FORTUNE blasts CEOs ... long


If specified, this will replace the title that
Have They No Shame?
Their performance stank last year, yet most CEOs got paid more than ever. Here's how they're getting away with it.
Monday, April 14, 2003
By Jerry Useem

But the pigs were so clever that they could think of a way round every difficulty.
--George Orwell, Animal Farm

Who says CEOs don't suffer along with the rest of us? As his company's stock slid 71% last year, one corporate chief saw his compensation fall 12%. Sure, he still earned $82 million, making him the second-highest-paid executive at an S&P 500 company in 2002, according to the 360 proxy statements that had rolled in as of April 9. And yeah, he's under indictment for the wholesale looting of his company, Tyco. But at least Dennis Kozlowski set a better example than the top-paid executive, who pulled in a whopping $136 million. That was Mark Swartz, his former CFO.

Unusual, you might say, for one company to produce the two top earners in a given year. But three of the top six? Now that's truly striking--especially since the other person isn't part of Kozlowski's gang at all. It's Ed Breen, the guy hired to clean up the mess.

You'd think that in the aftermath of a scandal that made Tyco a symbol of cartoonish greed, its board might want to make a point of frugality. Yet even as it was pressuring its former officers to "disgorge" their ill-gotten gains, it was letting its new man, who became CEO last July, gorge himself on $62 million worth of cash, stock, and other prizes. By all accounts Breen is doing a fine job so far (see Exorcism at Tyco), but still. And the gravy train didn't stop there. Tyco's board of directors dished out another $25 million for a new CFO, plus $25 million to a division head, putting them both on a par with the CEOs of Wal-Mart and General Electric. At least the company, now with a new board of directors, seems to recognize the need for some limits: Its bonus scheme "now caps out at 200% of base salary," notes Breen, "whereas before it was more like 600% or 700%."

That, in a nutshell, is what a year of unprecedented uproar and outrage can do. Before, CEOs had a shot at becoming very, very, very rich. Now they're likely to get only very, very rich. More likely, in fact. FORTUNE asked Equilar, an independent provider of compensation data, to analyze CEO compensation at 100 of the largest companies that had filed proxy statements for 2002. Their findings? Average CEO compensation dropped 23% in 2002, to $15.7 million, but that's mostly because the pay of a few mega-earners fell significantly. A more telling number--median compensation, or what the middle-of-the-road CEO earned--actually rose 14%, to $13.2 million. This in a year when the total return of the S&P 500 was down 22.1%.

"The acid test for reform," wrote Warren Buffett in his most recent letter to shareholders, "will be CEO compensation." With most of the results now in, the acid strip is bright red: Corporate reform has failed. Not only does executive pay seem more decoupled from performance than ever, but boards are conveniently changing their definition of "performance." "From a compensation point of view," says Matt Ward, an independent pay consultant, "it's a whole new bag of tricks."

What did fall last year were monster grants of stock options, like the 20 million awarded to Apple's Steve Jobs in 2000. The declining use of options (which even Kozlowski once called a "free ride--a way to earn megabucks in a bull market") would seem cause for reformers to rejoice. But delve more closely into the data for those 100 big companies and what do you find? That every other form of compensation--including some burgeoning forms of stealth wealth--has grown.

Options not paying what they once did? Have some cold, hard cash to make up the difference. Cendant's Henry Silverman got $11 million in salary and bonus, a 41% rise, while Cendant's total stock return fell 47%. Or take Disney's Michael Eisner. After he failed to clear his bonus hurdle two years running, his board lowered the performance bar, and then--hooray!--he finally cleared it. An Olympian effort worth $5 million.

The 5% rise in median salaries and 21% jump in median bonuses was chicken feed, though, compared with the boom in restricted stock. The number of people receiving such grants rose 42%. While awarding shares outright has some advantages over options--they can ease shareholder concerns about dilution and "option overhang"--it also supplants pay-for-performance with what Matt Ward calls "pay-for-attendance."

Even more troubling is stealth wealth. "Deferred compensation" plans, for instance, let executives sock away up to 100% of their salary and bonus in a tax-advantaged account until retirement, often with the addition of a company match and above-market interest. Meanwhile, many pension plans credit executives with decades of unserved "service," even shielding them from creditors in the event of bankruptcy (see The Latest Way to Hide Millions).

Perhaps most striking are the sums to be made at the most troubled firms. After paying huge severance packages to failed chiefs, Sprint and Lucent laid out eye-popping amounts for their would-be saviors. While reflecting the difficulty of luring anyone to a disaster scene, it also shows how much can be made in the comings and goings these days. Michael Capellas, for instance, pulled off the golden parachute and the golden handshake in the same week, collecting $27.8 million just for jumping from Hewlett-Packard to WorldCom. "With CEOs receiving an average of $15 million to start and $16.5 million to finish," notes Paul Hodgson of the Corporate Library, a research firm that advocates boardroom reform, "they hardly need to make any money in between."

While shocking in one sense, these developments are not wholly surprising. For several decades now, CEO pay has been governed by the Law of Unintended Compensation, which holds that any attempt to reduce compensation has the perverse result of increasing it.

• In 1989, Congress tries to cap golden parachutes by imposing an excise tax on payments above 2.99 times base salary. Result: Companies make 2.99 the new minimum and cover any excise tax for execs.

• In 1992, Congress tries to shame CEOs by requiring better disclosure of their pay. Result: CEOs see how much everyone else is making, and then try to get more.

• In 1993, Congress declares salaries over $1 million to be non-tax-exempt. Result: Companies opt for huge stock option grants while upping most salaries to $1 million.

You get the idea. Regulation is a spur to innovation, and in the pay arena innovation always means "more." As executive-pay critic Graef Crystal once put it, "The more troughs a pig feeds from, the fatter it gets."

To see all those troughs in use--and the peculiar doublespeak of the compensation realm--check out the employment contract of Bob Nardelli, the ex-GE man who joined Home Depot in late 2000. (At presstime, Home Depot had not filed the proxy for its 2002 fiscal year.) First comes the "make-whole payment." In Nardelli's case, that entailed reimbursing him for all the goodies he forfeited by leaving General Electric: $50,400 in cash, a $10 million loan, and a stock option grant of 3.5 million shares, a million of which came fully vested. The whole point of forfeiture rules is to induce CEOs to stay put. The whole point of the make-whole payment is to undermine them. It's a virtuous cycle--for the CEOs. In 1999, for instance, Hewlett-Packard made Carly Fiorina "whole" for Lucent options that soon after would have slipped deeply underwater. Says Crystal: "She stepped from one ocean liner to another just as the first one took six torpedoes from the tubes of a submarine."

Another lovely term is the "guaranteed bonus" (bo*nus [n.] Something over and above what is normally expected). Nardelli's contract actually calls it the "target bonus," (tar*get [n.] A goal to be achieved), but it's the same thing. Even if he drives Home Depot's stock to zero, Nardelli's bonus will be no less than $3 million. His "maximum" bonus may be no less than $4 million--his minimum maximum, in other words. But there is no maximum maximum, because "nothing contained herein shall prevent the [compensation] committee from paying an annual bonus in excess of the maximum amount." Naturally.

As an incentive to work hard, he also gets annual option grants of no fewer than 450,000 shares.

Home Depot agreed to these terms because it wanted a hotshot executive, and Nardelli--one of three finalists for Jack Welch's corner office--fit the bill. Since Nardelli took over, Home Depot's total return is down 43.4%; in 2002, the stock was the Dow's worst performer. "You can tell the world that Home Depot got more than its money's worth when it got Bob Nardelli," declares Ken Langone, the company's lead director. Still, it's worth asking: What would Nardelli get if the board wanted a regime change?

Again, Nardelli's contract comes to the rescue. Let's say he's fired for "cause." No, wait, that's almost impossible. Because these days "cause" doesn't mean what you think it might. Let's leave Nardelli for a minute and look at 3M CEO James McNerney. In his contract
... cause shall not include any one or more of the following:
(i) bad judgment,
(ii) negligence.

Screwing up, in other words, doesn't qualify. Would a felony conviction do the trick? Maybe. But the employment contracts of three former Kmart CEOs said it must be
... a felony involving moral turpitude or any other felony unless, in the case of such other felony, the Executive (A) acted in good faith and in a manner he reasonably believed to be in, or not opposed to, the best interests of the Company and (B) had no reasonable cause to believe his conduct was unlawful.

That is, as long as the CEO believed he was acting legally and in Kmart's interests, he could be convicted of drunk driving, possession of counterfeit securities, possession of a sawed-off shotgun, reckless homicide, or "lascivious carriage"--all of which have failed to meet some courts' definition of "moral turpitude." It's a loophole so gaping (and so common) that the CEO could theoretically join the army of a foreign state--Libya, say--and still not get fired for "cause." Which is why, in practice, nobody ever is.

It may seem like semantic hairsplitting, but that one little word makes all the difference. Because getting canned without cause can trigger an Ed McMahon-like payday. Let's go back to Nardelli. Not only would his "incentive" Home Depot stock become instantly convertible to cash, but the company would be forced to award him all new stock grants upon his departure--giving him an incentive to do what, exactly, isn't clear. Then comes $20 million in cash, straight up. By contract, Home Depot will also forgive the balance of and outstanding interest on his $10 million loan. Lest he have to pay income tax on this largess himself, Home Depot will cover the bill with what's called a gross-up payment. And since that payment is itself taxable, there will be a gross-up on the gross-up. Meaning shareholders will pick up the whole gross amount

All told, Nardelli could walk away with $82 million, estimates the Corporate Library's Hodgson--a figure that doesn't even include his deferred compensation or other benefits.

Those are the provisions spelled out in the contract. But many boards aren't afraid to hand out money willy-nilly. Consider how Texas Instruments couched its comp decision for top execs in its original 2002 proxy: The compensation committee says it followed no specific formula, only "factors it deemed relevant." (By Equilar's calculations, CEO Tom Engibous got $22.7 million while the 2002 shareholder return was -46.2%.) Playing make-believe is another option. Before the 2000 retirement of Engelhard Corp.'s longtime CEO Orin Smith, the board voted that his options should be extended "as if Mr. Smith had not retired."

As nonsensical as all this seems, board members insist there's an elemental logic to it. Everybody knows that (1) a great CEO is the key ingredient to corporate success, and (2) great CEOs are in short supply. Or so the executive recruiters and compensation consultants keep saying. "It's supply and demand," super-headhunter Gerry Roche is fond of remarking. "Everyone says, 'Get me Larry Bossidy.' How many Larry Bossidys do you think there are?"

Well, just one, according to an Internet phonebook search. But that's not the point. A headhunter "gets his gigantic search fees advancing the idea that there are only five or six people in the world who can do this job--and he knows all of them," says Joseph Daniel McCool, editor of Executive Recruiter News. "The shortage of CEOs is a myth." Graef Crystal puts it in Econ 101 terms: "If pay is rising, it's going to be due either to a change in supply or to a change in demand. Has there been a decrease in the supply of CEOs? No. And the business schools are churning out more people every year. Is there an increase in demand? For every company like ITT that splits into three, there are 100 that merge. So if anything, CEO pay should be sinking."

Why, then, isn't it? Because for all CEOs' free-market rhetoric, their pay has less to do with the market's invisible hand than with the invisible handshake. Studies have shown a link between a CEOs' pay and how much the people on their compensation committee make in their day jobs--often as CEOs at other companies. Verizon's Ivan Seidenberg (2002 comp: $22.4 million), for instance, sits on the comp committee for Viacom CEO Sumner Redstone (2002 comp: $39.5 million). "Everybody is stroking everybody else," says Herb Sandler, co-CEO of Golden West Financial, whose comp last year was just $1.3 million. "It's sort of like the Golden Rule gone wrong," says Harvard Business School professor Rakesh Khurana. "CEOs do unto others as they would have them do unto them."

The situation wasn't always so. Up through the 1970s, a chief executive's pay was generally linked to that of his underlings in a geometrically proportional relationship known as the "golden triangle." But soon a new breed of compensation consultant began whispering in CEOs' ears: Look what other chiefs are making. They pointed to a "peer group" and calculated the average pay. Because some of those peers were likely to have supersized salaries, just pegging the CEO's pay to the average usually guaranteed a raise. But nobody's CEO is just "average." One compensation consultant recalls a CEO asking him with a straight face if everyone in his industry was paid at the 75th percentile.

It's easy to laugh. But it is the chase for this mathematical impossibility that leads to what Charles Elson, director of the University of Delaware's Center for Corporate Governance, calls a "closed circulation market that's ever spiraling up."

So how do we break out of this spiral? We could tell boards to grow a spine. We could tell CEOs they're embarrassing themselves. We could tell people to be outraged. But we've done all that--two years ago, ten years ago, 20 years ago. "The irrationalities and excesses ... do not seem easy to eradicate," FORTUNE wrote in a 1982 cover story, "The Madness of Executive Compensation."

We could offer up the latest Rube Goldberg solutions for aligning CEOs' interests with their shareholders'. One proposal making the rounds, indexed options, would reward CEOs only if their stock beat a larger market index. Nifty idea, but ask a CEO to try this on for size: The value of your options, already hard to calculate, will now gyrate with some index, which, by the way, only a third of companies beat. What, no takers?

We could observe that European companies generally pay their CEOs a small fraction of what their U.S. counterparts make, yet don't seem to have any trouble "recruiting and retaining talent." We could point to a number of FORTUNE 500 companies that pay their CEOs moderately and seem to be doing just fine (see table).

We could even mention this year's record 275 shareholder proposals to rein in executive pay. Two of them--at Hewlett-Packard and Tyco--have gotten majority votes. But management is free to ignore those mostly nonbinding resolutions and routinely does.

Nope, it's going to take more than tinkering to reverse a dynamic this powerful. And there's only one way to do it: Address a basic power imbalance. Somewhere along the line, managers--who are, after all, just hired hands--started behaving as if they owned the place. And the real owners--mostly mutual funds and pensions--started behaving as if they didn't. In fact, they voted their shares just as their hired hands told them to. Taking orders from the help might seem humiliating. But then, institutional investors (including the mutual funds you own) don't have to declare the way they vote.

That's changing. A new SEC rule that takes effect in the summer of 2004 will require it. It may seem like just another procedural tinker. But there's reason to hope it could be something more. CEOs have already proved they can't be embarrassed. But maybe owners can be. If so, they might finally provide the counterweight that is so desperately needed--and keep CEOs from stuffing their bellies at the shareholder trough.

Let's hope so. Because until the owners come back, the pigs will be running the farm.

Additional reporting: Ellen Florian


And we wonder why our economy is in the toilet and big businesses are laying off thousands and going belly up.

This, literally, made me sick. I almost had to make a run to the restroom (as I was eating lunch at the time I read this).
Wow! Fortune isn't exactly some left wing liberal magazine like Mother Earth. Maybe we'll finally see those guys like Carty and Mullin get their pay cut when they're asking people who make less than ten percent of what they make to take pay cuts.

And screw retaining them. Who wants to retain someone who guided his company to billions in losses or to the verge of bankruptcy? Shouldn't the idiots in charge of the company in that case get fired?