committees are going to approve these packages because they can't find anybody who can do a better job.'' Examples of lavish compensation for less-than-stellar performance are common. Florida-based utility FPL Group Inc. doubled CEO James L. Broadhead's pay while total return on the stock sank 27%. FPL defended the pay package, saying it was merited by a 2.6% increase in net income. Idaho-based retailer Albertson's Inc., meanwhile, rewarded CEO Gary G. Michael with a 749% pay hike in 1999, while shareholders ended up with a loss of 48%. Albertson's declined comment. Many companies have been quicker to give underperforming CEOs the boot, as Procter & Gamble's (PG) Durk Jager, Coca-Cola's (KO) Douglas Ivester, and Mattel's (MAT) Jill Barad all learned the hard way. But the new numbers suggest a second trend: a willingness on the part of boards, whether stacked with insiders or not, to reward laggard CEOs lavishly, almost until the end. Corporate governance experts suggest a big part of the reason is that opportunities for CEOs to jump ship have never been better. Indeed, CEO turnover has increased sharply. In September, 103 CEOs of U.S.-based companies quit, more than double the number in September, 1999, according to Challenger, Gray & Christmas Inc., a Chicago outplacement firm. Reasons for the revolving door include aggressive recruiting by dot-coms, a willingness on the part of new employers to compensate CEOs for stock and options they forfeited by job-hopping, and increasing use of headhunters. The consequences for companies left in the lurch can be severe. A search for a replacement can take months. Meanwhile, key decisions get delayed, momentum is lost, and investors get nervous. ''More and more, directors are better recognizing the downside of the change in the CEO,'' said Richard M. Steinberg, a senior partner at PricewaterhouseCoopers LLP. ''It can create havoc in the organization and derail strategies the board has approved.'' To avoid that fate, even the most independent compensation committees are bending over backward to reward CEOs when shareholders might argue they least deserve it. Most justify those rewards by grading performance based on a longer time frame--five years instead of one--and using measures other than share price. CSX Corp. (CSX), for example, had 1999 shareholder returns of -22.1%. The Richmond (Va.)-based transportation company conceded in its proxy that its financial performance was ''disappointing,'' but said CEO John W. Snow ''achieved important strategic objectives,'' including the company's integration with Conrail, that justified his 75% pay hike. ''You reward people when they've done a good job,'' said committee member Bruce C. Gottwald. ''Sometimes it's in sync with the stock, sometimes it's not.'' Of course, some independent compensation committees still take a hard line on poor performance. When Becton Dickinson & Co.'s Clateo Castellini ended his final year as CEO of the medical-supply manufacturer with returns on the company stock of -36%, he was stripped of his bonus, reducing his pay 14%, to $3.9 million. Committee member Frank A. Olson, chairman of Hertz Corp. (HRZ), said the pay cut was Castellini's idea, and he doesn't understand why more companies don't follow Becton Dickinson's lead. ''The concept of pay for performance is if you perform you should be rewarded,'' he said. ''If you don't perform, you shouldn't be rewarded.'' Part of the problem may be that some boards are more independent in name than in fact. IRS rules that reward companies with independent compensation committees fall far short of stricter standards used by regulators, stock exchanges, and shareholders. For example: The IRS includes in its definition of insiders former employees who were compensated in the past year. But the Council of Institutional Investors goes further by including relatives of employees, while other shareholder groups include recipients of the company's charitable giving. You have to pity the compensation committee. Caught between a stock market that is wildly divergent in the valuations it bestows on different industries and job-hopping CEOs, committees believe they have little option but to pay up. Still, abandoning the principle of pay for performance, or for that matter, board independence, may end up costing more in the long run than having to search for a new chief executive. By Louis Lavelle in New York _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS CEO Pay: The More Things Change... TABLE: Who Needs Friends in High Places? INTERACT E-Mail to Business Week Online

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