Speech by SEC Commissioner:
Remarks Before the 2007 Summit on Executive Compensation
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
New York, New York
January 23, 2007
Good morning. I'd like to thank Scott Bohannon and the entire staff of the 2007 Summit on Executive Compensation for the invitation to join you here. It's great to be here in New York, although given the weather of the past few days, I really wish this were held in Southern California. In any event, before I begin, I must remind you that the comments I make today are my own and do not reflect the opinions of the staff or the other Commissioners.
Let me turn to the topic of my talk today. I'll begin by offering some general thoughts on the SEC's role with respect to executive compensation and my opinions about increased CEO compensation. Then, I'll discuss briefly some steps that boards might take with respect to executive comp, and discuss some legal trends that I think are coming. Finally, I'll close with a brief discussion of stock option backdating. Of course, time permitting, I'd be happy to answer your questions on any topic you see fit.
Before I really begin, let me warm you up with a quick joke about accountants and lawyers two professions that will be struggling very hard to help companies comply with our new executive compensation rules:
A man invites his lawyer and accountant into his office. "Gentlemen," he says, "I have a simple question. How much is two plus two?" The accountant clears his throat and says that he thinks it's probably three or four, but he can't be sure without a full audit. The lawyer says to the accountant, "excuse us please." The accountant leaves. The lawyer goes to the door, opens it, looks both ways up and down the hall, closes it carefully, and sits back down. Leaning across the desk, he whispers conspiratorially, "How much would you like it to be?"
Let me just say that I hope that phrase "how much would you like it to be" is precisely not what boards are asking their CEOs when it comes to executive compensation.
II. General Ruminations
Executive compensation has surely been one of the hottest topics in the business world over the past year. That said, I thought that the focus on this topic was diminishing somewhat, after the initial flurry of news reports regarding stock option backdating and our executive compensation rules. But things then exploded again a few weeks ago with the resignation of Bob Nardelli and the disclosure of his pay package and our pre-Christmas rule release regarding disclosure of the fair value of option grants.
A. SEC's Mission: More Disclosure, Not Less Compensation
I'll begin by noting, as I have before, that the SEC is not in the business of setting compensation, and we will not interfere in the free market for salaries. Rather, our goal is to make executive compensation as transparent as possible, so that shareholders fully understand what executives are being paid. Further, with our new rules requiring a "Compensation Discussion & Analysis" section, it is also our goal to require disclosure of the board's process of setting executive compensation and to have companies explain the board's analysis as to why it settled on the levels of compensation granted.
I'm sure that some are hopeful that the new disclosure rules will have the effect of lowering CEO compensation, and that might be the case, but I'm not sure. Laws and rules have curious unintended consequences. For example, I think most of us recognize that the $1 million legislative cap on the deductibility of salaries for top public company executives, which was added to the Internal Revenue Code in the early 1990s, has been a major reason for the massive growth in non-salary forms of compensation since that time. Further, some have argued that our new rules will actually lead to an increase in compensation, as CEOs, and not just shareholders, will also become more knowledgeable about their peers' amounts and types of compensation, and will want to be paid similarly the "me too phenomenon." Perhaps this will happen, but nobody really knows.
My point is this: any change in levels of executive compensation is not going to come from the SEC. Rather, it is board compensation committees and shareholders who will be the parties to effect any change. Of course, there is sometimes a tension between these two groups, and in my opinion, the balance of power in this regard falls on the side of boards and compensation committees. But that's been changing slightly in recent years, which is something I'll turn to later in my remarks.
B. Thoughts on Increased Compensation
Having offered the caveat that the SEC is not in the business of setting levels of executive compensation, let me note that executive compensation particularly CEO compensation seems excessive to almost all outside observers, including Congress, regulators and the general public. I think we've all noted the statistics on the growth of executive compensation as compared to employee compensation. In 1982, the pay ratio between CEOs and the average employee was 42:1; in 2004, this figure apparently increased to over 400:1. Now, there may be some play in these figures, but I think most would agree that the performance of CEOs over the last 25 years hasn't improved by a magnitude of ten.
I know that the main argument put forth by those that see nothing wrong with these compensation levels is that there's a free market for CEOs, and thus the levels of compensation reflect the workings of the free market. However, I question whether there really is a free and competitive market for executive compensation, particularly CEO compensation. I've made this point before, but to illustrate it this time, let me quote Gregg Easterbrook, who is a visiting fellow at the Brookings Institution, a contributing editor for The New Republic, The Atlantic Monthly and The Washington Monthly, and most importantly, the author of the extremely entertaining "Tuesday Morning Quarterback" column on ESPN.com. Here's Easterbrook's take on Bob Nardelli's compensation package, from a column back in September (before Nardelli's recent departure). So, after first sympathizing with the idea that it might not be fair to judge a CEO by a company's stock price which is a fair point Easterbrook notes as follows: "But sympathizing with the pressure Nardelli is under is no justification for him being wildly overpaid, at shareholder and worker expense. And please don't tell me the prevailing prices for executives justified Nardelli's huge number, because this requires you to argue that there was not one single qualified manager willing to run Home Depot for less than $245 million. 'You're only offering $244 million? Forget it!'"
Let me add my own thoughts to that. Even if Nardelli was far and away the best candidate to run Home Depot and I know that he was considered a superstar candidate when he was hired it seems likely that the Home Depot board probably could have negotiated a little better and brought his compensation down at least a few million. Just my opinion, though . . .
Easterbrook also presents an entertaining analogy to highlight the point that runaway CEO compensation might be due to the fact that compensation committees are often made up of CEOs from other companies, who themselves benefit from higher CEO wages. He writes: "Suppose I was placed on a committee that would vote on Peter King's [from Sports Illustrated] salary. Suppose King would be paid with someone else's money; that there would be no penalty to me no matter how much I voted to lavish on him; and that my next ESPN contract offer would be based on a survey of what football columnists, including King, are earning. I'd vote King a huge increase maybe to $196,000 a day!"
I use this story to make a point, not to condemn boards most are earnestly trying hard to deal with this problem. This example also demonstrates why the so-called free market for CEOs is anything but.
III. The Realities that Will Make it Difficult for Boards to Change the Levels of CEO Compensation
So, while I do think that boards have an obligation to take steps to eliminate unfair and excessive CEO pay and I'll offer a few suggestions in this regard I'm also skeptical that boards, by themselves, will be successful in reining in executive pay. There are a few reasons why this is so.
A. Joining the Country Club
Being invited to become a director is like being invited to join a country club. In my opinion, when boards through their governance or nominating committees select potential director candidates, one major consideration is how the prospective director will get along with the CEO.
This leads to what I call the "ingrate dynamic." Given the relative paucity of director positions at public companies, they are highly desirable jobs, even in the post-Sarbanes-Oxley era, and I would guess that most directors are excited and honored to be nominated. Thus, I think there's a natural tendency for directors not to be an ingrate. How can a director be unappreciative by trying to lower the CEO's compensation (particularly when so many directors are CEOs themselves)?
Unfortunately, I don't think being independent shields directors from the "country club" dynamic. This is not to denigrate the various rules and regulations passed during the past few years requiring increased director and board independence these are important and necessary rules. But that said, I think that independent directors will continue to struggle under huge pressure to award ever-greater amounts of compensation to CEOs.
B. Compensation Consultants The Real Estate Appraisal Phenomenon
Another significant driver of excessive CEO compensation is the use of compensation consultants. I call this the "real estate appraisal phenomenon." That is, when has a real estate appraisal ever come back for an amount less than the contract price of the property? Pretty much never, I think. The property is always worth the agreed-to purchase price.
I think it's pretty similar with CEO salaries. It is extremely difficult to avoid using high comparables, and consultants can pretty much find high comparable income data to support paying a high amount to the CEO. This is the case even if the consultant reports directly to the board.
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In short, there is huge pressure placed on boards by CEOs seeking large pay packages. And, in part because of the reasons discussed above, it is difficult for boards to resist. Add to this the fact that one side is not bargaining with its own money. That is, on the one hand, you have CEOs, who are (of course) immediately and directly affected by their compensation packages, and they make it personal in their compensation pleas to the board. On the other hand, you have the board or compensation committee with fiduciary duties, which I believe are taken seriously by most boards. However, a pay package with stock options and other equity probably does not feel like it is "real" money or hurting shareholders in any significant amount. Given this dynamic, is it any wonder that CEOs have extracted such huge pay packages? So, where does this leave us? In summary, I think that boards will have a difficult time controlling runaway executive compensation.
IV. What Should Boards Do?
A. Their Homework
With that said, I don't want to be completely negative and defeatist as to the ability of boards to control executive compensation. There are many strong boards out there who want to do the right thing. So, I'll offer a few thoughts on what these boards can do. My first suggestion: do your homework, before the executive is hired. The board must investigate and do diligence on the front end, when the executive is hired. If there's an employment contract or agreement even one that provides for termination at will it will be too late to do anything later. In my experience, most terminations are without cause cause is often narrowly defined and limited to things like felonies and other serious misconduct. And termination without cause triggers acceleration of vesting and other large severance payments. Cause virtually never includes stagnant stock price or declining market share and earnings.
The popular press will often jump on the story of how a particular executive has been paid tens of millions in severance pay upon termination, but the real story is that this pay was often contractually agreed to long before the termination occurred. For example, it seems pretty clear that the $210 million package given to Bob Nardelli wasn't an exit package; rather it simply reflected what he was entitled to under his employment contract signed years earlier. Home Depot's Form 8-K states as follows: "Nardelli and the Company have agreed in principle to the terms of a separation agreement which would provide for payment of the amounts he is entitled to receive under his pre-existing employment contract entered into in 2000."
Allen Sloan, from Newsweek and the Washington Post, makes a similar point: "What's truly amazing here is that if you read Home Depot's documents, you discover that Nardelli did not negotiate any special exit package. Home Depot, as best I can tell, is paying him nothing more than called for by the contract that he signed in 2000 when the company 'won' the bidding war to get him."
It seems that many boards truly do not understand the ramifications of their executive compensation decisions, particularly as they relate to severance pay, pensions and golden parachutes upon termination without cause or a change in control. For example, there have been numerous public reports that the NYSE's compensation committee was unaware of significant aspects of Dick Grasso's pay.
The Commission is trying to help in this regard. Generally speaking, I think the breadth and specificity of our new executive compensation rules will have the effect of focusing compensation committees on the details of executive compensation packages. But there is also a specific provision that I think will help. That is, we are requiring narrative disclosure of arrangements that provide for payments in connection with the resignation, severance, retirement or other termination of an executive officer or upon a change in control of the company. Our amendments call for disclosure of the following information, among other things:
- the specific circumstances that would trigger payments or the provision of other benefits; and
- the estimated payments and benefits that would be provided in each covered circumstance.
In other words, companies must give quantitative examples of estimated change in control or severance payments, using the assumptions that the triggering event took place on the last business day of the company's last completed fiscal year and using the closing market price of the company's securities as of that date. This is entirely new disclosure, and I'm hopeful that this will lead to compensation committees actually running the numbers and understanding them before agreeing to specific termination payments.
B. Negotiation Teams
Another action that boards could take is to set up a negotiation team, working for the board and the compensation committee, which is led by a neutral professional whose objective is a fair compensation package. There are many potential options for the composition of such a team, but it could be led by a lawyer (not the company's regular outside counsel, who then has to work for the soon-to-be new CEO) or a law professor who is knowledgeable about executive compensation. And just to show that I'm not biased, it could even be a compensation consultant or a member of the compensation committee. The board, of course, is not relinquishing its duties as the decision maker.
There are a number of principles that this negotiation team should employ and questions that they should answer. I clearly can't present a comprehensive list, but here are a few thoughts.
- First, the team or committee must decide whether it wants to engage in competitive bidding to hire a celebrity CEO. This will obviously impact the negotiation positions of the parties.
- Second, the committee should commit itself to not paying an outrageous amount in total compensation.
- Third, the negotiation team should focus on long-term, sustainable performance, not just quarterly or yearly stock price, EPS or revenues. Of course, there should be adequate compensation for good performance, but good performance may not be related to stock price. For example, the company may find it especially valuable if the CEO keeps a company together in bad times or keeps the stock price or market share from declining in difficult periods.
- Fourth, the committee should concentrate on job jeopardy. As I discussed in more detail above, there should be an increased focus, at the time of hiring, on how much (if anything) the CEO should be paid if he or she doesn't deliver the goods and is to be terminated earlier than expected.
- Fifth, the team should get investor buy-in with respect to whatever package has been tentatively negotiated. Input and suggestions should be solicited from significant investor groups prior to finalization of the package (making sure, of course, to keep Regulation FD in mind). Investors are, after all, the loudest potential critics of that pay package. Further, the committee should be prepared to communicate the theme and rationale for the features of the package to the company's investors. A large package may have justification, for example, if a company has serious problems. These reasons should be clearly communicated to shareholders. The new CD&A offers an obvious place for doing this, and I believe that clear, justifiable reasons will capture shareholder support.
In summary, I think the compensation committee and the negotiation team must be ready, as a viable alternative, to hire someone within the company who has not been a CEO previously. As I previously mentioned, this person will likely be cheaper than a rock-star CEO, and further, he or she probably knows the business much better than does an outside CEO. Of course, every situation is different, and tough times may require a unique person with attendant unique costs. But boards really have to give significant thought as to whether this is appropriate.
C. Compensation Consultants
Let me touch briefly again on compensation consultants. As I alluded to above, there has been criticism of their role in the compensation process, particularly by those who believe that they are contributing to the trend of rising CEO compensation. A large part of the problem, in my opinion, is the perception that compensation consultants are not entirely independent. Once again, the Commission has acted in this regard. Our new rules require disclosure of: any role of compensation consultants in determining or recommending the amount or form of executive and director compensation; the identification of such consultants; a statement as to whether such consultants are engaged directly by the compensation committee or any other person; a description of the nature and scope of their assignment; and the material elements of the instructions or directions given to the consultants with respect to the performance of their duties. I'm also pleased to see that, according to recent reports, companies such as General Electric are responding to shareholders by disclosing even more information about compensation consultants than our new rules require. Let's hope this trend continues.
D. Input from Truly Independent Sources
Earlier in my remarks, I expressed concern about the extreme pressure on boards to pay high compensation to the CEO. Given this, some credible and esteemed body or person must at some point in time say the obvious with respect to CEO compensation: "this is nuts." I'm not completely sure who this might be, but I would advocate pulling together a distinguished group of credible business leaders, academics and former public servants perhaps sponsored by institutional investors, foundations or academic organizations to look at the issue.
Of course, I'm not sure what this group's ultimate recommendations would be, but they might come to a conclusion such as: "CEO pay should not exceed (gasp) 200 times the average line worker's." The group could retain consultants on an industry-by-industry basis, and suggest appropriate severance packages in the event that the CEO doesn't perform up to expectations. I would also suggest that this group look to international norms when making recommendations. The key is that entire companies should share in the wealth creation; not just a few people at the top who are getting paid whether or not the company does well.
V. Future of Executive Compensation Shareholder Advisory Votes
Finally, I think that boards should consider carefully giving their shareholders an advisory vote on executive compensation. Specifically, I'm referring to the ability of shareholders to have an advisory, non-binding vote on a company's compensation report. While this is not required in the U.S., it is a right that shareholders in the United Kingdom and Australia have. I'm not advocating that we adopt this in the U.S., but I am saying that the idea deserves study.
So far, I don't think this issue has hit critical mass. It wasn't a part of our executive compensation release, and only a handful of commenters but large, thoughtful and influential ones raised this issue during the comment process. That said, I do think that the topic of shareholder advisory votes has gained significant traction over the past year or so, and I'm pretty confident that this could be one of the new hot-button topics in proxy proposals.
It's also starting to hit the mainstream media Gretchen Morgenson of the New York Times ran an article on it this past Sunday. In her article, Morgenson quoted Charlie Munger, vice chairman of Berkshire Hathaway, who apparently voiced his thoughts on executive pay in an interview with The Los Angeles Times this month. Mr. Munger noted that our current system of executive pay, "'with its envy-driven compensation mania, has developed to a place where it brings out the absolute worst in good people" and that if "more executive compensation issues required shareholder approval, I think that might dampen some of the excess." Munger admitted that there was some risk in requiring shareholder approval. He stated: "There are also a lot of malcontented nuts in the world, and you wouldn't want the malcontents to get too much power." But I don't think that having shareholder advisory votes would allow the malcontented nuts to get too much power. After all, these votes are only advisory, and further, malcontents probably don't own over 50% of a company's stock.
While I'm sure that the natural inclination of companies is not to allow such advisory votes, I think there are some distinct positives. First, it fosters dialogue with and feedback from investors, and it gives shareholders a sense of empowerment without a company actually being bound by anything. Although these are no doubt intangible benefits, they are also real and will likely lead to better relations between boards and shareholders, and they might perhaps also head off a proxy contest.
Further, there appears to be some evidence that this may have some effect in curbing excessive executive pay. For example, one study in the United Kingdom found that executive pay is declining, and another article noted that the typical British CEO makes only a little more than half of what the typical U.S. CEO makes. Of course, this might not be due to shareholder advisory votes, given that this is a relatively new concept even in those jurisdictions. But I think boards and compensation committees might be able to use advisory votes to their advantage here because it provides cover for the compensation committee and the board as a whole. Take, for example, a situation in which a company that has agreed to shareholder advisory votes is negotiating with a prospective CEO. It seems to me that the presence of a shareholder advisory vote gives the board greater bargaining power to say to the potential CEO: "Look, it's not just the board that you're negotiating with we also submit our executive compensation packages to our shareholders for an advisory vote. We really don't want an adverse vote, and therefore, we're simply not willing to give you an exorbitant package."
Now, this scenario may be a pipe dream, but I do think that shareholder advisory votes are the future of executive compensation, and I'm sure there will be a substantial upswing in proxy proposals in this regard. Given this, companies should strongly consider whether to be proactive and to adopt such policies before they are forced to put them in their proxy materials.
VI. Stock Option Backdating
Let me conclude with a brief mention of stock option backdating, which is still a fairly hot topic on the executive compensation front. The Commission is addressing this issue on two primary fronts, which I think stem from our dual role as an enforcer of the federal securities laws, on the one hand, as well as a regular and a facilitator of the nation's capital markets, on the other hand.
On the enforcement side, our Enforcement division is investigating over 100 companies that may have engaged in the improper backdating of options. While each case presents its own facts and circumstances, the Commission will not hesitate to bring an Enforcement action where one is warranted. We have already authorized cases against former executives from Brocade and Comverse, and we've reached settlements with two former Comverse officials. As yet, we have charged only officers in option backdating cases. However, if the specific facts are present, it wouldn't surprise me to see charges brought against outside directors.
On the regulatory side, we issued guidance in our executive compensation release as to the types of disclosure that must be made with respect to the timing of stock options. Further, we recognize that not every case in which stock option paperwork is less than 100% correct presents grounds for an Enforcement action. Indeed, our Office of Chief Accountant has made public a letter to the AICPA that gives guidance with respect to stock options, and I know that some companies have found this reassuring. Further, just last week, our Division of Corporation Finance posted a sample letter on our public website, which contains filing guidance to companies who are faced with restating multiple years for errors in accounting for stock compensation.
At its heart, however, stock option backdating and timing, whether or not the SEC brings an Enforcement action, is a serious issue. Coming on the heels of the scandals of a few years ago, it highlights the fact that there is still a significant trust issue between boards and shareholders. Option backdating and undisclosed option timing has the effect of transferring wealth from shareholders to employees. Now, it may be that employees are better incentivized by being granted in-the-money options, but this doesn't excuse blatant backdating, and option timing shouldn't be hidden from shareholders. Our Enforcement actions and regulatory initiatives will hopefully shed some light on this subject, and make option granting processes more transparent.
I'd like to thank you for your time and attention. I'd be happy to answer any questions.