(FORTUNE Magazine) – In the great, continuing, and probably everlasting debate about executive compensation, the world knows pretty well what two sides of the pay triangle think. Most CEOs seem to believe they're worth every dollar they get. Many investors, in stark contrast, think executive pay is unfair, bears little relationship to performance, and is totally out of control.

The indistinct part of this picture--we move now to the third side of the triangle--is what directors think. It's they, after all, who make the pay decisions. And it's they who are charged with representing the shareholders' interests. So what's their opinion about those rich amounts they're doling out and the process by which the giving gets done? There, for sure, is a question to which you'd like to have a full, revealing inside answer.

But you think Alfred Kinsey had trouble getting answers in his studies of sexuality? Try getting directors--especially members of compensation committees--to go on the record about executive pay, and you really hit a wall. That's particularly true if someone has the least bit of bad stuff to say: There is still a code of silence among directors that usually makes them unwilling to publicly criticize their peers.

So we came up with an alternative approach: In exchange for candor, we promised anonymity. Seven directors, all with board experience at major companies, spoke to us on that basis. They told war stories; delivered opinions about compensation consultants; and spoke about where executive pay goes from here.

We then compressed what they said, added a few words for clarification, and in a few of the cases made nondistorting factual changes to obscure the identity of the companies the directors were talking about. But we have been scrupulous about presenting their views on how the compensation system works--or doesn't.

As you will see, the directors come from varying spots on the spectrum of opinion, though all believe unequivocally that pay should be related to performance. The trick is in making that happen. The surprise in what many of these directors say--and they are all smart, strong-minded people--is how helpless they sometimes feel in the grip of a system that inexorably sweeps executive pay toward ever higher levels. Said one director defeatedly: "You sort of get rolled over by the system even if you try to do well."

The speaker, who has served on several bigtime boards, is the well-paid CEO of a FORTUNE 500 company.

Compensation committee members are not malevolent. I've seen situations that are f---d up, and yet the directors think they're doing a hell of a job. They delude themselves. They think things are being done right and fairly--they don't think they're being had--when actually the excesses they're approving are just mind-boggling.

On my own board we have very sophisticated people, and we expose the full board to what's going on about compensation. Even so, since I know more than they do about this subject, I can have them. So in a different kind of situation, where the board doesn't know much and doesn't care, it's like shooting fish in a barrel.

It's really "amateurs vs. pros." I'm classing the directors, in most cases, as amateurs, and management, together with the compensation consultants they hire, as pros. You can have a very sophisticated board--and it'll still be amateurs vs. pros.

You say you know instances where tough, rigorous people haven't survived on boards and compensation committees. I don't think that's the normal case. I think that the day of packing the board with patsies is over, if for no other reason than appearances. In any case, the odds are so stacked in favor of management that you don't need patsies.

Yes, a board needs the help of compensation consultants. They are a source of data about what comparable companies are paying, and they provide the board with reassurance. The data is often flawed, but it's better than doing back-of-the-envelope calculations.

I would say that it is unusual to find a consultant who does not end up, at the least, being a prostitute. The consultants are hired by management. They're going to be rehired by management. There's some thought given by conscientious compensation committees to hiring their own consultants. But the consultants don't want to be hired that way, because then they cut themselves off from management.

The government got in all this, of course, by passing what's called "162 (m)," which says that any cash paid an executive over $1 million is nondeductible unless the excess is related to performance. This made everybody change their compensation systems to get around the $1 million ceiling, and in the process they built in new kinds of excess.

They now use performance formulas--based, say, on return on equity--that determine the size of the bonus pool. Most of the formulas are b.s. When you've got a formula, you've got to have goals--and it's the people who are the recipients of the money who are setting these. It's in their interests to keep the goals low so that they will succeed in meeting them. You've got the fox in the chicken coop.

One of the main ways that enormous amounts of money have been made is with up-front options. An executive is issued a huge number of options today, and as the stock goes up, he gets the benefit. It will say in the proxy that this is a "multi-year" option, supposedly taking care of the executive for a while. But the proxies seldom state how many years are covered. And then maybe you'll get two years down the road, and the deal will be renegotiated. So anytime there are up-front options, the shareholders should want it to be very explicitly stated that the grant covers a certain number of years. That doesn't prohibit the board from changing the deal, because the board can always do what it wants. But at least an investigative person like a reporter can go back and find out what was said originally.

What's going to happen in the next ten years? What's happening immediately is that the vehicle of stock options, given the slowdown in the stock market, may not be so lucrative. Still, everybody's appetite has been whetted, and today there's a sense of entitlement. People say, "We're worth it, goddamn it." So if options don't do the job, some other mechanisms will be used instead. And if today's formulas don't produce big enough pots, they will disappear and be replaced by something else. Anyone who is greedy, anyone who is on the make, anyone who is aggressive about what they're being paid will get rid of formulas they don't like.

Government isn't going to change anything. We're not going to turn into Cuba. When you've got some smart lawyer like Marty Lipton working against two members of Congress from Illinois, it's no contest.

I think there's been some progress. There's much more punishment for bad performance than there used to be. I think the fact that they're knocking executives out at a greater rate is good.

But some of what you see is so over the top. There's something intrinsically wrong with some of these amounts of money. I don't know that anything will stop that except self-control. But to ask for self-restraint flies in the face of human nature.

The speaker is a corporate executive who has had wide experience on boards.

When it comes to relating pay to performance, compensation committees are really in the pockets of CEOs. There are all kinds of cozy relationships involved. And when a CEO wants the rules changed as to how people are paid, the rules simply get changed. I think that one of the problems in the whole compensation system is that you pay for performance--and you pay well--but you also pay for subpar performance.

A few years ago I was on the comp committee of a company that had lots of problems. We were having a committee meeting, and the head of human resources said that the CEO doesn't have any equity in his stock options. And I said, "Well, he shouldn't have any equity, because the stockholders have lost a lot of money in this company, and there should be some kind of relationship between what the executives are accumulating and what's happening to the shareholders." Well, the HR director listened, but I think what I said just didn't register with him.

Then there was a case at another company about five years ago in which I took a strong stand regarding a guy who ran a major division. He was the architect of some terrible deals for the company. On top of that he never seemed to have a handle on what was going on. All of his projections for his division were wrong. He underestimated what capital expenditures needed to be. He was way off on growth.

So the comp committee has a meeting to talk about bonuses--and if there was ever a person who didn't deserve one, it was this fellow I'm talking about. Nevertheless, the CEO came into the meeting and recommended that this guy get a pretty good-sized bonus. And I said, "How can you do this? This guy's poor decisions have cost the company billions of dollars. If you're going to pay for performance, you have to have both a carrot and a stick. Basically, this guy should be kicked out of the company. But if he's going to be around, you've got to send a message not only to him but even more importantly to the organization that if someone screws up, they don't get a bonus."

Well, I think the committee sort of agreed with me. But ultimately the others said, "We've got to let the CEO have the authority to run his organization," which I actually think is a bunch of crap. So what happened--and I think this was mainly because of my bitching and complaining--is that the CEO cut this fellow's bonus by half. That meant he ended up getting a reasonable amount for costing the shareholders billions.

I then said to the chairman of the committee, "This stuff is wrong." And he said, "I agree, but we've got to do it." Basically, what people understand they have to do is go along with management, because if they don't they won't be part of the club. You sort of get rolled over by the system even if you try to do well. What it comes down to is that directors aren't really independent. CEOs don't want independent directors.

I think of another comp committee I was on, at a company run by a friend of mine, a good guy. When he asked me to move from the audit committee to become chairman of the comp committee, I said, "We're friends, but you should know that I'll do what's right." And he said, "That's why I want you to have the job." Well, for the two years I was chairman of the comp committee, the company didn't make any money. So I zeroed the CEO out both years--yes, didn't give him a bonus. The first year we gave some bonuses to other people in senior management, but the second year we zeroed everybody out. Our friendship was greatly tested. We're still friends, but we're not close.

The speaker is the CEO of a very successful FORTUNE 500 company.

I've been on nearly 20 boards. But people know I believe strongly that exceptional compensation should be paid only when there's truly exceptional performance, and I've therefore been asked only once to be on a compensation committee. That was not one of the great periods of my life. Management came up with a compensation plan that was terrible for the shareholders. I told the other two members of the comp committee that I would vote against it. The funny thing is that they agreed with me about the awfulness of the plan. But they said that it would undermine the CEO if we voted against the plan, and besides, no matter what we voted, the full board would see that the plan was passed. So they voted to approve this thing and naturally it went through.

I've been on other boards where the CEO earned unholy amounts of money. I don't have any objection to that--in fact, I applaud it--if it's truly earned. There's one case I'm thinking of where if I'd been in charge of the compensation arrangements, which I certainly wasn't, the CEO might have earned even more money than he did--and that was already huge. But what he earned would have been strictly tied to the company's performance, and that wasn't the case with the plan he had.

The scandal of what goes on in compensation is how much is paid in the many, many instances when it isn't at all deserved. But a sub-scandal is the lack of a charge against earnings when stock options are issued. Companies go along as if these things are free, when actually they cost the shareholder enormous amounts. If you think how much more money CEOs have gotten because there isn't an earnings charge for options, it blows your mind.

CEOs will claim it's all deserved, saying, "Look at the way I made my stock go up." That's bunk in a lot of cases, egregiously so at companies that don't pay dividends. Let me refer you to a Treasury zero bond: If you buy one today and hold on for ten years, it will rise by 74%. And you won't even have had to give President Bush an option on the bond.

The test of how much you pay someone is "Do we lose him if we don't pay him this?" In Economics 101, they call this a market system. So why did Ted Turner get options at AOL Time Warner? Is he going someplace else? Or did Oracle think they'd lose Larry Ellison if they didn't give him all those options? Or was Michael Dell going to leave Dell?

A good name for every compensation consulting firm would be Ratchet Ratchet & Ratchet. Any other kind of consultant you can think of is brought in to try to cut costs. The basic goal of compensation consultants is to justify whatever it is the CEO wants to make. After all, who's going to recommend these consultants to other CEOs? Not the little old lady in Dubuque, with her 100 shares, that's for sure.

It's basically what's called a "corrupt system." A corrupt system is where non-evil people do evil things. That's the real problem. If there are corrupt people, you can do something about it. If it's a corrupt system, it's very difficult to do something about it.

I think the best chance for bringing compensation under control would be, say, a dozen really powerful institutions--organizations like Fidelity and Vanguard--stating that they're going to vote against any management that oversteps on compensation. But we haven't seen that happen, and I don't think we will.

The way I see it, the stockholders are going to continue to get screwed. Baseball players will get paid according to their batting average, entertainers will get paid according to the size of their audience, and CEOs will get paid according to a system that scorns objectivity and market forces.

And that will basically be because most directors see what they're handing out as play money. What it amounts to is that there's no one representing shareholders. It's like having labor negotiations where one side doesn't care. That would be a travesty, and this is too.

The speaker is a wealthy financier who has served on many compensation committees.

I have never asked to serve on a corporate board, never even hinted at wanting to be on one. And I have never asked to be on a compensation committee.

I suspect that the reason I've been put on so many is that word gets around that I believe in paying people very, very well. I believe in capitalism in every sense of the word. Every comp committee I'm on, we're saying, "Goddamn it, let's make it worthwhile for people to want to work here." On the other hand, I'm the first guy to get really tough--it's in my DNA--when somebody is doing a bad job. The comp committee is where it all coalesces and you say, "Job well done," or "You did a crummy job, and you're not getting paid."

The reason I believe in paying good people very, very well is that talent is scarce. I'll never understand a guy running a $50 billion business, and doing it well, and the comp committee arguing over whether they should give him an extra $200,000 a year. That's stupid. I recognize that there's got to be some balance and some order to the process. Look at a place like GE, for example. You can't have Jack Welch, even though this guy's done his job unbelievably well, making $100 million and the next guy making $86,000.

You're asking me what the limits are. If it's okay for Welch to get salary and bonus of more than $15 million, is it okay for him to get $50 million? I cannot sit and say to you what the right compensation number is. That's the judgment call, the business judgment call. That's what a board of directors does. Look, if we had a manual that told us what directors should do, we could go to Actors' Equity and hire six or eight very attractive people, take them to Brooks Brothers, buy them suits, and put them on the board.

I won't go on any board of any company unless I'm prepared to invest at least $5 million in it. I suspect that because of my net worth, the compensation numbers that I think of are different from a director who, say, has worked for a bank for 30 years and he's now retired and is making no more than $400,000 or $500,000 a year in pension. And we all walk into a comp committee meeting and I say, "Let's give that guy $10 million. He did a great job." And the other director says, "Ten million dollars? That's all the money in the world!" And I say, "No, it's not."

What are the directors at the other end of the spectrum from me arguing? They're saying, "We have to think about the public image of this thing. We have to worry about what impact this has on people down the line. And about what our customers think."

Horsefeathers! You know what our customers think? Are we selling them a great product at a competitive price, and are we willing to stand behind it? And the lowest guy in the organization? What he's thinking is, "I want that guy's job. If I do as well as that guy did, I'm going to be filthy rich."

What I know most of all is that when I see extraordinary effort and results out of a CEO, you can't pay him enough.

The speaker is a corporate executive with strong opinions about shareholder rights.

Most of the people I talk to think that CEO compensation is kind of out of control. There's the constant ratcheting that goes on. How in the world do you stop that when every self-respecting compensation committee--I just read this once again today in a proxy--says, "We want our CEO's compensation to be between the 50th and 75th percentile in our peer group." If everybody does that, it's Lake Wobegon, where every kid is above average.

Until very recently I was on the board of a company that's vaguely tech in nature, enough so that for a while the dot-coms were coming after our people. In the past we'd been relatively stingy with options. But early last year management said to the board that we should be giving away about three times as many options as we were. And I was a voice in the wilderness on this. The proposal said we'd issue options for stock that had a current market value of $750 million. And I said, "If you do the arithmetic and just say as a rule of thumb that each option has a value of one-third of the market price--I think that's a good benchmark to use--then we're jumping our compensation expense by $250 million!" And I said that wasn't fair to the stockholders.

I suggested we think about giving some amount of restricted stock instead. And two executives immediately said, "We can't do restricted stock. We'd have to run that through the income statement."

So we did the options. But then the company's stock went down and down. And everybody was unhappy because their options were underwater. So later in the year management came back with a proposal that we do another big grant of options. And this time they had a study of their peer companies, showing that the company was just about in the middle on stock performance and earnings performance. And I looked at the numbers and said, "This is baloney. When you've figured earnings here, you've left out that huge charge the company took for our problems this year." Well, they issued the options anyway. It's all pretty depressing.

What's going to happen this year about compensation, generally? I think bonuses will go down--sharply. Companies may award more options to make up the downdraft. They'll say, "I gave good ol' George $2 million in options last year. This year the stock is down 75%, so I'll give him four times as many options." That'll fit what most people want. They say, "You can fiddle with my bonus, but don't cut out my options"--because they know there's the big casino waiting out there.

The speaker is the head of a privately held company.

My views about compensation go back to a brief period in my early life when I worked at a consulting firm and had to do comp work--it's not anything that people volunteer for, or at least I didn't. The joke at this firm was about one company that we got a lot of business from and that, coincidentally or not, had the highest-paid CEO in its industry. And the challenge for our guys every year was, "How do we justify a higher salary for this CEO?"

And then fast-forward to maybe ten years ago, when as a director of a major Fortune 500 company I'm named to the comp committee. This company had several different CEOs during the time I was a director. In my experience, there are few things that CEOs are interested in more than their own compensation. And also it seems that everybody's got his own ideas about comp, or at least that was true in this company, which was not highly institutionalized in terms of structure. So every time a new CEO came on board, there'd be a whole new compensation idea. You jog left, you jog right.

Our view at this company, given that we weren't a spectacular performer in our industry or in terms of management, was to try to keep our people somewhere in the upper half of the compensation spectrum. Since we didn't have world-beating people, the rationale for going higher than that just wasn't present.

Both my consulting days as a kid and my time on this company's comp committee taught me a lot about "in-cen-tive com-pen-sa-tion." What I've come to believe in my dotage is that incentive compensation works fine as long as the people who are incenting have the guts to follow what they say they're going to do--but usually they don't.

An example: We got a new CEO, and he wanted a more modern, competitive comp system. In addition to regular compensation, there was to be a performance-share plan that granted executives stock based on the growth of the company. That was to be midterm compensation. And then there were to be options on top of that.

And I remember saying to the CEO at the time, "Fine, we'll do this. But what you're telling us is that the rules are changed and that you're really going to enforce this." And he said, "Of course, of course. This is a new deal. We're serious. We're going to incent these guys to do a job for the shareholders."

Well, you can imagine what happened. The first year of this CEO we had write-offs. And what he does then is come to the comp committee and talk about all the wonderful things they'd accomplished. And why this guy on his team--why it really wasn't his fault--da-da-da-da-da-da.

So we listened, and we kind of gave him half of what he wanted for his people. We were thinking that the rules had changed and the guys in the organization didn't really understand it--"But you'd better tell them," we said to the CEO. And because he was the one who had proposed this plan, we hit him damn hard in pay right off.

Then the next year, same thing. He had a lot of write-offs and the same line of horse manure. And that year, we hit everybody pretty hard.

So my view of incentive comp of any kind is that it's fine if it isn't just a giveaway program. The pendulum has to swing both ways--and usually it doesn't. A comp committee also hears a lot about external factors, things that couldn't have been anticipated when the budget was being made. People say, "We worked our butts off"--da-da-da-da. And you have to answer, "Look, that was the deal. You agreed to work here for a year under that deal, and if the shareholders get dung, then you get dung."

My view is that the guys at this company were swept along by the general out-of-control executive comp mentality. For the level of sophistication that this company represents, its people were extraordinarily well compensated. A rising tide lifts all boats, and today some very mediocre people are making very nonmediocre income. Or maybe I'm just out of date.

Highly regarded as a CEO, the speaker has served on many boards.

I've had a lot of experience on comp committees. I've seen them run beautifully, when you've had responsible people on the committee and when management, in my opinion, was never aggressively promoting things for themselves.

Once in a good situation like that I voted for something that some people wouldn't think was in the interests of shareholders: At the end of a guy's career, we decided that he'd done such a great job that we gave him a generous option grant. Now most people feel you should only give options as an incentive. But an interesting thing is that good management has a carryover for the future, and of course bad management does too.

The other kind of case you run into on compensation committees is when you have management that is very aggressive financially for itself. I was chairman of a comp committee, and the company's earnings were down dramatically, and there was a relatively new CEO who wanted to get a substantial amount of new options. I wouldn't give him what he wanted, and there were other people on the committee who agreed with me. And very shortly after that, all the people on the board were rotated to new committees. Nobody was told why. I knew why.

I've seen another case where a new CEO got a lot of options when he came. But within months one of his people came to me and said that it would be good to give him more. We said the timing wasn't right. We said the business ought to show some improvement before he got more. A little later, I got the request a second time. I then went to the CEO and said I couldn't do what he wanted, but that if things turned for the better in the business, I'd see that he got the options he was after and even more. And pretty soon the company's performance did improve, and we kept that promise. By the way, he did a superb job. He deserved every dollar.

I don't see the escalation of income and options ending. I guess it's possible the government could take some kind of action. You're not apt to get that with this Administration, but maybe you could with a Democratic Administration. You remember, though, that in the past the government put in limits as to how much money you could pay a chief executive, unless it had some relationship to performance. We've gotten around that beautifully.

REPORTER ASSOCIATE Paola Hjelt

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