Fortune Magazine
by Geoff Colvin
April 15, 2008: 5:29 AM EDT
Email | Print    Type Size  -  +

Rewarding failure

CEO pay has risen faster than corporate profits, but there are major obstacles to changing the system.

By Geoff Colvin, senior editor at large

reward_illo.03.jpg

Fortune Magazine -- You might suppose that the stars are in near-perfect alignment for major reform of CEO pay. The mammoth pay and disastrous performance of Countrywide Financial's Angelo Mozilo, Citigroup's Chuck Prince, and Merrill Lynch's Stan O'Neal should be enough to make the public furious.

Each CEO departed with $100-million-plus compensation after misadventures with subprime mortgages. Now add the economic slowdown to the mix; ordinary Americans are worried about making ends meet while failed pooh-bahs rake it in. Then throw in one more element - a presidential election. Put it all together, and how could change not be imminent?

The answer is that whatever remedies reformers enact, corporate boards can always find a way to pay the boss whatever they like. Over the past 25 years CEO pay has risen regardless of the economic or political climate. It rises faster than corporate profits, economic growth, or average workforce compensation.

A recent study by the compensation consulting firm DolmatConnell & Partners found that CEO pay in the companies of the Dow Jones industrials increased at a blowout 15.1% annual rate over the past decade.

A more sensible alternative to the current compensation system would require CEOs to own a lot of company stock. If the stock is given to the boss, his salary and bonus should be docked to reflect its value. As for bonuses, they should be based on improving a company's cash earnings relative to its cost of capital, not to more easily manipulated measures like earnings per share. They should not be capped, but they should be banked - unavailable to the CEO for some period of years - to prevent short-term gaming.

Proxies are telling

To see why that is unlikely to happen, check out this spring's crop of corporate proxy statements, which are still being filed. You'll note that this year many companies are reporting the specific performance targets on which CEO pay is based - saying not just that pay is based partly on free cash flow, for example, but reporting the amount that must be achieved.

Companies are doing that because the SEC is making them. But by wangling pay formulas in a dozen ways, they can still pay CEOs as crazily as they like. Look, for example, at one of America's legendary pay abusers, Occidental Petroleum (OXY, Fortune 500). Its latest proxy is full of impressive-looking targets and formulas, but the bottom line is that the company has consistently paid CEO Ray Irani huge sums ($110 million for 2007) during his 17 years at the top, regardless of performance, which has mostly been terrible.

Even the way boards are elected appears immune to reform. Why? Since the number of board candidates exactly equals the number of vacant seats, shareholders who don't like a candidate can only "withhold" their vote, so even one vote is enough to get a candidate elected. A popular reform proposal would require a majority of votes cast. The theory is that directors who could get voted off the board will more zealously serve shareholders - and that includes getting tough on CEO pay. But the worry is that they'll adopt the go-along-to-get-along culture of many boardrooms.

It may seem obvious that CEO raises will have to slow down, if only because of simple arithmetic. Pay that gallops ahead far faster than the economy is one of those things that can't go on forever. If it did, then someday the entire GDP would be used for paying CEOs, and that isn't likely.

Meanwhile, let the reformers battle on. One of the most prominent, Nell Minow of the invaluable Corporate Library, which rates board effectiveness, says, "My colleagues and I have found that there is no more reliable indicator of investment, litigation, and liability risk than excessive CEO compensation."

Boards that can't manage to pay the CEO properly are damaging the company, punishing the shareholders they represent, and weakening America in a global economy. It's in everybody's interest to turn them around - or at least to keep trying.  To top of page