What do you think about the overall policy and regulatory climate that CEOs and boards face these days?
It’s more intense than it’s ever been. That’s both good and bad. It’s good in the sense that the board has a keener focus on issues like strategic direction, CEO compensation and the competitiveness of the company. It’s bad in that a number of practices have been adopted, in committees or at the board level, in which too much time is spent talking about compliance with Sarbanes-Oxley or worrying about some of the techniques of corporate governance. If you’re not careful, all this can become a check-the-box mentality that’s about protecting your rear end. That may divert time from talking about the customer and where the business is going.
My own guess is that the major part of adapting to Section 404 and New York Stock Exchange requirements is behind us. The better companies are going to come out of all this stronger. The information flows between senior management and the board are more intelligent and constructive. That’s a good thing.
But boards have to be very careful that they don’t become so process-oriented that they concentrate on form versus substance. Boards should not be so focused on risk-avoidance that we scare the CEO and management out of taking legitimate business risk.
How can a board member judge whether his or her board is spending too much time on process?
Well, just sit there after the meetings are over and ask yourself, “How much of that time was really spent in a constructive fashion?” That doesn’t mean that you don’t need to spend time talking about risk definition and risk management, because risk properly goes well beyond the financial and audit risk that have traditionally been the purview of the audit committee. In my mind, each committee and the board itself have to try to identify the reputational risk, the environmental risk and the customer exposure risk, any one of which could do serious harm to the company. They need to talk about those.
Have some boards become so bureaucratic that they are hurting their companies’ competitiveness? Has it gone that far?
Well, I think it can go that far if boards aren’t careful. If you look over the past 20, 30, 40 years, American industry has done a phenomenal job of generating choice in products and services to U.S. consumers and also at the international level.
When you look ahead, American businesses need to continue to do that, because they’re going to be in an increasingly competitive environment. Look at China. Look at India. Those economies are getting their acts together. That is a very good thing indeed, because the safest world is an economically interdependent one.
In the final analysis, competitiveness must be kept at the forefront of the board’s and management’s thinking. If there are no sales, there are no jobs.
Do you think it’s fair to say that by shifting the relationship between government and companies, and by encouraging shareholders to demand more accountability from directors, we’re at risk of changing the American capitalist model?
There is a risk. It doesn’t mean that a lot of initiatives and views from some of those groups are wrong. If they are challenging boards and managements to be accountable, that’s an appropriate thing. We have to ask, however, whether accountability forces short-term thinking and worrying about quarterly earnings. It’s too easy for activist shareholders or others to focus on the short term and prevent management from pursuing long-term investment ideas.
Looking ahead to the next proxy season, is the issue of CEO compensation going to be hotter than ever?
I think it will be, and I think it should. It got out of hand over the past eight to 10 years. The markets of the 1990s perhaps helped account for part of that. When you moved into the year 2000, option awards and other decisions were made with the expectation that companies would deliver value X, but it turned out to be value 5X. Shareholders by and large did well. But a lot of the performance of older-line companies has to be attributed to years and years of investment by prior management teams.
How did CEO pay get out of control, as the critics allege? Was it the boards or the CEOs or the compensation consultants?
All of the above. Any board, in trying to set management’s compensation, needs to look at several things. One fundamental is, are they losing senior people to the market because they’re not paying them? That’s a pretty clear indication. The other is, if you want to get a step ahead of losing people, you want to be sure that you’re competitive. Therefore, you look to the compensation consultants to give you a survey of what other companies of like size and similar characteristics are doing.
Too often, CEOs game the system. You pick the highest-paying company as part of the competitive set, and then you put forth the concept, based on testosterone, that, “Clearly, we see ourselves as a leadership company. Therefore, we should target our compensation at the 75th percentile. We don’t want to be just average.” Well, the mathematics of that continue to ratchet up every year. As other companies see what you’re doing, they use that benchmark. Before long, you have a nice kabuki dance that’s driving up compensation.
How can boards halt that pattern? They can’t take money back, can they?
You can— and you can adjust downward. Compensation is based on three basic things. First is base salary. Most boards today are trying to price that at a midpoint. Then there is bonus, which is a percentage of salary. The bonus is supposedly tied to the delivery of various performance measurements such as sales or return on investments. The third component is long-term equity. There you ask yourself, what kind of long-term incentive target do we need to offer to senior management? That is usually a multiple of two to three times what the total cash is. For some period of time, there were stock options—the bulk of them 10-year nonqualified stock options. Those options have come under criticism because of the size of the awards. So companies started to introduce restricted stock. That also has been subjected to criticism, properly so, because you pay to breathe.
Pay to breathe?
In other words, with restricted stock that vests in years three, four or five, all a senior executive has to do is be there. The rationale is that if you’re not performing, you won’t be there. But restricted stock typically is not tied to performance. You’ve had efforts to put performance measurements on restricted stock. Until X, Y or Z happens, the plan doesn’t pay out. Other approaches have been to limit restricted stock to no more than 15 percent of the long-term total. You also have phantom performance units, which set targets for per-year growth and aggregate growth or earnings per share over three years, for example. If those targets are met, then the plan pays out. But by and large, a lot of these things got on automatic pilot.
Was it that the wrong payment devices were used, or was someone asleep at the switch?
There was nothing wrong with the methodology. It was the interpretation of the data that led to pricing at the 75th percentile. And it was an absence of some sort of cap. We should be saying, “Let’s project that you as management are quite successful. How big would the compensation numbers get? Is there a point where too big is too big?” Maybe there should be a cap.
The problem comes on the downside. A lot of options out there are under water right now. They have no value at all in the short term, but they still have several years to run, and presumably they will be worth something. Black-Scholes makes an effort to value those things. But what happens on the downside, and when do you pay nothing? A number of companies I know of have long-term plans that have paid nothing.
Do you think it’s fair, in the case of Bob Nardelli at Home Depot and Ivan Seidenberg at Verizon Communications, to argue that they’re overpaid simply because their stock price hasn’t performed as well as some shareholders would like?
I don’t know whether it’s fair or not fair. But the perception that the stock has gone no place in five years while these guys are making so much money, that perception is a reality. I don’t want to speak specifically about these two individuals. I’m speaking generically. This is an issue that boards of directors have to think about. The CEO has to be accountable for everything, including the relative performance of the company. What the CEO and management can do is deliver revenue and deliver results that are trustworthy and credible.
That ties back to Sarbanes-Oxley and doing it right the first time. The theory is that if they do that, the stock will take care of itself, because there will be good growth and the market will recognize it and put a premium on it. That theory falls down in practice when, for whatever reason, some goals were met but not enough. As a result, the stock market overvalued the company.
But wouldn’t it be very difficult for directors to look across the table at the CEO and say, “We’re cutting your compensation”?
Well, it may have been tougher to do in the past than it is in this environment. The investment community has decided that the way to deal with this has to be more than, “If you don’t like us, sell your stock and go buy the shares of another company.” They’ve spoken up. Institutional Shareholder Services [ISS] and other shareholders have raised issues about compensation. Some of their prescriptions are ridiculous. But nevertheless it has given boards an added warning that they have to be more judicious in how they set the compensation program.
If these groups spend time with management determining what the targets are, and if those targets are not met, then the targets are not met. Management can’t say, “Let’s make up for that, because we didn’t really mean what we said about targets.” That’s happening all the time. The best thing you can do is to get fired, particularly when your stock is under water, and get a big severance. The severance contracts themselves have been excessive and provide for two to three times salary and bonus. I think that’s a mistake.
Is it a real concern for boards that top management talent will simply move over into private equity firms?
It’s very real. Good vice-chairmen, presidents and CEOs are asking, “Why do I want to put up with all the headaches of the public market and Sarbanes-Oxley? I’ve just been offered a bundle of money. I can go and make the kinds of investments in a business that I think ought to be made in a particular company because I’ve got a board of directors that understands that our objective is to build long-term value.” The kinds of deals that are being done are large, and they have plenty of money to put before an executive if he delivers results.
Is it good for us as an economy to have such a major restructuring of our capital markets as seen by the rise of private equity and the hedge funds?
It’s what happens in a dynamic economy. You’ve got checks and balances of all sorts. The checks in the public arena come in the form of the requirements of Sarbanes-Oxley, litigation and class action lawsuits and pressures from ISS and activist shareholders. That’s going to put a lot of pressure on publicly traded companies. In some cases, it’s called for. In other cases, it’s extreme. But in any event, the capital markets are such that they can offer alternatives, and that’s what happens.
One of the greatest assets that this country has is the depth and breadth and liquidity of our money and capital markets, whether it is LBO funds or the venture funds or the derivative markets. Capital is very mobile. And capital comes here from around the world because there is opportunity in this country.
Concern has been expressed by New York Senator Charles Schumer and Mayor Mike Bloomberg that some of the requirements of the Securities and Exchange Commission are driving IPOs and listings offshore. That is true. Whenever you get excessive regulation, there is going to be a reaction. In today’s and tomorrow’s world, competition can come from London or Hong Kong or even Dubai. They have the capacity to tap into this capital flow, with the Internet and telecommunications being what they are, to offer alternatives. There’s a discipline that brings about the correction of excesses, no matter where those excesses are.
Do you think there’s recognition of that danger in Washington, given the recent moves from the SEC and the PCAOB regarding Sarbanes-Oxley, plus the easing of some Justice Department guidelines?
I can’t say whether there is a recognition in Washington, but I can say that both those events have been the result of a concern that things have gone too far and that we need a more appropriate balance. It is not saying, “Let’s do away with a lot of the fundamentals of Sarbanes-Oxley.” It is not saying, “The Justice Department should roll over.”
I do think we’ve gone through a period in which attorney generals and U.S. attorneys were competing with each other to bring down CEOs. In some cases, appropriately so, but in other cases, maybe it was extreme. I’m not against effective checks and balances. I think at times they can be driven to extremes.