HOW TO PAY THE CEO RIGHT As the furor widens, America's business chiefs and corporate boards can fix the system -- or let Washington whack at it.
By Geoffrey Colvin ) REPORTER ASSOCIATE Stephanie Losee

(FORTUNE Magazine) – CEOS ARE PAID a lot to face facts, however unpleasant, so it's time they faced this one: The issue of their pay has finally landed on the national agenda and won't be leaving soon. It is now inevitable that someone will do something about it, and one of the fiercer dramas of the next several months will feature Congress, the Securities and Exchange Commission, the accounting profession, and the CEOs themselves battling over who that someone will be. The fight has already begun. Anyone can tell you what the problem is. Just ask your neighbor or cabdriver -- then stand back. Largely unharnessed from corporate performance, the pay of America's CEOs has been galloping forward faster than the average production worker's pay, faster than corporate profits, industrial production, the national debt, the population of India, channels on cable TV, or just about anything else on earth but the number of newly independent republics. The CEOs of 282 large and medium-size U.S. industrial companies studied by the Hay Group consulting firm earned, on average, $1.7 million in total compensation last year; in the 30 largest, some $3.2 million. Maybe if the economy were thriving and big employers were hiring, no one would care. Maybe if President Bush hadn't taken the auto company CEOs to Japan to meet their lower-paid, more successful competitors, or if consumer confidence weren't in the tank, or if giant companies weren't still announcing vast layoffs, CEO pay wouldn't be on the front pages. But all those things have happened, making Americans deeply, bitterly mad and creating an issue no politician can resist. When a conservative like Dan Quayle rails against ''those exorbitant salaries paid to corporate executives unrelated to productivity,'' something's up. The issue should only get hotter as proxy statements detailing executives' 1991 compensation go out to shareholders in the next few weeks, about the same time as several of the most important primary elections. The Securities and Exchange Commission, among the first to act, recently reversed its longstanding practice by allowing shareholders a nonbinding vote on corporate pay policies. The commission is considering requiring fuller disclosure of executive pay in proxy statements, and Washington could go still further. SEC Chairman Richard Breeden says, ''God only help us if the government gets in the business of trying to regulate compensation. It is the board of directors' job, and I would warmly and strongly recommend them to please do it -- because if they do not, then someone will call on us to do it.'' Who's to blame for all this? That's easy: CEOs. A pedant might insist that boards of directors are the culprits, since they set top executives' compensation. But in practice most CEOs appoint their own directors, presenting only their nominees to the shareholders for a vote. Besides, 63% of all directors are CEOs. Face it, fellas: You got yourselves into this mess. Now it's time to get yourselves out. Fixing CEO pay is a two-level challenge. Level one is devising a pay plan that works; many innovative companies -- Georgia-Pacific, Avon Products, Becton Dickinson, and several others -- are exploring new ways to link pay and performance. Level two -- much harder to reach -- is getting boards of directors to adopt those smart pay plans instead of the stupid ones they so often favor. The bedrock principle of paying the chief is aligning his interests with the shareholders'. Sounds simple enough. But the favorite instrument for doing that over the past 40 years, the beloved stock option, turns out to be full of problems. That fact guarantees conflict ahead, because options have been the main engine powering the hypergrowth of CEO pay since the Eighties. In 1985 the typical CEO of a fair-size American industrial received long-term incentives, mainly options, with an estimated value of $58,000. Last year it was over $527,000. Base salary, bonus, perks, benefits -- each figures in, but not like options. They are the form of compensation getting the closest scrutiny from Congress, the SEC, and the accounting profession. A standard option gives an executive the right but not the obligation to buy company shares for ten years at the market price on the day the options were granted, though usually he must wait two to four years before he may exercise them. The incentive seems straightforward: The executive will work like mad to maximize his wealth by raising the stock price, and shareholders get the benefit.

Trouble is, it doesn't work very well. Options can be employed intelligently and effectively. But because they have built-in flaws and are often abused, their record of linking executives' interests with shareholders' is far from good. One reason is that the optionee doesn't put up any money. For most ordinary investors, the fear of loss is at least as strong a motivator as the hope for gain, but recipients of options face no risk. If the stock rises, terrific; if it falls, they simply discard the worthless things. As compensation consultant James F. Carey puts it, ''From the participant's viewpoint, the option grant may seem like a no-risk wager in a game of craps called 'the market.' '' The CEO with options has another advantage over the ordinary investor: inside information. Knowing the company's prospects more intimately than anyone, he has a far better chance of choosing a peak in the stock price to exercise options and take his profit. There's nothing illegal about this. That's just the way it is. And that is how options work when companies play fair. Many play otherwise. Suppose a company issues options to a CEO when the stock is at $50, and it then falls to $30. You might think it's only right for the optionee to be out of the money in that case, but some compensation committees instead take pity on him. They cancel those options and replace them with new ones at $30. America's champion option repricer is Apple Computer. ''They're worldclass,'' says Ralph Whitworth, president of the Washington shareholder rights group United Shareholders Association, with bitter admiration. Apple has repriced executive stock options six times since 1981, with two repricings affecting options held by CEO John Sculley. As a result, he has earned gains on those options before investors who stayed with the stock earned a dime. Venture capitalist Peter O. Crisp, chairman of the compensation committee of Apple's board, won't comment on the repricings. The bottom line is that when compensation expert Graef S. Crystal examined the option gains of 281 CEOs vs. the performance of their companies' stocks in the 1980s, he found scant correlation. Chief executives could often wring substantial option gains out of shares with merely middling long-term performance. In short: Options on average do not put CEOs in the same boat as shareholders, or even in the same body of water. So why do boards of directors award them in such superabundance? Mostly for a few reasons, none of them good but all of them powerful. One is the near- magical way options are treated in a company's financial statements. Pay a CEO in cash, and that money becomes an expense that reduces profits. But give < him a stock option, even a mammoth option that may one day pay him tens of millions, and under the rules of accounting, reported profits do not decline 1 cent as a result. On the corporate income tax return, however, options do have an effect: They eventually create a deduction if they turn out to be worth something. When an employee exercises his options, tax rules recognize that his gain is value the company has given away -- after all, it could have kept those shares and sold them later at a higher price -- so it is tax deductible. ANOTHER extraordinary feature of options is that their value is almost never fully reported to shareholders. Stock options most assuredly have value, even though any option's precise payoff is uncertain until it is exercised. A company's annual proxy statement reports top-executive option grants but gives no hint of what those options might someday be worth -- a value that can be estimated through several techniques. Yes, the proxy will also report the CEO's gain when he exercises options, but only if he is still an officer. Consider a few related facts: Most options are good for ten years; most CEOs hold that job for less than ten years; most options can be exercised for three years or more after an optionee retires. Shareholders never know about most of a CEO's option profits because he takes them after he is no longer an officer. Now imagine you're a corporate director when profits are under pressure and CEO pay is a bare-wire issue. At the February board meeting do you vote the CEO an extra million dollars in salary and bonus, which will reduce profits and increase his compensation as reported in the proxy statement? Or do you give him options that are worth perhaps two or three times that much, will not affect profits, may reduce the company's taxes later, and will not show up as a dollar amount in the proxy? This may be where the phrase ''no brainer'' originated. All in favor say aye! If the financial treatment of stock options seems crazy to you, you're not alone. The SEC, Congress, and the rulemakers of accounting have all recently begun considering changes that would wipe out the striking attractions of options. And many CEOs are steaming. At the top levels of giant companies, meddling with the boss's pay is known as ''playing with the sheriff's daughter.'' SEC Chairman Breeden has directed his chief accountant to report by mid-June on ways companies might be required to calculate a dollar value for option grants, which would be reported in proxy statements. Some of these valuation methods make your temples throb, but a rough rule of thumb for ordinary ten- year options is to take the grant's face value -- number of shares times exercise price -- and divide by three. Senator Carl Levin (D-Michigan) has introduced a bill that would, among other things, make companies value option grants and reduce reported profits when they award them, just as when they award other forms of compensation. Much more significantly, the Financial Accounting Standards Board, which sets accounting rules, has just shoved to the front burner a long-simmering project on the treatment of options. If the board concludes -- as it well may, and should -- that giving options involves an expense, the effect on CEO pay could be enormous. The directors' no-brainer isn't so simple anymore. Financially, options are the one big freebie in the world of pay, since you can award all you like and never reduce reported earnings. But if the accountants start charging for them, you can be certain companies won't use them as much. It is even conceivable that some CEOs' pay could go down. If you think CEOs don't worry much about this technical accounting stuff, consider what happened the last time FASB tried to tackle the issue of options, in the mid-1980s. It never even got a chance to write a proposed rule. Scores of high-powered CEOs -- ''not the people who normally write in on accounting matters,'' recalls a former board member -- came down like a ton of bricks with strongly worded letters, many not bothering to give reasons, according to people who have read them. The simple message: Drop it. FASB tabled the matter for four years in favor of others it decided were more important. And this time? ''The forces of opposition have not quite been marshaled yet,'' said FASB Chairman Dennis Beresford on the day the board stepped into the ring for Round Two. ''But they will be.'' And where will these forces come from? One place to look is the Business Roundtable, the club of CEOs from 200 of America's largest companies. It has been feuding with FASB for years and lost no time staking out a position on this issue. Executive stock options, it believes, are just about the greatest thing for America since microwave popcorn. In a statement so audacious it makes one's head swim, the Roundtable claims that the bull market of the 1980s is proof that stock options work. Options did multiply enormously in those years, but most compensation consultants say cause and effect were just the opposite: Boards saw the market taking off and jumped to ladle out more options. THE WHOLE IMBROGLIO is a shame, because options, for all their problems, can be useful incentives if adapted and applied with rigor. Directors courageous enough to demand real performance from a CEO can, for example, index the option's exercise price to some target return they want to beat -- the stock market's, an industry peer group's, or the rate on Treasury bills, for example. Becton Dickinson, the New Jersey medical technology company, did that last year when it adopted a plan that sets executive option prices for the next four years according to the performance of the S&P 500. The board grants options each May, and if the S&P has outperformed the stock since the last grant, then the exercise price of new options is set higher than the actual share price. That will give CEO Raymond V. Gilmartin and his top officers a windfall if Becton stock has beaten the S&P but will leave them struggling to catch up if it has fallen behind. That element of risk tied to the stock's performance is key to effective CEO pay, say most compensation consultants. A little imagination can find all sorts of ways to create it. One, similar to indexing but simpler, is to set an option's exercise price way above the market and then just sit back and watch the CEO try to beat it. The best example is the 1.8-million-share option granted to Time Warner co-CEO Steven J. Ross two years ago at $150 a share when the stock was at $118. The grant could still earn him a vast sum, but with the stock currently around $105, Graef S. Crystal calculates there's about a 40% chance it will never earn him a thing. Another effective way to add risk is to substitute some form of stock compensation for cash. That's still unusual; the story of CEO pay over the past few decades is a tale of clever but riskless incentive plans piled ever higher as consultants thought them up. Each one, intended to motivate the CEO afresh, simply tossed him another no-lose way to make a bundle. But taking away old-fashioned cash and putting some form of risky stock in its place -- that focuses the mind. Avon has just done this in a new plan to be described in its proxy statement due out any day now. CEO James Preston, working with Goodyear CEO Stanley C. Gault, who is chairman of Avon's compensation committee, came up with a plan that freezes Preston's base salary for the rest of his career -- he'll be 65 in seven years -- at $610,000 annually. His target bonus had been 65% of that but is now reduced to 50%. In return for giving up seven years of raises, which at a modest 10% annually would have lifted his salary to nearly $1.1 million by retirement, plus giving up part of his bonus, he gets a one-time grant of options on 50,000 shares. Because Preston's salary is frozen, those options have a hurdle built in. Preston has been telling the world that Avon can increase profits 10% to 12% annually for the next three to five years. If that happens, and the stock rises in tandem, then Preston's gain on his options will merely equal what he gave up in expected raises and bonuses. In other words, to come out ahead, Preston will have to beat his own projections for the company. That's incentive. Note that the plan is not fancy. Yet it more than satisfies major institutional shareholders who have been ticked at Avon for beating back four takeover attempts in three years. Preston meets twice yearly with representatives of these shareholders, and Ralph Whitworth of the United Shareholders Association came to last November's gathering ''loaded up to talk about compensation,'' he says. But Preston preempted the attack by announcing his new pay plan first. ''Jim and I have talked about compensation for years,'' says Gault. ''At Goodyear the vast majority of my reward will be directly tied to stock. It's not a surprise that Jim would want his compensation on this basis.'' Preston explains how the plan has affected him: ''I have an incredibly vested interest in shareholder value. My focus is on making myself and thousands of others wealthy.'' To see a sophisticated and effective use of options, check the pay plan at UGI, a diversified gas and electric company in Valley Forge, Pennsylvania. When James Sutton took over as CEO in 1986, UGI ranked 23rd in a group of 23 peer companies on the basis of total return to shareholders over the previous five years. To turn things around, Sutton and his board decided to replace a jumble of long-term pay plans with a single option plan. He and his top officers would get option grants, and then no more options for five years. During that time the substantial dividends associated with the option shares would be placed in a special account for each officer. After the five years -- which ended last December 31 -- the officers could get their dividends according to how UGI ranked in its peer group based on five-year total return. If it ranked No. 10 or below, they would get nothing; if No. 7 through No. 9, they would get 50% of the dividends; if No. 2 through No. 6, 100%; and if UGI ranked No. 1, they would get 160%. When the big day came, UGI ranked No. 2 (after Indiana Energy), with a five- year compound average annual return of 17.2% -- far better than the stock market. Sutton collected $1.5 million. After paying taxes, he invested the rest in UGI stock. All his top officers did the same. ''We wanted a high-risk, high-reward plan,'' he says. ''It caused us to take a long-term view. Every time we looked at a major project or strategic decision, we ended up reducing it to shareholder value.'' GEORGIA-PACIFIC recently adopted a different sort of stock-based incentive. At the instigation of CEO T. Marshall Hahn Jr., the company abandoned stock options for top officers in 1988, replacing them in 1990 with outright grants of stock carrying some tight restrictions. If the stock rises 20% from a $50 base (about $8 higher than the actual price when the program started) and stays at that level for 20 consecutive trading days, the officers get 20% of their grants. If it rises 40% and stays there for 20 straight days, they get 40%, and so on. After five years the program ends and the officers can receive up to 100% of their stock grants -- if the stock has doubled. They must hold for at least five years whatever stock they get. Wall Street analysts who follow the struggling paper industry like the plan. Says Chip Dillon of First Manhattan: ''It gives management more incentive to do what's in the interests of the shareholders.'' Design such a plan without sufficiently high hurdles and you're asking for trouble. Ralston Purina's board told CEO William P. Stiritz and his top officers in 1986 that if they could get the stock up 60%, they would collect large helpings of it. The job took five years, and Stiritz collected $16 million of shares for a performance that barely exceeded the market's and failed to match the food-processing industry's. The plan did exactly what a good plan shouldn't: pay big for subpar performance. Stiritz won't talk about it, but Ralston has said in a prepared statement that the plan ''was appropriate for the company at the time and has achieved cost-effective results.'' The common element in well-designed plans is getting a lot of stock into the CEO's hands and making sure it costs him. It could cost him years of raises, as at Avon, or it could cost him a pay cut. That's what happened at International Multifoods in Minneapolis, where CEO Anthony Luiso asked the board to trim his cash compensation by $200,000 a year for five years in return for stock options of equal value. Such reforms could even cost the CEO money out of his checking account. A number of compensation experts think a smart board might simply set a stock ownership goal for the CEO and tell him to reach it any way he wants -- by exercising old options or by calling up his broker. In any case, whenever a CEO exercises options the board should insist that he sell only enough of the shares to pay the taxes -- and hold the rest. That doesn't just sound like common sense; it also is in sync with research by consultant Ira Kay of the Hay Group, who has found that the more of his company's stock a CEO owns, the better the company performs. But wait. Isn't this just a bit draconian, making the CEO live and die by the stock? After all, researchers have shown that most of a stock price's movement results not from the actions of managers but from the movement of the market. Is it really fair to make a good, hardworking corporate chief suffer when the inscrutable market moves against him? Sure it is, say investor rights advocates, who point out that when the stock goes down, investors suffer and employees often suffer, so why shouldn't the CEO suffer too? A better response is that ''suffer'' is perhaps not the mot juste here. No CEO of a large American company is going to suffer, as most people would understand that term, no matter what the stock does, thanks to two little items called base and bonus. In major companies these generally furnish a million or two annually to keep body and soul together no matter how chill the wind on Wall Street. Preston of Avon, whose base salary is barely average for a company with sales of $3.6 billion, maintains a wry sense of perspective on the matter: ''I have a safety net of $610,000, and believe me that's more than adequate. My family and I have agreed that no matter what happens, we'll squeak by.'' In truth, salaries are not much of an issue in the furor over CEO pay. They account for only about one-third of total compensation, and finding one much above $1 million isn't easy. That's a lot of money, but it won't get you on a magazine cover or denounced on the Senate floor. Bonuses are another matter. The practice of awarding them ''at the discretion of the board'' is an invitation to negate all the good intentions of a pay-for-performance plan. To avoid this, many companies set explicit targets -- for earnings, return on assets, or some other measure -- that will trigger a bonus, and stick to them. At UGI, James Sutton received no bonus in 1990 or 1991 because abnormally warm weather cut demand for gas and electricity, which clobbered earnings per share. Is that fair? ''Life isn't fair,'' he shrugs. Varying this approach, some boards set the bonus as a flat percentage of profits. Reebok famously did this for CEO Paul Fireman when the company was tiny, and as it mushroomed his bonus did too -- alarmingly -- exceeding $15 million in 1987. Disney CEO Michael Eisner gets a profit-based bonus, $4.7 million in fiscal 1991. So does Time Warner's Steve Ross. While the 1991 amount hasn't been announced, it will be larger than last year's $2 million because operating profits were higher. The danger in the focus on profits is that it zooms in on just one accounting measure, one that a clever CEO may be able to manipulate, perhaps to the detriment of the company. It may be ''too easy to kite,'' as Stanley Gault says. So there's no easy, mechanical approach to calculating bonuses; fickle as the board's judgment may be, you've got to rely on it. WHICH LEADS to the great big question in the world of CEO pay: How do you get the board to do the right thing? Even if you devise the most brilliant compensation plan ever, why should the directors adopt it? Because their job is to discipline management for the good of the shareholders? Remember that effective CEO pay plans always involve a hefty risk -- something many CEOs, like most other people, don't like. Remember also that CEOs in essence appoint the directors to their prestigious positions and usually recommend their pay. These directors are not naturally eager to hold the CEO's feet to the fire on compensation. Note that not one of the well-designed pay plans cited here was imposed on a CEO by his board. On the contrary: In each case a confident CEO approached the board saying, ''I'm willing to take on more risk if you'll give me a shot at some extra reward.'' Such cases are rare. Countering the temptations for a director to go easy on CEO pay are a few building pressures to get tough. One is the threat of legal action. Directors seldom get sued for overpaying the CEO, but it happens, and in the current climate it could happen more. Fairchild, a miniconglomerate built around the old Fairchild Industries, last year settled a shareholder suit alleging that directors overpaid CEO Jeffrey J. Steiner. His salary and bonus totaled $6 million in 1990, when the company earned only $1.5 million. The settlement cuts Steiner's salary, restricts his bonus for five years, and cancels options on 50,000 shares. Institutional investors, the wakening 900-pound gorillas of corporate life, are turning their attention to CEO pay. A group of them, including the formidable California Public Employees Retirement System (Calpers), last year went after ITT and won its agreement to tie CEO Rand Araskog's pay more closely to the performance of the stock. That was only one company, but the ugly publicity it endured has probably frightened many others into changing their ways. As the public grows more fascinated by CEO pay, the threat of personal embarrassment or shame may be one of the strongest forces building up on directors. Time was when they scarcely had to explain their actions to anyone. But when Mike Wallace pushes a microphone under your chin, you'd better have something to say. LESS CONCRETELY but just as certainly, the spirit of the times is having its effect. These are the frugal Nineties, and directors can feel it. The zeitgeist has often influenced CEO pay, which hasn't always advanced at its recent breathtaking clip. A couple of decades ago it increased more slowly than the pay of factory workers. Jude Rich of Sibson & Co., one of America's most respected compensation consultants, says the bull market in pay that's still going on began around 1975. That was a time when the larger culture was throwing off self-restraint everywhere. Significantly, it was also around the time federal courts freed baseball players from indentured servitude by invalidating the reserve clause. Don't laugh: Many pay experts agree that when 20-year-old shortstops started making more than CEOs, everything changed. If pay practices are improving now, it's because CEOs and directors are feeling the heat of public outrage. It should burn steadily through the proxy season, and the presidential election will keep it alive for a while afterward. And then? Real reform, if it's to happen, will have to occur hundreds of times in boardrooms across the U.S. That is necessarily a touch- and-go proposition. Revolution may seem to be in the air, but never underestimate the power of chief executives who would really rather not change the way they're paid. Like CEOs, the rest of the country must face facts, however unpleasant: If a recovering economy or some other issue quenches the outrage and eases the pressure, there's no assurance that anything significant will change at all.