The Sec's Ceo Pay Plan: No PanaceaDean Foust
"If executive pay is going north while performance is going south," says Richard Koppes, a California state pension-fund executive, "something is wrong." By that standard, something is deeply wrong in many corners of U.S. business: Executive pay keeps spiraling into the stratosphere even at poorly performing companies.
The Securities & Exchange Commission thinks it has a remedy. On June 23, the commission proposed new proxy rules that would force companies to provide shareholders with clearer details about how executives are paid and how that pay relates to the company's stock performance. The SEC reforms "could force a dramatic change in how boards set executive pay," says Ralph V. Whitworth, president of United Shareholders Assn.
But before shareholders celebrate a victory, they may want to think about the possible unintended consequences of linking executive compensation to stock price. Some experts who have studied companies that tether pay closely to performance have isolated some worrying trends (table).
BAD OPTIONS? Consider a study by three professors at schools in Nebraska. It looked at 324 companies that adopted stock-option plans for executives in 1978. Over the following five years, the managers trimmed spending on research and development by 10%, sometimes in favor of risky new ventures. Shareholders "suffered more risk, but didn't get a better return," says Richard DeFusco, a University of Nebraska finance professor. He and his colleagues discovered that the average return on assets dropped from 12.45% to below 9%. And profits fell from 102% of the average of similar companies to 92%.
Research by Richard G. Sloan, an assistant accounting professor at the University of Pennsylvania's Wharton School, makes a telling point. Sloan studied 58 drug, chemical, and technology companies that tied pay to performance. He found that in the five years before CEOs retired, companies cut back on R&D and advertising. Sloan's inference: The CEOs were trying to boost their earnings, bonuses, and retirement pay.
It's hard to argue with higher earnings and stock prices, but Meredith Corp. Chairman Robert A. Burnett, who was at the center of a pay flap as head of ITT Corp.'s compensation committee, is wary. Linking pay more closely to stock price, he warns, "is just giving an invitation to management to manipulate figures and actions."
DRIFT. Take Ralston Purina Co. In 1986, directors of the St. Louis-based consumer-goods maker agreed to award management nearly half a million shares if the stock closed above 100 for 10 straight days. What did Ralston executives do? Management used borrowed funds and much of the company's free cash flow to buy back nearly one-third of Ralston's shares. Ralston's stock price, adjusted for a two-for-one split, doubled, to 116 1/2.
That was fine for executives--and shareholders--in the short run. But since January, Ralston's stock has drifted down to a split-adjusted 91. Analysts fault the company for excessive financial engineering and a lack of attention to core businesses. A Ralston spokesman says the pay plan and management's later actions "have been beneficial to shareholders."
The SEC reforms are welcome--they could even slash some megasalaries. But it's not at all certain that corporate performance will grow. For shareholders, the price of a well-run company will still be eternal vigilance.
A CLOSER LOOK AT EXECUTIVE PAY Academic studies suggest a higher stock price doesn't always mean a better company. Here's why: RESEARCH DECLINES One quick way to boost a company's stock price is to cut R&D spending. But corporate performance suffers from a lack of new products ROA DROPS When companies link pay to stock performance, return on assets declines, both in absolute terms and when compared with similar companies THE CEO TINKERS Since the chief's retirement pay often is pegged to his or her earnings in the last years on the job, some will go to great lengths to produce big profits just before retiring DATA: BW