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EXECUTIVE PAY

Stock options plus a bull market made a mockery of many attempts to link pay to performance

For Richard M. Scrushy, CEO of health-care company Healthsouth Corp. in Birmingham, Ala., 1997 was an outstanding year. He took home $106.8 million in salary, bonus, and--primarily--exercised options to become the third-best-paid CEO in BUSINESS WEEK's annual executive pay survey. While his compensation may boggle the mind, so has his performance. In the 14 years since he founded Healthsouth with three partners and $50,000, Scrushy has built it into the largest outpatient care center in the U.S., with a market capitalization of $11.4 billion. In 1997, the stock rose 31%, bringing its gain over the past 10 years to more than 1,200%. Says Scrushy: "Finally, I rang the bell and got paid."

So did Ray R. Irani, longtime CEO of Occidental Petroleum Corp. In order to replace an incredibly lucrative 1990 employment contract that provided Irani a guaranteed paycheck worth close to $5 million a year for life, Occidental's board gave him a 1997 payoff valued at $101.5 million. That was enough to make Irani one of the best-paid executives in Corporate America. Did Irani, too, build a business from scratch, or bring shareholders great rewards? Hardly. Since 1990, Occidental's stock has risen just 10%, and the company lost $390 million in 1997--in part, due to Irani's sweet deal. Occidental is being sued by Teachers' Retirement System of Louisiana for breach of fiduciary duty. Irani wouldn't comment.REALITY CHECK. If these two examples leave you scratching your head, you're not alone. While the concept of linking pay to performance has caught fire in the boardroom, reality has proved to be quite different. Certainly, many CEOs who delivered the goods last year received huge--and often justifiable--payoffs. And a very few poorly performing executives saw a portion of their pay docked. But the proliferation of stock-option grants, combined with the rise of cushy retirement deals, sign-on bonuses, and ironclad severance packages for CEOs, have made a mockery out of many attempts to truly link pay to performance.

The upshot: Good, bad, or indifferent, virtually anyone who spent time in the corner office of a large public company in 1997 saw his or her net worth rise by at least several million. Thanks to an exploding stock market, CEOs were more handsomely rewarded than ever before. Indeed, the average boss collected an options-fueled package worth $7.8 million for 1997, pulling down a 35% raise over 1996's $5.8 million. But for many CEOs, those gains bore little relation to how well their companies--or investors--did. In the pay-for-performance sweepstakes, the "performance" half of the equation increasingly fell by the wayside.

Big, big money was only the most obvious finding of BUSINESS WEEK's 48th annual Executive Pay Scoreboard. Compiled with Standard & Poor's Compustat, a division of The McGraw-Hill Companies, the survey examines the pay of the highest-paid executives at 365 of the country's largest companies. The average salary and bonus actually fell, to $2.2 million from $2.3 million, as some CEOs deferred bonuses or took options instead.

But don't let that decline fool you. It's just that the upfront elements of pay are shrinking in importance. The real money now comes from the exercise of options, long-term incentive plans, and perks. "Salary and bonus don't mean anything anymore," says David M. Leach, executive vice-president at pay consultant Compensation Resource Group Inc. Throw in all the extra goodies, and CEOs continue to rake it in. Indeed, although the 35% increase in CEO pay was less than 1996's 54% leap, that's still more than 13 times the average 2.6% raise earned by blue-collar workers and over nine times the 3.8% boost white-collar workers pocketed, according to the Bureau of Labor Statistics' Employment Cost Index. For the year, the average boss earned 326 times what a factory worker did.

Few would dispute that 1997 was a fabulous year for much of Corporate America--and most CEOs weren't shy about taking credit along with the check. The high payouts, they say, were well deserved: Profits rose 5%, and the Standard & Poor's 500-stock index ran up a scorching 31% gain. With stock options responsible for 55% of a CEO's average pay package these days, Wall Street's bulls powered most of the rise.

But those big market gains--along with a huge increase in the number of options granted--have combined to fuel an unprecedented inflationary spiral in executive pay. Take the $7.8 million paycheck CEOs earned on average in 1997. Just 10 years ago, that would have shot an executive into the No.13 slot on BUSINESS WEEK's pay rankings; 20 years ago, it would have topped the list.

What's more, the 1997 numbers don't even reflect the largest single option sale ever: In December, Walt Disney CEO Michael D. Eisner exercised 7.3 million options worth over $400 million. Eisner's move came after the close of Disney's fiscal 1997 year. "Pay just goes up and up and up," says Corey Rosen, executive director of the National Center for Employee Ownership.

So what does it now take to be king of the pay hill? For 1997, Sanford I. Weill, CEO of Travelers Group Inc., was Corporate America's best-paid executive. Thanks to an outstanding year--as well as a controversial technique known as reload options--his total pay package hit a stunning $230.7 million. His closest competitor, former Coca-Cola Co. CEO Roberto C. Goizueta, cashed in options worth $104 million before his October death. Others atop the list include Scrushy, Irani, and Eugene M. Isenberg, CEO of Nabors Industries Inc., a $1.1 billion oil-well drilling company. He took home $84.5 million in 1997, mostly from exercising 10-year-old options. The payout "doesn't one iota affect the way we work," says Isenberg, whose salary and bonus haven't changed in a decade. Nabors' investors, who have seen shares rise an average of 43% annually over that time, have profited, too.

Indeed, in a year when shareholders saw their own coffers expanded comfortably, many were less likely to complain. Says Robert L. Rodriguez, chief investment adviser at First Pacific Advisors Inc., a $4.5 billion money manager: "We're not opposed to having people make lots of money if we make lots of money."

Much of the outrage that accompanied news of huge executive pay hikes just a few years ago also seems to have gone into hibernation. "I don't hear the same level of anxiety I've heard in the past two years," says Patrick S. McGurn, corporate programs director at Institutional Shareholder Services, a proxy-advisory service. The healthy economy and job market help, as does the fact that employees are participating in the equity market themselves via 401(k) plans or broad-based option plans. According to a study by consultant William M. Mercer Inc., some 30% of the largest 350 companies have set aside grants for broad-based option plans, though only 10% have given them to 50% or more of their employees.OUTRAGE FATIGUE. Some also think it's because the sums are too huge to comprehend. For example, Henry R. Silverman, CEO of Cendant Corp., is sitting on close to $1 billion in exercisable stock options (table, page 68). "Since companies are doing well," says governance expert Ira M. Millstein, a senior partner at law firm Weil, Gotshal & Manges, "people aren't focusing on the increasing distance between the top and the bottom or the levels to which CEO pay has gone."

Still, if the dissenting voices have gotten quieter, they haven't disappeared. Options repricing--exchanging options for new options at a lower price after the stock falls--is one area in which activism is rising. The State of Wisconsin Investment Board (SWIB) has made repricing its focus this year, trying to get 22 companies to allow shareholder approval of any such plan. Says a SWIB spokesman: "You don't see this until you get the company's proxy. We think it is an issue that shareholders should have a say in."

The attack on repricing may represent a tactical shift by investors. Rather than decrying the swelling level of pay in general, critics are focusing on more specific issues. The AFL-CIO is turning the spotlight on how close ties between execs and directors can lead to excessive pay, for example. And on Mar. 31, the Council of Institutional Investors, a group representing more than 100 pension funds with assets of more than $1 trillion, called for companies to "index" option grants, or make their value contingent on outperforming the market or a peer group. Although the proclamation has no teeth, it is significant that the members unanimously approved it.

Ironically, soaring CEO pay is in some ways a consequence of a well-intended push to get--and keep--good management. Where succession was once the CEO's domain, activist investors have forced boards to take a bigger role in choosing leadership. So, directors are more readily dumping laggard CEOs and working to keep good ones.

The shift has led to one unintended side effect: When it comes time to choose a new CEO or renegotiate an old one's contract, boards are going after the same small pool of experienced CEO candidates. It's the human equivalent of the old adage "no one ever got fired for buying IBM." Few boards get criticized for choosing an experienced, well-known CEO rather than taking a shot on a promising but unproven No.2. "Boards are becoming more risk-averse," says pay consultant Pearl Meyer. "They are looking for a proven track record and immediate acceptance."

For those executives lucky enough to enter this charmed circle, the shift has translated into almost limitless leverage come contract time. It's the law of supply and demand--and it's a seller's market if ever there was one. As a result, more and more CEOs are demanding contracts that lock in enormous payouts. From huge signing or retention bonuses to perks such as tax planning and jet use in perpetuity, to exit packages that guarantee big bucks even if an exec is chased out of office, financial risk is virtually eliminated. Such contracts "are getting really egregious," says Carol Bowie, research director at Executive Compensation Advisory Services.

Stephen F. Wiggins, until February the chairman of Oxford Health Plans Inc.--is only the most recent example. Despite presiding over computer foul-ups that have decimated earnings and sent the once-stellar stock tumbling 73% last year, Wiggins got severance worth $9 million when he left. His juicy deal included the continuation of his Harvard Club membership and a nearly $2 million annual consulting salary. While such packages are becoming routine, the reaction sure wasn't: In April, the New York State Superintendent of Insurance strong-armed Oxford into withholding the pay until it proves that policyholders won't be hurt.

The story is essentially the same all over Corporate America. Sure, there were instances where laggard CEOs saw their bonuses cut or even eliminated. That happened to Eastman Kodak's George Fisher, who failed to meet earnings targets and saw the stock slump dramatically, and to Union Pacific's Richard K. Davidson, who oversaw a disastrous year in which UP bungled its merger with Southern Pacific. But given the packages of earlier years, the cuts can amount to window dressing. When Fisher's contract was extended earlier in 1997, he got 50,000 shares of Kodak stock and 2.1 million new options. Although the options are under water, his stock grant is still worth over $3 million.BYE-BYE, BONUS. Elsewhere, too, some CEOs seem to be tightening their belts. But appearances can be deceiving. Take Lester M. Alberthal Jr., CEO of Electronic Data Systems Corp. After a year in which EDS' earnings goals weren't met and the stock underperformed, Alberthal's bonus disappeared and he got no new options. So the board gave him $13 million in restricted shares--making up for the bonus and more.

To their credit, not all boards are relying exclusively on options to align executives' interests with those of shareholders. Many also require CEOs to own stock. According to a KPMG Peat Marwick survey, 53% of large-cap companies have adopted formal CEO guidelines, with the median target holdings equal to four times salary. At Caterpillar Inc., officers are supposed to hold shares equal to the average number of options given in the last three option grants. If they don't, their next option grant will be reduced.

Certainly, few would dispute the value of tying a CEO's net worth to a company's stock by making him hold shares: Unlike options grants, where the worst that can happen is that there is no gain if the stock plummets, a shareholding CEO actually has real money at risk. Ownership is certainly rising: As of the end of 1997, the average large-company CEO held a $58 million stake in his or her company, estimates Pearl Meyer & Partners Inc.--up nearly 50% from 1996.

Rather than making CEOs put the money up themselves to buy stock, however, many companies are giving it away via continuous options and stock grants or through forgivable "loans" and other helpful measures. But that defeats the whole purpose of the transaction.

Moreover, it raises some particularly thorny issues of its own: Not only can such transactions increase shareholder dilution, they also boost the level of equity ownership going to nonfounding CEOs. According to Pearl Meyer, in 1996, 17% of option grants went to proxy-level execs, and the value is rising too: In a survey of 55 large companies, nearly half made option grants worth more than $10 million in 1997. Says corporate-governance consultant B. Kenneth West of Teachers Insurance & Annuity Assn.-College Retirement Equities Fund (TIAA-CREF): "I don't think shareholders and compensation committees recognize the degree to which some of these programs result in a transference of wealth and voting power to management."

Still, amid the pay sweepstakes, some slightly hopeful signs are on the horizon. Some companies have begun to put more stringent price hurdles into effect for their options grants. These "premium-priced options" are granted at prices above the stock price on the grant date. So the stock must appreciate before the executive starts to profit.

At Monsanto Co., for example, the top 12 execs now have to buy their premium-priced option grants--albeit at a 50% discount to estimated value--in addition to owning five times their salary in stock by 2000. Says CEO Robert B. Shapiro: "I didn't want people to psychologically shift to protect what they have rather than looking ahead." Is a 50% stock rise all that tough in this market? "You want some stretch," says Shapiro, "but it shouldn't be so daunting that you don't participate.""WALLPAPER." Such plans remain rare. According to KPMG Peat Marwick, just 2% of companies have implemented them. And with the Dow flirting with 9000, the question is how--and whether--the ever-upward pay spiral will moderate when the bull market finally ends. Some think shareholders and execs will feel the pain together. "The one thing that provides comfort," says Peter T. Chingos, national practice director at KPMG Peat Marwick for compensation, "is that the lion's share is coming from options. If the stock doesn't appreciate, [executives] can end up with a lot of wallpaper."

Or will they? With even run-of-the-mill CEOs now used to multimillion-dollar pay packets, few expect CEOs to settle for their relatively tiny base salaries and bonuses when a buoyant market can no longer supercharge compensation. Kevin J. Murphy, finance professor at the University of Southern California's Marshall School of Business, thinks companies will be forced to use their cash to boost their long-term cash incentive plans. "[Execs] won't just drop their stock-option plans and say `game over,"' he says. "They'll find new games to play."

Many think that CEOs will insist on repricing their options, the equivalent of heading for the lifeboats while everyone else goes down with the ship. Repricing is considered anathema even among pay consultants; Brent M. Longnecker of Deloitte & Touche's human-resources strategy group says it's "like fingernails on a chalkboard." Yet last year's proxies show that even in a good year it happens. Such companies as Guess?, U.S. Surgical, Netscape, the Learning Co., and Oxford Health Plans repriced, though not all included the CEO.

At U.S. Surgical, the practice has a particularly cynical tinge. Its repricing came last April, just two months after a February, 1997, option grant. Although CEO Leon C. Hirsch--in better days, a regular on the BW list--didn't reprice, his wife, Executive Vice-President Turi Josefsen, had 200,000 options repriced after the stock dropped to $33.63. Originally priced at $42.31, they were reset at $36.98--a 10% premium to the lower price. But that wasn't a hurdle set to challenge her: As part of the 1995 settlement of two shareholder suits alleging excessive pay, the company's three top executives agreed to set future grants at 10% above the existing market price for the next three years. So Josefsen did so, using the new, lower price as her base. It's a luxury shareholders never get.

If repricing can't even be stopped at a company that has already been the target of shareholder fury, what will happen if hundreds of companies see their share price drop? "From everything I'm hearing," says W.O. Bell, chief of management policy for the Florida State Board of Administration, "it's safe to say repricing would rise exponentially if markets go down." These days, things rising exponentially just seems normal for those in the corner office.By Jennifer Reingold in New York, with Richard A. Melcher in Chicago, Gary McWilliams in Houston, and bureau reportsReturn to top


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