Members will hear testimony on issues relating to the compensation of CEOs, and in particular, public concern that such compensation is excessive. Senator McCain will preside.
Prof. Brian Hall
Chairman McCain, and distinguished members of the committee, thank you for inviting me to provide testimony on the topic of CEO compensation. In the recent two decades, we have seen dramatic changes in the way that American CEOs are paid. Although the press and media have often sensationalized the issue in ways that misinform the public, there has been about a 7-fold increase in the inflation-adjusted median level of CEO pay since 1980, which far outstrips the increases seen by rank-and-file workers. As important, there has been a dramatic shift in the composition of CEO pay. As recently as 1984, the median option grant (valued at the time of grant by standard option pricing models ) to CEOs of large American companies was zero—which implies that fewer than half of the CEOs received any option grant at all. In recent years, option grants have been (on average) about twice as large as cash-based pay, representing about two-thirds of total CEO pay. Options became “icing on the cake” for CEOs in the mid 1980s. Today, the icing has become the cake. The option explosion is clearly the central and most controversial development in CEO compensation. It has dramatically affected the level of pay, the composition of that pay and, crucially, the incentives that top executives face to create or destroy value. As a result, I will focus most of the remainder of my testimony on what is good and bad about the CEO option explosion for the American public. Let’s start with what is good. In the 1970s and early 1980s, American CEOs received very little equity-based pay and, as a result, had a very weak ownership stake in the companies they managed. Although I am simplifying a bit, their main financial incentive was to increase the size of their companies (in terms of revenues, assets and employees) while virtually ignoring the company’s owners. American CEOs were largely protected from shareholders and had financial incentives to do something they already enjoyed doing – making their companies bigger and expanding their empires. They responded in kind. US companies became larger, but absent meaningful incentives for top executives to make decisions consistent with raising shareholder value, there were essentially zero returns to shareholders on an inflation-adjusted basis for more than a decade. The financial incentives facing US executives changed dramatically following the shareholder rebellion that began in the 1980s. The increase in takeovers (and takeover threats) removed the inappropriate way in which CEOs were insulated from the wishes of company owners, while appropriately lessening their job security. Moreover, management buyouts —which virtually always led to large increases in the ownership stakes for top managers—increased dramatically and were typically quite successful in raising efficiency, productivity and company profits. The use of equity-based pay then began to spread throughout corporate America, and became mainstream following the rise of institutional investor influence and the subsequent entrepreneurial wave of the 1990s. Although the move toward equity-based pay created new problems and abuse, it has had many benefits, the most notable being that top executives—who now hold significant amounts of stock and options in the companies they manage—began to focus more on creating value for shareholders and society. Many top executives began to think and act like owners, at least relative to the period before the option explosion. The incentives created by ownership are at the core of well-functioning market economies and are fundamental to long-run economic prosperity and dynamism. In my view, one of the risks of the recent corporate scandals is that they may create an excessive backlash against equity-based pay, even though well-designed equity-based compensation is the central tool for aligning the incentives of managers and owners. The problem with the option explosion is that it has too often led to excess and abuse. In specific cases, option plans have been poorly designed, leading to perverse incentives and huge payouts to top executives following (or preceding) poor performance. But even for the typical (or the median) CEO, the option explosion may have indirectly caused total compensation to become excessive. Some argue that CEO pay is not excessive in general, even though there are clearly specific instances where CEOs seem to have been overpaid. This view is generally based on the logic of the efficiency of markets—CEOs are simply getting what the market will bear. If companies are willing to pay a price for CEOs, who is to say that the market price is “wrong”? Unfortunately, a close examination of the pay process for CEOs reveals some serious doubts that the CEO labor market is not a particularly well-functioning one, which, in my view, gives weight to the argument that the overall level of top executive pay is excessive. The most crucial problem is that boards are often too weak and too cozy with top executives, and as a result, fail to adequately represent shareholders when negotiating CEO pay packages. CEOs are quite powerful in most American boardrooms. They typically chair the board and have a large influence over who is selected to be on the board. In such circumstances, most directors (and the compensation consultants advising them, who desire to please their client) feel pressure to please the CEO and one of the ways that they do this is by providing generous compensation, even in relatively well-functioning boardrooms. Second, the compensation determination process has become dominated by the use of surveys, whereby pay is determined by benchmarking against other CEOs of comparable size and in similar industries. The key problem is that very few boards want to pay their CEO below the median of this distribution while a very large percentage of boards believe that their “above average” executive should be paid “above average” compensation. But when boards consistently pay at above median levels while using peer benchmarking to determine the median, the uncompromising laws of mathematics imply pay ratcheting over time. And this is precisely what we have observed. Finally, the dramatic increase in the use of options has led to an upward bias in CEO pay since many boards perceive options to be much cheaper than their true economic cost to shareholders. Indeed, many boards incorrectly view options to be “free” or “costless.” The false view that options are inexpensive is the result of three reinforcing factors. First, the current accounting rules allow companies to treat standard options as free from an accounting perspective since there is no required expense on the income statement. Second, options require no cash expense up-front, even though the dilution cost is economically equivalent. Third, option valuation is inherently complex, leading many people to refer to option costs in terms of the number of options, which often seems much smaller than the expected economic dollar cost of options. In my view, these three factors—especially in combination—have led to upward biases in CEO pay. Thus, CEO pay is probably significantly higher than what we would see in a well-functioning labor market where well-informed owners spent their own money to attract, retain and motivate high-quality executives. For similar reasons, I have serious doubts that the specific design of most CEO pay (as opposed to the level of pay) packages is the “optimal” result of a well-functioning market. The way in which some top executives have been able to get huge payouts (from selling equity and/or exercising options for a profit) preceding huge declines in stock prices represent perhaps the most egregious example of poorly designed equity-pay plans. The “solutions” to the executive pay problem involve strengthening shareholder rights and corporate governance while also requiring companies to appropriately account for all compensation expenses (including stock options) on their accounting statements. More generally, solutions that take the form of improving the underlying problem (involving the incentives of the involved parties and the information they have) are much preferable to trying to micromanage the pay process or pay outcomes through federal legislation. Such legislative micromanagement is likely to be ineffective in solving the problem and may well have harmful and unintended consequences. The best example of this is the 1993 rule aimed at curbing executive pay. This so-called “million dollar rule” disallowed companies from deducting non-performance-related-pay above $1 million for corporate tax purposes. Around the same time, the SEC passed new regulations creating greater executive pay disclosure on company proxy statements. At best, these changes were ineffective. At worst, they distorted pay towards options (which automatically count as performance-based pay) while contributing to CEO pay excesses. Indeed, a quick glance at the pay trend in Figure 1 makes it look as if the 1992/1993 changes were passed with the intention of accelerating, not curbing, CEO pay increases. There are many specific ways in which boards can better design CEO pay packages. For example, in my view, aligning CEO incentives with long-run shareholder value creation would require longer vesting periods, stronger and more widespread ownership requirements (which require executives to hold specific amounts of stock) and automatic clawback of payouts following accounting restatements (that is, executives would be required to pay back any payouts that preceded accounting restatements combined with stock price declines). But such specific changes are not easily legislated and would happen anyway (if they are good ideas) if boards became stronger and more empowered representatives of shareholders. One of the important ways in which Congress can act to curb excesses in, and distortions to, executive pay is to encourage rather than discourage FASB to begin expensing options. Much of the current debate regarding the expensing of stock options is about whether or not expensing will help investors value companies more accurately. While I agree with many opponents of option expensing that requiring expensing will not significantly improve the information flows to investors, this largely misses the key point. The main problem with the current accounting treatment is that it distorts the compensation decisions made by boards and executives. Very few boards are willing to design (or even consider) equity-pay packages that create an expense on the income statement when they can give out “free” options instead. As a result, boards (and managers) grant options, even though options may not be the most cost-effective and beneficial form of compensation. An example that likely illustrates the distortion created by the current accounting rules involves the infrequent use of restricted stock (stock that vests slowly) relative to options. As noted earlier, the main rationale for paying top executives in the form of equity is to create ownership incentives. But since shareholders hold stock, why do boards primarily pay executives in options instead of stock? The likely answer is the distorted accounting treatment of equity (which requires an expense for restricted stock but not options), not the inherent superiority of options as a compensation and incentive tool. Indeed, there are many advantages to stock relative to options. Stock is simpler and easier to value, which helps incentives while also curbing abuses. Stock does not have the huge underwater problem that plagues options (underwater options undermine ownership incentives, create retention problems and lead to perverse pressures to reprice options or grant large “refresher” grants following stock price declines) since stock cannot fall underwater. Stock also better aligns shareholder and executive decisions regarding dividends (and sometimes risk-taking ). But despite these advantages, many boards rarely consider stock—or other types of pay that create an accounting expense—because of the current accounting rules. Requiring an expense for options will level the accounting playing field, leading to fewer distortions in the way that executives are paid. Especially combined with rules that give shareholders more influence in board rooms, this will also curb many of the excesses in pay levels—especially with regard to many of the large outliers paid to CEOs, virtually all of which involved abuses of “inexpensive” and “hard-to-value” option grants. To summarize, although we must not forget the large benefits of the option explosion, there are good reasons to believe that there is an executive pay problem. But the executive pay problem is best solved by improving governance and accounting, rather than by attempting to solve the problem directly without addressing its underlying causes. In addition to improving the accounting, making managers and boards more accountable to shareholders will make the executive pay process sounder and less prone to abuse and excess. Currently, there are a host of mechanisms that disempower shareholders including poison pills, staggered boards and proxy voting rules that serve to weaken the ways in which boards and managers are held accountable to the company’s owners and other stakeholders. Although appropriate changes to the governance and accounting rules are best accomplished through the exchanges, the courts (especially the Delaware courts) and regulatory bodies such as the SEC and FASB, congressional support of these changes would well serve the interests of American public. I thank you for this opportunity to provide testimony on this important issue.
Mr. Peter C. Clapman
I am pleased to appear before the Senate Committee on Commerce, Science and Transportation to discuss issues of corporate governance, particularly as they apply to current concerns about executive compensation practices in the United States. I will focus on TIAA-CREF’s philosophy and approach to corporate governance; executive compensation principles; and suggested ways to achieve “best practices” for corporate governance. TIAA-CREF Philosophy and Approach In my capacity as Senior Vice President & Chief Counsel, Corporate Governance, I manage a staff of 6 professionals who are dedicated to TIAA-CREF’s efforts on behalf of shareholders. TIAA-CREF has been a leader in trying to improve corporate governance, both domestically and globally for over 20 years. Our organization is a full-service financial services provider with approximately $262 billion in assets under management. Our main asset base goes to support the pensions of nearly 3 million individuals at nearly 15,000 institutions in the educational and research field. As such, TIAA-CREF is uniquely independent compared with other large institutional investors because it works solely for the benefit of its participants. TIAA-CREF’s broad focus is to seek higher favorable investment returns for the millions of stakeholders in the same companies in which it invests. The TIAA-CREF investment strategy is long-term buy and hold – a significant percentage is quantitatively managed or indexed, and for that reason TIAA-CREF does not “vote with its feet”. In addition to its public activities with individual portfolio companies, TIAA-CREF works at the policy level with groups such as the Financial Accounting Standards Board (FASB), New York Stock Exchange (NYSE), National Association of Securities Dealers Automated Quotations (NASDAQ), Securities and Exchange Commission (SEC) and internationally at the International Accounting Standards Board (IASB). Our corporate governance program seeks to enhance our investment operations by taking on issues that further the long-term interests of shareholders. Although TIAA-CREF is a large shareholder, the interests it seeks to advance are those of concern to all long-term investors, both large and small. TIAA-CREF has an active corporate governance program that identifies companies where we see problem areas. We enter into a dialogue with these companies in an attempt to correct the situation. Although “quiet diplomacy” is our preferred course, we are prepared to file shareholder resolutions on a number of issues and, in fact, have received high votes in favor of our positions, often a substantial majority among all votes cast by shareholders. We have been strong advocates for more director independence, board accountability, and much higher standards of boardroom vitality. As shareholders we cannot micromanage our portfolio companies, but must rely instead on the directors performing in practice what is their duty in legal theory – to be the fiduciaries for the long-term shareholders. In actual practice, this means that the directors must be willing to oversee and monitor the senior managements of companies, and if necessary, be willing to say “no” when appropriate. Executive Compensation Principles This brings us directly to the current problems with executive compensation in the United States. We have long believed that executive compensation in a real sense is a “window” into broader corporate governance issues at a company. If the directors do not get executive compensation right, they probably will fail shareholders in other areas as well. Disclosure rules applicable to executive compensation are not fully adequate in many respects. For example, disclosure is obscure for retirement benefits and executive perquisites. Nevertheless, shareholders are able to glean through executive compensation to make reasonable assumptions as to how the directors are doing – or not doing – their job. Executive compensation has its own importance in other ways. Individuals respond to the incentives and motivations given by the system. If those incentives and motivations are the wrong kind, we should not be surprised to find that wrong actions are the result. For example, if the current system provides great incentives for focusing on the current short-term share price of a company, is it any wonder that some executives abused the system by cashing out short term gains from options while at the same time encouraging or fostering accounting aggressiveness or even fraud to keep earnings high enough to support the high share prices at which they cashed out? Regrettably, that today is the state of affairs for executive compensation at too many companies. The typical option today is fixed-price, and why? The current accounting rules not only impose no cost of compensation for such options, but even worse require expensing for other forms of equity compensation such as performance-based options or restricted stock. We have heard from all of the compensation consultants that this accounting discrepancy is responsible for crowding out those forms of compensation that would be better for shareholders – more acceptable to shareholders – solely because of the accounting rules. TIAA-CREF filed shareholder resolutions this year challenging these practices, calling for performance-based options with a substantial holding period for holding stock after exercising the options. The main point argued by proponents of equity compensation is that such compensation will produce alignment between management and shareholders. The overemphasis on options, however, and our experience under that approach, is that the alignment for option holders is only with other option holders. Top Priorities for Executive Compensation Reform So what executive compensation reforms are needed, and where will they come from? First, we will need better performance from compensation committees. Under the new NYSE rules only independent directors may serve on compensation committees. This is a good first step, but not a panacea. The fact that directors are nominally independent does not necessarily equate to their acting independently. Will directors become more educated as to what compensation is all about – and abide fully by the intent of the new accounting rules? Secondly, will directors retain truly independent consultants? In the past, all too often directors relied on the consultants selected by incumbent management. This has got to change since the entity that hires and pays the consultant is the entity that will motivate the consultant’s advice. That entity has got to become the compensation committee and not the management. Third, what objective is being sought in executive compensation? We see the ratcheting effect of every company seeking to position its CEO compensation between the 50-75th percentiles, a statistical impossibility. Fourth, we must strongly encourage the system to stop rewarding failure. The public has seen and is outraged by the high levels of severance payments to failed CEOs. Such executives have also received service credit for time not served, a semantic twist of words that convey total cynicism for the purpose of the grant. This season we have seen the response by shareholders as they have supported shareholder proposals attempting to introduce some rationality into this process, requiring shareholder approval of severance payments that exceed reasonable formulas. The question again is how boards could have given such contracts if they were truly representing the interests of shareholders. Fifth, we need to better link compensation with long-term performance goals. There are two problem areas with the current system: (1) reliance on fixed-price options and (2) absence of substantial holding periods for stock after exercise of options. In analyzing the situation recently, the Conference Board identified one of the current barriers to proper management of these issues – the absence of accounting neutrality regarding treatment of different forms of equity compensation. Until the properly authorized expert independent organization, FASB, acts to correct this problem, many companies will hide behind differing earnings treatments and disdain performance-based options even while recognizing that they are the better approach to executive compensation. Congress should be careful not to politicize this issue and should permit FASB to take on this issue on its intrinsic merits. The recent support of the FASB by SEC Chairman Donaldson is encouraging as to the view at the SEC. In the final analysis, shareholders have been more than reasonable on this issue. Despite large stock losses, despite revelations about executive compensation excess, despite reasonable concerns about board performance, shareholders have been patient and understanding. Shareholders are willing to support improvements in the process of determining executive compensation, believing that the excesses will be squeezed out if the process improves. The need now is to make the expectations of the new stock exchange rules work. The culture in the boardroom must undergo change so that the directors are truly accountable to the shareholders and not the management. With that change in board culture, the right accounting changes, and the generally improved corporate governance practices, hopefully the excesses in the system can be corrected. Congress needs to strongly support these reforms to restore investor and public confidence in the system. ###
Mr. Joseph E. Bachelder
A. INTRODUCTION A recently completed study of 437 companies out of the S&P 500 shows that, taking into account salary, bonus and long-term incentives including stock options, the average CEO pay is down 23.6% in 2002 from 2001.** Looking farther back, over the past fifty years, CEO pay (salary and bonus) has grown an average of approximately 5.8% a year. That compares to the S&P 500 total shareholder return (stock price growth plus dividends deemed reinvested) of approximately 12% a year over the same fifty-year period. It is noteworthy that during the 1950s, the 1960s and into the 1970s, the rate of increase in CEO pay (salary and bonus) trailed the rate of increase in production workers' pay. Another way of looking at CEO pay is to compare it as a percentage of employer revenues over a period of time. Looking at over 230 U.S. corporations that are in the current S&P 500 and that were in the same index a decade ago, salary and bonus paid to the CEOs of those companies represented approximately 0.035% of their revenues a decade ago and represents approximately 0.029% today. What about stock options? In the early 1980s, after approximately 15 years of almost no growth in the stock markets, stock options were encouraged as a favored form of long-term incentive award. Consultants, investors and academics looked favorably on stock options. Why? Because they wanted to tie CEO pay to increase in shareholder wealth. What better way to do that than with stock options? If the markets went up, the CEO shared in the growth. If the markets went nowhere, the CEO made nothing. What happened? The stock markets exploded! From the early 1980s to the end of the 1990s, the stock markets rose 1400%. In a September 2002 report, the Conference Board indicated that approximately 80% of the increase in CEO pay over the period 1992 to 2000 was attributable to gains in stock options. The stock market had its remarkable success in the 1980s and 1990s and so did stock options for many CEOs in that same period. In a sense we got what we asked for: we tied CEO pay to increasing shareholder wealth and shareholder wealth overall increased dramatically. B. SOME OBSERVATIONS ON CEO PAY TODAY 1. Free Market First, let’s recognize that the market of CEO pay is a free market, much in the way the stock market is a free market, or the real estate market is a free market. In order to get a CEO to move from Company A to Company B, Company B must pay what it takes. If Company A wants to keep that CEO from accepting the offer from Company B it must pay what it takes. It is a bargaining process, much as goes on in other free markets. 2. The Market Value of CEOs If asked, the vast majority of directors of the approximately 15,000 public companies in the United States likely would say that the single most important factor in a company’s success over the next several years is the CEO. This is one reason why CEOs have the leverage they command in negotiations over their pay. There are not a lot of people who possesses the qualities necessary to be a successful CEO. To succeed, they must: Master the business operations — most frequently global in scope — of companies with hundred of millions, and in some cases hundreds of billions, of dollars of revenues and market capitalization. Have the vision and leadership to keep their companies ahead in developing and marketing new products and services, improving existing products and services, and in marketing those products and services. Understand and oversee increasingly complex financial structures (and we all know the tragedies associated with leadership that either, willfully or neglectfully, fails to do this). Attract, motivate and retain talented people — frequently tens of thousands and, in some cases, hundreds of thousands. Work effectively and productively with multiple constituencies including employees, shareholders, directors, Wall Street analysts, the media, Federal, state and local governments and, frequently, foreign governments as well, and the citizens of the communities of which they are a part. Individuals who effectively combine these skills, with the energy, commitment and personal sacrifices required, do indeed command a premium in today’s market. Ironically, institutional shareholders criticize CEO pay and yet many of them have been a force in increasing CEO pay. Representing some of the greatest concentrations of stock wealth in the history of our country, institutional shareholders have provided constant pressure for increasing stock prices. CEOs respond to this pressure. With or without stock options, the pressure would have been there. Did the 1990s produce too much in the way of institutional shareholder gains? Where were many of the institutional shareholders just a few years ago on the subject of Enron? On the subject of Worldcom? I am not sure I would look to institutional shareholders as the oracle on CEO pay. 3. CEO Pay Versus the Value of the Companies They Run For major US corporations, CEO pay represents a very small portion of the value of the companies they run. If, for example, Jack Welch received over his career a billion dollars of value, and the publicly available information that I have reviewed indicates it to be significantly less than that, this would be approximately 0.25% of the Company’s market value as of September 2001 when he retired. You will pay more than that as a percentage of most transactions to your stockbroker. If you sell your house, you will pay something like 6% to your real estate broker. From a different perspective, Jack Welch's pay for his entire career would probably equal less than ten cents per share of GE stock currently priced at approximately $28 per share, with approximately 10 billion shares outstanding. C. STOCK OPTION GAINS AND THE BLACK-SCHOLES BUGABOO As already noted, CEO salaries and bonuses have increased — but not to an egregious degree — over the past 50 years. As also already noted, the rate of increase in CEO salary and bonus trailed the rate of increase in pay of production workers during the 1950s, the 1960s and into the 1970s. So why the extra fuss over CEO pay? To a very significant degree, it is due to stock options. And this, in turn, is due in large part to the way we report stock options as compensation. (I am addressing the issue of reporting CEO pay and not the issue of whether options should be expensed for accounting purposes, a separate issue that is not the subject of this testimony.) Much of the reporting of huge CEO pay gains in the 1990s was based on values attributed to the awards of stock options using the financial model called Black-Scholes. Black-Scholes seeks to value an option based on a number of factors, including the current stock price, the option exercise price and the historic volatility of the stock to which the option applies. Other elements of the model include the term of the option, the dividend yield and the risk-free interest rate. Black-Scholes' initial applications were to freely tradable short-term options — meaning options for periods of less than a year, frequently in the range of only three to six months. Applied to ten-year executive stock options, Black-Scholes is like planning a long drive through traffic by taking a one-time look in the rear view mirror. Let’s compare an executive stock option to one of those short-term options traded on the Chicago Board Options Exchange. An executive stock option cannot be sold. It usually cannot be exercised for a significant period of time (typically it becomes exercisable in tranches over several years). If the option is exercised, the sale of the stock may be subject to SEC insider restrictions on sale or to employer-imposed blackout periods. If the executive quits, the option is probably forfeited. If the executive is fired, the option is generally forfeited unless it is vested. If the executive dies, the post-termination exercise period is generally limited to one year. Even if the executive continues on during the full option term, how does one forecast the consequences of wars, recessions and the growth or collapse of particular employers over that period? To report one “dollar” of such highly speculative value as the equivalent of one dollar of salary paid today is debatable, to say the least. Notwithstanding the foregoing, many U.S. surveys report — side-by-side — dollars of theoretical option value with dollars of salary paid as if they were equivalent. These surveys then compound their sin by adding the two together. Many billions of dollars of supposed option value evaporated in the 1990s. There are cases of executives reported to have received hundreds of millions of dollars of option compensation during the past ten years whose options are now underwater. In a study of CEO pay over an approximately ten-year period ending in 2001, the Bachelder Firm found 210 CEOs (out of a much larger group of CEOs of major public companies) who were employed as CEOs by the same company for the entire period of approximately ten years. The ratio of stock option gains to salary and annual bonuses for these 210 executives over the approximately ten years was a little over 1 to 1! (By option gains I mean both realized and unrealized gains, the latter being represented by the spread in options held at the end of the period less the spread at the beginning of the period.) Over half of the gains of this group of 210 CEOs was attributable to just 11 executives (some of whom are founders or co-founders at companies like Oracle, Dell and Sun Microsystems). To the vast majority of CEOs in the United States, the 1990s were a rewarding period (with rewarding results to shareholders) but not the bonanza of extravagance suggested by the media. D. SOME SUGGESTIONS 1. Let's adopt a consistent yardstick for valuing stock options in reporting CEO pay. (I am speaking of surveys and reports on options, not accounting for options, which is a different issue.) I suggest using gains, both realized and unrealized, rather than the theoretical Black-Scholes value at the time of grant. In this connection, we should recognize that when a long-term award pays out or a stock option grant is exercised, it normally represents compensation attributable to a number of years of service, not compensation for just that one year. 2. Let's stop focusing on the outliers who attract headlines and distort the overall picture of CEO pay and instead focus on the average CEO when discussing CEO pay. 3. It would be very helpful if there was at least one common database of companies that we all could refer to — like the S&P 500. Standard and Poor's and Equilar, Inc., for example, provide such databases. Throughout each proxy season we go from surveys that in some cases cover 50 or fewer companies in a limited number of industries to surveys concerning much larger numbers of companies in many industries. When that is combined with differences in valuation methods and differences in the use of terminology, it becomes very difficult for the public to get an accurate picture of what really is happening to CEO pay. 4. When CEOs and other executives exercise stock options, it would be reasonable to require that a specified percentage of the stock attributable to the spread at time of exercise, net of shares needed to pay taxes incurred as a result of the exercise, be held for a minimum period of time. **** Mr. Bachelder, founder and senior partner of the Bachelder Law Firm, has concentrated in matters associated with executive compensation for over two decades. Mr. Bachelder has represented many prominent chief executive officers and other senior-level executives of United States corporations. He has also represented boards of directors and compensation committees. Mr. Bachelder writes a regular column, "Executive Compensation," which provides current commentary on the subject of executive pay, for the New York Law Journal. He speaks regularly to professional groups such as the American Law Institute/ABA and the Practising Law Institute. He has spoken at forums sponsored by academic institutions such as Harvard University, Stanford University, Northwestern University, the University of Wisconsin and the University of Delaware.
Mr. Sean Harrigan
Mr. Chairman, Senator Hollings and members of the Committee, it is my pleasure to be here today and to provide the perspective of an institutional investor in regards to executive compensation. I also have some suggestions where Congress could take action to help support reform in executive compensation. I am Sean Harrigan, President of the California Public Employees’ Retirement System (CalPERS) Board of Administration. CalPERS is the largest public pension system in the U.S., with approximately $125 billion in assets. We have long been a leading voice in Corporate Governance, and an advocate for better alignment of interests between shareholders and management. Executive compensation is a critical issue to investors. Compensation is a truly powerful tool that will drive behavior. Unfortunately, it can drive the wrong behavior if the proper checks and balances are not in place, or if the compensation schemes are just poorly constructed. CalPERS and I believe most investors are not anti-compensation. In fact, we believe paying competitive salaries for managerial talent is an important motivational tool. But, we feel strongly that pay should be linked to long-term sustainable performance in a very significant manner. Something has gone wrong with executive compensation in the United States. It is unconscionable to see that CEO pay has swollen to 400 times that of the average production worker. It is shocking to see example after example of top executives insulating themselves from any risk in their own compensation, and ensuring their own financial security at the same time employees are being asked to shoulder the burden of cuts, and shareholders are losing value. At American Airlines shareholders and employees were shocked to find out that the company made a $41 million dollar payment to a fund designed to protect the pensions of executives if the company filed bankruptcy. This fact was not disclosed during negotiations to secure $1.8 billion in wage concessions despite the fact that the payment was made months before. If I had to identify one issue that is at the heart of the problem with compensation in the United States, I would point to accountability. More appropriately perhaps to a lack of accountability. This is an area where we can make reform with the support of Congress. As public markets investors we rely upon boards of directors to represent us. In the case of compensation, the Compensation Committee is charged with representing shareholders. It is clear to me that a major contributing factor to the problem with executive compensation is that Compensation Committees are not accountable to shareholders. They obviously do not feel that approving abusive compensation packages will cost them their job. Rather, it appears that not approving what the CEO wants is what they feel will cost them their job. This represents the central conflict of interest inherent in the problem of executive compensation today. Until this fundamental issue is solved, we will continue to have widespread abuse in compensation practices. In the last five years alone, CEO compensation has doubled according to compensation consultants Pearl Meyer & Partners. In 1996, the average CEO at the largest 200 companies made about $5.8 million. By 2001, that figure jumped to $11.7 million. The following table compares the trends in specific components of CEO pay to the performance of the S&P 500 for 2001 and 2002. 2001 2002 Median base salary Up 10.1 % Up 4.2 % Median cash bonus Down 17.6 % Up 8.8 % Median stock option grant Up 43.6 % Down 18.6 % Average restricted stock Down 21 % Up 1.3 % Median overall compensation Up 26.7 % Down 10.9 % Total return S&P 500 Down 11.88 % Down 22.09 percent Source: compensation data – calculated for CalPERS by Equilar (includes only CEOs that were in the position for the entire three year period); S&P 500 returns - Bloomberg We think this shows a disconnect between compensation and performance on a broad scale. Part of our concern is that it appears companies shifted compensation from cash to options in 2001, then from options to cash in 2002 – most likely due to the bear market. It is also important to note that the value of the option grants declined at least in part due to lower overall stock prices. It appears that a similar number of options are still being granted (median number of options declined only 9 percent in 2002). This was the only factor driving the median total compensation down in 2002. However, while the absolute levels of pay are a concern, perhaps the most troubling element of executive compensation is the heads I win, tails you lose attitude of corporate executives. CalPERS is deeply concerned over what appears to be an attitude of entitlement in the executive suite of corporate America. This attitude manifests itself in many forms. Perhaps some of the more offensive entitlements are the so called forms of “stealth compensation.” Lavish severance packages complete with perks for life that are fit for a king, guaranteed pension benefits far outstripping the value of benefits provided to employees, enormous loans to executives that are eventually forgiven, and provisions providing that the company shall pay all the taxes due (including gross-up provisions) should the executive incur a tax liability all send a clear message to shareowners. The message is that we do not respect you as owners, and we do not feel accountable to you as owners. In other examples demonstrating a lack of respect for shareholder’s capital: Delta Airlines, Leo Mullin will be credited with 22 years of service toward his pension upon termination, plus two additional years in a Supplemental Retirement Benefit. The company also put $25.5 million in a protected pension trust for him according to press accounts. Home Depot has an employment contract that includes a $10 million loan with predetermined criteria for forgiveness in addition to base salary, 2,500,000 stock options (plus annual increments of no less than 450,000 more options), a target bonus of between $3,000,000 and $4,000,000, deferred stock units (750,000 in 2002), pension benefits and change in control provisions that include (if the executive leaves for good reason or for any reason within 12 months) $20,000,000, immediate vesting of options, and immediate forgiveness of any outstanding loans and payment of the gross-up for taxes. We do however feel that there are concrete steps that can be taken to help reign in abusive executive compensation. Shareholders must take a more active role overseeing directors at the companies in which we invest with the goal of increasing the absolute level of accountability of directors to shareholders must be increased. There are also several improvements to the structure of compensation programs that we believe can have a dramatic effect on rationalizing executive pay. Let me briefly go over the steps CalPERS is taking in the area of executive compensation and mention some of the specific proposals we have made to improve the alignment of interests. Executive Compensation Policies CalPERS amended its U.S. Corporate Governance Core Principles and Guidelines recently to call on companies to formulate executive compensation policies and seek shareholder approval for those policies. Currently, Compensation Committees issue a statement in the proxy to briefly describe the company’s compensation philosophy. Shareholders’ role in this process is relegated to a distant back seat. In discussions with companies about this issue, they often state emphatically that only the board has the right and the expertise to manage the affairs of the company and particularly the issue of compensation. Companies state that the Compensation Committee must have the flexibility to attract and retain executives and that shareholders should essentially trust them to do the right thing. Yet the behavior of corporate America in regards to executive compensation indicates otherwise. We believe it is a completely appropriate role for owners of a corporation to approve broad policies in relation to executive compensation. Perhaps most importantly, it would force Compensation Committees to face shareholders with a plan on how they will use compensation of all forms in managing the corporation. This will help to shift the accountability back to where it belongs, to the owners. Action item 1: Congress could support these recommendations and call upon the SEC and the exchanges to consider requirements that shareholder approve executive compensation policies. We believe that executive compensation policies should provide the following, at a minimum: The company’s desired mix of base, bonus and long-term incentive compensation; The company’s intended forms of incentive and bonus compensation including what types of measures will be used to drive incentive compensation. Again, we believe companies should construct incentive plans with a significant portion of performance based components; The parameters by which the company will use severance packages, if at all. Quantitative Model - Website Application as a Research Reference Tool CalPERS is also dedicating a portion of its website to executive compensation issues. In the near future we will post a catalog of extensive research available in the executive compensation arena. We are also developing a quantitative model that we will apply to our U.S. indexed holdings to help identify on a more systematic basis where compensation abuses are occurring. The model will be used to identify companies where performance and compensation diverge by analyzing peer relative and market relative compensation measures along with performance data. It is our intent to use our website to highlight cases of egregious compensation much in the way we have used public means in our Focus List of under-performing companies. Greater Performance Based Metrics In another major effort, we are pushing for greater use of performance based metrics in equity compensation plans. Standard at-the-money fixed price options - those with the strike price set at the current market value of the stock on the day of the grant - have been used extensively in the United States, and have become the largest single component of CEO pay. While fixed price options do have some merit as an alignment tool, they are inferior in many ways to performance based plans. Yet companies have been reluctant to say the least to adopt performance based equity plans. CalPERS recently co-sponsored a shareholder proposal at General Electric calling for the company to make a significant portion of their option grants to top executives performance based. The company adamantly opposed the resolution, they said because not many companies are using these types of equity grants. One can only suspect that it was really because they do not want to be held to true measures of outperformance to obtain the highest levels of incentive compensation. It is easy to see why shareholders and management differ on these issues. Shareholder Approval of Equity Based Compensation CalPERS is also lobbying hard to help ensure that shareholders have the right to approve any equity based compensation plan. Under current exchange rules, companies are not required in certain circumstances to obtain shareholder approval to adopt equity-based compensation plans. In other words, companies are allowed to unilaterally dilute the equity owners of the corporation. It is ridiculous to think that an owner should not have the right to decide if he or she is willing to dilute their equity, no matter what the purpose. It is even more ironic when you consider the fact that boards and management have a significant self interest in adopting equity based compensation plans. While shareholders have fought the NYSE and NASDAQ for years over this issue, it has finally come to pass that the proposed changes to the listing standards include greater shareholder approval of equity based compensation plans. But the fight is not over. Despite the fact that the proposed changes to the listing standards were developed last summer, the SEC has yet to implement this change. Most troubling of all, the exchanges are seeking a number of exceptions to shareholder approval that would continue to let companies unilaterally dilute equity owners. We are opposed to these exceptions. We believe this can be the shortest rule the SEC will ever be able to issue, and it can be stated in a single sentence: Any new equity based compensation plan or material change to an existing plan must be shareholder approved. Action item 2: Congress could join shareholders in supporting shareholder approval of all equity-based compensation plans without exception. Shareholder Access to the Proxy And finally I would like to mention one remaining reform we are advocating, shareholder access to the proxy. This would provide that shareholders who meet minimum ownership thresholds could nominate directors to corporate boards through management’s proxy. While this may not appear to be particularly relevant to executive compensation at first glance, it has everything to do with accountability. With responsible yet meaningful reforms to the SEC rules governing access to the proxy, shareholders will be given greater ability to hold directors accountable for poor performance. As I mentioned earlier, we believe this has a material impact on their behavior and on the quality of their representation of shareholder’s interests. This has an obvious impact on our ability to right the ship when it comes to compensation. Action item 3: Congress could join shareholders in seeking fair access to the proxy. Thank you, I would be glad to answer any questions that you may have.
Mr. Damon A. Silvers
Good morning Chairman McCain and Senator Hollings. My name is Damon Silvers, and I am an Associate General Counsel of the American Federation of Labor and Congress of Industrial Organizations. Thank you for your leadership on the issue of executive compensation and for the opportunity to appear before you today. The AFL-CIO is the federation of America's labor unions, representing more than 66 national and international unions and their membership of more than 13 million working women and men. Union members participate in the capital markets as individual investors and through a variety of benefit plans. Union members’ benefit plans have over $5 trillion in assets. Union-sponsored pension plans account for over $400 billion of that amount. Worker-owners and their benefit funds have become increasingly active participants in corporate governance in the last fifteen years. Of the 1000 shareholder proposals filed in the 2003 shareholder season, more than 380 were filed by unions. Seventy-five percent of these union-sponsored proposals dealt with the issue of executive compensation. So far, worker fund proposals on executive compensation have won majority votes at companies like Alcoa, Apple, Delta (2), Hewlett Packard, International Paper, PPG, Raytheon, Sprint, Tyco, Union Pacific, US Bancorp (2), Weyerhaeuser, and Whole Foods. At Adobe, Airborne, Coca-Cola, Exelon, General Electric (2) and Verizon the AFL-CIO or an affiliate union recently negotiated agreements to phase out extraordinary executive pensions. Of particular note, building trades unions’ funds have led the fight to get companies to expense stock options at dozens of public companies, following up on their success last year in winning auditor independence proposals. The AFL-CIO has been involved in the effort to reform executive compensation since well before the corporate scandals of the last several years. Since 1997, the AFL-CIO has sponsored the PayWatch website (www.paywatch.org), where workers and investors can track CEO pay at the companies they care about, compare it to their own compensation, and take action to reform executive pay practices. PayWatch is a very popular web site, with over 2 million people visiting since its launch and over 400,000 visits in 2002. Executive compensation should be a key part of the web of relationships that make up the corporate governance process. It should contribute toward getting companies to make smart, long term focused decisions that lead to sustainable benefits for all who participate in the company. Unfortunately, executive compensation has become the best-known symptom of the breakdown of that process. This year 277 of the approximately 1000 proposals filed at companies pertained to reining-in executive compensation. We believe executive pay matters. Amazingly, there are companies where executive pay matters in the simplest possible way—it has grown to a level where it is materially and directly affecting companies’ economic performance. But the more common problems involving runaway executive pay are that (1) it is structured to create perverse incentives, (2) it corrodes organizational cultures, and (3) it is a symptom of an unaccountable CEO and a weak board. A couple of examples of each problem. First, perverse incentives. Stock options that can be exercised after three years give the CEO an interest in both increased share price and increased volatility. If the stock price is falling, the CEO begins to develop an interest in taking risky decisions that shareholders, particularly long-term shareholders, do not share. In addition, equity based compensation, whether options or stock, that can be converted to cash during the executive’s tenure creates a strong incentive to manipulate company stock prices through massaging accounting statements or other disclosure manipulations. Second, organizational culture. Consider recent events at American Airlines. The company was seeking concessions from its employees in the name of business survival, including cutbacks in retirement benefits. The employees had narrowly voted to accept these cutbacks when it was revealed that the CEO was secretly increasing his retirement benefits at the same time. Not only was this grossly unfair, it jeopardized the approval of the agreements the company had said were necessary to avoid a bankruptcy filing. Treating people unfairly has consequences. Finally, executive compensation as a symptom. You have seen Professor Brian Hall’s list of the top paid CEO’s of 1999, and noticed the overlap with the corporate villain list of 2001-2002. This suggests that when pay is out of control, other things are likely to be as well. But scandalous levels of executive pay are neither a permanent feature of the American economy nor a necessary byproduct of prosperity. In 1964, at the end of the greatest period of economic performance in this country’s history, CEO pay stood at roughly 25 times that of the average worker, a level comparable to that of the other major industrialized countries. Today of course it stands at over 500 times the pay level of the average worker, and the pay of the median CEO continues to rise even though by every measure corporate performance is falling. Yet, solutions to runaway executive pay have been elusive in more recent American history. CEO pay increased throughout the 1980’s, to the point where in 1992 Congress felt it had to take action to tie pay to performance. Then pay really took off. We should learn from these experiences that in the absence of effective corporate governance, mechanical measures to rein in pay are unlikely to be successful – CEO’s and their consultants can and will game these rules if they control the processes by which their pay is set. For example, today we are seeing executives shift from stock options to SERPs and other retirement plans as stock options become both controversial and relatively unprofitable. So we believe that solutions to the problem of executive pay require at a minimum good disclosure to investors and the public and real accountability on the part of corporate boards, accountability that will result in real bargaining between boards and CEO’s. Specifically, this requires the enactment of two reforms—reforms that are under discussion at the agencies that have the power to enact them but which face serious political opposition. These reforms are the expensing of stock options and the democratization of corporate board elections. Stock options need to be expensed so they can be managed and so they can be on a level playing field with other types of executive compensation that are better suited to aligning executive interests with the long-term interests of their companies. There is no good reason not to expense options. But there are a number of bad reasons. These bad reasons include the spurious assertion that options cannot be valued, that options turn up in earnings per share calculations, and that options vary in value after they are granted. Options can be valued using Black-Scholes and a variety of other pricing methods related to Black-Scholes. Though these values are estimates, so are the values used for numerous other line items on corporate financial statements, including depreciation, amortization, and inventory-related adjustments. Options do vary in value after they are granted—but so do a variety of payments and agreements made by companies—for example payments made in foreign currencies or long-term commodity contracts. No one would suggest they should be left off the companies’ financial statements. Finally, the inclusion of options in the creation of the fully diluted earnings per share figure does not treat options as a cost, which in fact they clearly are. Frankly, the only reason why option expensing is an issue at all is because FASB’s efforts to require expensing have been thwarted in the past by political pressure. Similar pressures are now being brought to bear as FASB tries once again to do its job. The AFL-CIO strongly supports Bob Herz’s efforts to restore credibility to GAAP in this area, and commends the Chairman and Senator Levin for their leadership in supporting FASB’s independence. In our opinion, more is at stake here than just option accounting or executive compensation. Our markets will be damaged if after the events of the last two years it appears that our accounting standards are still being held hostage to the very political dynamics that prevented effective regulation in the 1990’s. Part of the reason the AFL-CIO supports option expensing is that we believe that with a level playing field companies will, in part due to investor pressure, choose better forms of executive compensation such as restricted stock. But we are skeptical frankly of mechanical approaches to executive compensation in general. Any mechanism, any one metric, can be gamed. A model executive compensation program, in our opinion, would include a thorough evaluation by the board of both quantitative and qualitative performance measures aimed at assessing the executive’s contribution to the long term health of the business. This kind of process can only work though when the board is genuinely independent from the CEO and accountable to long-term investors. That is not the reality of today’s corporate boards. That is why worker pension funds and other institutional investors are looking to make long-term investors a real counterbalance to management power in the board room. Last week the AFL-CIO filed a rulemaking petition with the Securities and Exchange Commission asking the Commission to democratize the director election process. The petition asks the Commission to adopt rules giving long-term significant investors in public companies the right to have short slates of directors they nominate listed on management’s proxy along with management board candidates. This proposal for access to the proxy is designed to give long-term institutional investors voice, not to facilitate takeovers. We suspect that access to the proxy, while rarely used, by its very availability as an option will make dialogue between boards and investors much more substantive. In particular, it is only through this type of reform that boards will become independent enough to really negotiate CEO pay packages. The SEC has announced a review of the issue of shareholder access to the proxy, and in particular shareholder involvement in director selection. The SEC staff has been asked to report to the Commission on the issue by July 15. But the reality is that CEO’s will oppose this reform as strongly as they are opposing option expensing, and that without it, it will be impossible to prevent further abuses of executive compensation. FASB and the SEC have the power and the tools to do something about runaway CEO pay. But not if they succumb to Congressional and company pressure to continue business as usual. One would think that after the last couple of years it would not be necessary to say this. Ultimately, the crisis in executive compensation is a microcosm of the crisis in corporate governance that brought us Enron and WorldCom and HealthSouth and so many others. Only by getting disclosure right and giving institutional investors the power to act on what they know can we get executive pay under control. But the long term health of our economy and the basic principles of fairness demand we do so. The AFL-CIO is grateful to this Committee for its commitment to this task and we would be pleased to assist the Committee in any way as you continue your work in this area. Thank you.