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Executive Pay


For Lawrence J. Ellison, it was the best of years, it was the worst of years. Really. The Oracle Corp. (ORCL) chief executive earned a special place in the history of executive compensation last year with the $706 million he pocketed from exercising long-held stock options. It was an amount that far exceeds the gross domestic product of Grenada and constitutes the single biggest one-year haul of all time. But looked at another way, Ellison was also history's biggest loser. With Oracle stock off 57% for the year, the value of his option holdings fell by more than $2 billion.

Ellison's $706 million windfall is all the more remarkable considering that it occurred in a year when the nation's corporate elite experienced their first double-digit decline in pay in seven years, ending an extraordinary decade-long inflationary spiral that increased their average take by more than 550%. In a year when a slowing economy killed bonuses and plunged stock options under water at companies across the land, the average CEO's pay declined 16%, to $11 million, according to BusinessWeek's 52nd annual Executive Pay Scoreboard, compiled with Standard & Poor's EXECUCOMP. Take out Ellison's princely haul, and the drop in total pay was nearly 31%, to $9.1 million, a level not seen since 1997. "It was a sobering year, even for those who profited," says Patrick McGurn, director of corporate programs at proxy adviser Institutional Shareholder Services.

Nobody knows that better than Ellison. How could he record both the biggest gain and the biggest loss in one year? The answer points to a fundamental problem in the way executive pay is tallied. Most watchers, including BusinessWeek, count option gains in the year the exec cashes in, even though that value may have been building for a decade. Others estimate the future value of new options, sometimes miscalculating by hundreds of millions of dollars. Both methods miss an important change in executive compensation. For at least two decades now, compensation has been far more about wealth creation than pay for services rendered over the year. The engine of change has been stock options, which have been handed out so lavishly they now make up 15% of shares outstanding.

To get a better reading on how much Corporate America really pays its CEOs, BusinessWeek is introducing a new measure that we call the change in pay-related wealth. It's based on the annual gain or loss in an executive's stock options, whether exercised or not, along with any salary, bonus, and stock grants for the year. We still rank executives based on how much they took home from options exercises, salary, and bonuses, but we believe that this new measure adds clarity to an increasingly complex and contentious topic.

Both the vast riches and the almost unimaginable losses recorded in the executive suite last year were a function of options, a perk that has come to represent a decade of corporate excess and greed. Compared with 2000, many more executives in the BusinessWeek Scoreboard took home less cash in 2001 and suffered losses in the value of their option holdings, just as shareholders suffered losses. What rankles critics is that many had enjoyed such enormous option gains in recent years that even big one-year losses left them with Everest-size mountains of stock-option wealth.

Some CEOs, of course, were punished for their companies' less-than-stellar results. Disney's (DIS) Michael D. Eisner, JDS Uniphase's (JDSU) Jozef Straus, and Texas Instruments' (TXN) Thomas J. Engibous all lost their bonuses. Straus and Adobe Systems' (ADBE) former CEO John E. Warnock received dramatically smaller option grants for the year. Others, including Archer Daniels Midland's (ADM) G. Allen Andreas, were deprived of new grants entirely. Harry M. Jansen Kraemer Jr., CEO of Baxter International (BAX), voluntarily cut his bonus by 40%, even though his company's stock climbed by 20% in 2001. The reason: Defective Baxter dialysis machines were linked to the deaths of more than 50 people. Kraemer, who earned total cash compensation of $1.6 million plus a grant of 600,000 options, says somebody had to pay the price for the dialysis machine deaths: "Fifty people died. If you have a problem, the buck stops somewhere, and it stops here."

As usual, though, many other CEOs were insulated from their companies' falling stock prices with new option grants or favorable repricings on their existing options. At Eastman Kodak Co. (EK), where the stock declined 23%, CEO Daniel A. Carp received 410,000 options, up from 100,000 the year before. A company spokesman said the option grant was small compared with other large companies' and intended to compensate Carp for assuming the position of chairman. With Cisco Systems Inc.'s (CSCO) stock price down 72% in a year, CEO John T. Chambers last April requested that his annual base salary be reduced to $1. Instead, Chambers, who has pocketed $322.8 million over the past seven years as CEO, was awarded six million options.

A similar gargantuan option grant is how Ellison managed his $706 million miracle last year. In June, 1999, with Oracle stock trading at about $6, he agreed to trade four years of his salary and bonus in return for 10 million options, an almost unheard-of stockpile that escalated in value over the next 16 months as the stock hit a high of $46 in September, 2000. Proponents say that options align the chief executive's interests with those of shareholders, but that's not the way it worked at Oracle. By 2001, with the tech bubble bursting, Oracle stock was in a free fall. Rather than sit tight in a show of confidence, Ellison sold 29 million shares in a single week in January, flooding the market when investors already were jittery. He exercised 23 million options the same week for a gain of more than $706 million.

Within a month, Oracle stock had lost a third of its value, and the company was announcing that it would miss third-quarter earnings forecasts. That triggered further price declines and a rash of shareholder lawsuits alleging that Ellison engaged in "what appears to be the largest insider trading in the history of the U.S. financial market," according to one such suit. Ellison's stock sales were a factor in the sell-off that followed, says Henry Asher, president of Northstar Group Inc., which owns 48,000 Oracle shares. "Was that a ringing endorsement for the company's short-term prospects?" asks Asher. "I don't think so." Oracle and Ellison declined to comment.

In a post-Enron world that has little tolerance for corporate financial maneuvers, Ellison's decision to cash out will likely add more fuel to the fiery debate over options, the perk that has sparked as much disdain for its overuse as the three-martini lunch of another era. Once a minor perk, options have come to account for 80% of the executive-compensation pie. Shareholder activists, institutional investors, and governance experts all viewed them as a way to turn managers into owners who would keep one eye trained on the stock price. Throughout the 1990s, boards gave out options with abandon, seeing them as a way not only to appease shareholder activists but also to compete in the increasingly tight market for top-flight talent. And best of all, they were free. Since accounting rules allow companies to grant options without treating them as a compensation expense on their income statements, options--unlike cash--have no impact on earnings. They were, and are, a license to print money.

But the increased use of stock options has created a host of problems. Many critics object to the sheer magnitude of the riches CEOs can now pocket. In 1950, when BusinessWeek first catalogued the pay of the nation's corporate elite, the highest-paid executive was General Motors Corp. (GM) President Charles E. Wilson, whose $652,156 pay package--$4.4 million in inflation-adjusted dollars--would make modern-day CEOs like Ellison laugh. Worse, the link between pay and performance that options are supposed to provide is often subverted by compensation committees that ladle on more options when the company stock falls or swap the old underwater options for new, more valuable grants. Amazon.com Inc. (AMZN) and Lucent Technologies (LU) both repriced or swapped executive stock options. Says Peter Clapman, chief counsel for TIAA-CREF, the world's largest pension system with $275 billion in assets: "It's sort of heads you win, tails let's flip again."

Even worse for shareholders is the dilution problem. Every option granted makes the shares of every other stockholder less valuable. Investors are starting to catch on. This year, dozens of resolutions targeting exorbitant pay--at companies that include Boeing (BA), Citigroup (C), and even General Electric (GE)--will be voted on by shareholders, and support for such proposals is on the rise. "We have this kind of stock-option madness," says compensation consultant Alan Johnson. "The system is significantly broken."

Part of the problem is that while options decline in lockstep with stock prices, on the upside they offer far greater leverage. The gains in the fat years can provide a generous cushion during downturns. That's why some executives in our Scoreboard could suffer massive losses but unlike shareholders, still have lots left over. We believe our pay-related wealth measure provides a more complete look at this crucial component of CEO pay.

The results are eye-opening. Looking solely at cash compensation and option exercises, the nation's top executives had a bad year: 315 out of 730 in the BusinessWeek Scoreboard saw their total compensation decrease. But BusinessWeek's new measure of executive wealth reveals much steeper losses. In all, the plummeting value of stock-option holdings reduced pay-related wealth for the average executive by 43%, to $27.5 million. Of the 441 who either broke even or had holdings that increased in value, the average gain was 13%. Of the 216 who saw their wealth decline, the average loss totaled 60%. Indeed, at company after company, top executives with huge option stockpiles saw their wealth depleted by hundreds of millions of dollars. Cisco Systems' Chambers, Sun Microsystems' (SUNW) Scott G. McNealy, and Walt Disney's Eisner all took major hits to their wealth.

To be sure, not everyone was hurting. Howard Solomon, CEO of Forest Laboratories Inc. (FRX), saw his salary increase nearly 13%, to $823,765, his bonus double to $400,000, and his take from option exercises top $147 million. In a year when Forest shareholders saw gains of 40%, compensation committee members felt he deserved every penny. Forest has enjoyed spectacular growth over the past five years. Solomon, who has been CEO since 1977, benefited enormously, since that growth sent the value of his options soaring. Says committee member Dan L. Goldwasser: "If a man is delivering substantial increases in shareholder valueit's only appropriate that he be rewarded for it."

Other CEO pay packages were harder to justify. Tyson Foods Inc. (TSN) had a lousy year. Net income fell to $88 million from $151 million. Shareholder return was essentially flat--at a time when Tyson's peer-group companies doubled in value. And in December, a federal indictment in Tennessee accused the company and six managers of conspiring to smuggle illegal immigrants into the U.S. from Mexico to work in its poultry-processing plants, a charge the company denies. The upshot? CEO John H. Tyson received 200,000 new options and a $2.1 million bonus. The company says Tyson was rewarded for reducing debt by $86 million and negotiating the acquisition of meatpacker IBP. But others didn't see it that way. "I'm surprised the board would be so generous," says Charles M. Elson, director of the University of Delaware's Center for Corporate Governance. "It raises a lot of questions."

At other companies, boards quietly scaled back the tough performance targets executives needed to meet to win millions in rewards. At GM, CEO G. Richard Wagoner Jr. and other top executives who were entitled to a special performance bonus if the company's net-profit margin reached 5% by the end of 2003 will now be held to a less rigorous test. And at Coca-Cola Co. (KO), the goal line for CEO Douglas N. Daft to receive one million performance-based shares--20% annual earnings growth over five years--last year got a little bit closer. It's now 16%. With shares down 23%, his pay package totaled $55 million, including $5.1 million in salary and bonus and $49.9 million in option exercises.

Overall, though, the anemic economy skewed BusinessWeek's pay-for-performance analysis sharply downward: CEOs with the best and worst shareholder returns relative to pay got less and posted sharply poorer returns than the executives in last year's analysis (table). The CEO who, dollar for dollar, gave the most this year was B. Wayne Hughes of Public Storage Inc. (PSA) He delivered a 47% gain for stockholders for $254,300 in pay from 1999 through 2001--a pittance compared with last year's winner, David M. Rickey of Applied Micro Circuits Corp. (AMCC), who was paid $4.5 million for a staggering 4,751% return. At the bottom of the performance heap was Ellison, whose mammoth 2001 payday overshadowed his company's 92% three-year return for shareholders.

Companies that fared poorly in our pay-for-performance analysis took issue with our methodology. Oracle said it unfairly inflates pay by counting exercised options. Cisco said it compares fiscal-year pay with calendar-year performance. In fact, calculating Cisco's return on a fiscal-year basis would result in a three-year return of 20% and move Chambers from the No. 2 slot to No. 3. Tyco (TYC) said our methodology doesn't account for internal performance measures such as earnings, and IBM (IBM) said it disregards nearly a decade of exceptional stock performance by Gerstner. Says IBM Vice-President Carol Makovich: "Mr. Gerstner's long-term leadership at IBM has produced outstanding results."

This year's survey of executive pay shows just how significantly CEO compensation has changed since Charles Wilson steered GM in the 1950s. Chief executives, once employees, have become owners. Salaries and bonuses are now afterthoughts compared with the potential wealth that options represent. Put another way, in a lousy year, Ellison took home almost three-quarters of a billion dollars. Imagine what he could make if Oracle shares turned around. By Louis Lavelle, with Frederick F. Jespersen in New York and Michael Arndt in Chicago


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