KEY POINTS:
There is widespread unrest among shareholders across the world about CEO pay.
As our own NZX can testify, considerable investor and media scrutiny is now coming to bear on remuneration of chief executives. Boards should expect more of the same in the future.
In 1970, the remuneration of the top three executives in large US corporates was around 40 times the average wage. Thirty-five years later this had risen to 160 times, while the last two years have seen it grow to 400 times.
An Australian study shows CEO salaries in top-50 companies leaping from 27 times average earnings to 98 times in the 10 years to 2002. Anecdotal evidence suggests the trends in other English-speaking countries are being replicated here.
While some CEOs warrant 27 times the average wage, a small number 98 times and a very few perhaps even 400 times, such disparities are always going to be attention-grabbers.
Concerns are also raised when comparisons are made with shareholder returns.
An Australian Council of Superannuation Investors' study of CEO salaries in the top 100 listed companies showed that over a five-year period there was a 73 per cent increase in base pay and a 59 per cent increase in bonuses, versus a total return to shareholders (TRS) increase of just 42 per cent.
Shareholders of all shapes and sizes, like much of the general public, are increasingly outspoken about the rewards offered to corporate leaders. Historically it was large redundancy packages to get rid of poor performing CEOs that were headline grabbers.
This is still occurring of course. Look at Stan O'Neal of Merrill Lynch, who received over US$100 million ($126 million) for "retiring" after his bet on sub-prime mortgages went wrong to the tune of US$8 billion.
That reinforced public perceptions that when companies get into trouble, it is the employees and shareholders who pay the price while top executives walk away.
It is clear that attention is now focused on the remuneration packages being offered to CEOs, as well as those being shown the door.
In New Zealand, this was evident in the swift reaction from institutional investors to the option package put forward by the NZX for CEO Mark Weldon.
If boards fail to heed the messages that are being delivered by mainstream shareholders, not just traditional activist groups, then they will have far bigger concerns to deal with. This is a potentially galvanising issue for workers.
Worse still is the prospect that real and perceived corporate largess that benefits an elite group, regardless of performance, will bring increased Government involvement in the business world.
Warren Buffett, quoted in the Economist, has this to say: "In judging whether corporate America is serious about reforming itself, CEO pay remains the acid test. To date the results aren't encouraging".
That a leader of the investment world like Buffett thinks the need for reform is beyond debate must carry weight with those at the head of our companies.
CEO remuneration and the communication and process around it are fundamental to shareholder perceptions of their boards' competence and fairness.
It is critical the CEO pay is linked to appropriate measures.
Marianne Bertrand of the University of Chicago and Sendhil Mullainathan, a Harvard economist, studied the US oil industry to investigate whether CEOs were paid for luck as much as their own accomplishments. They found that chief executives' pay always benefits when the oil price is high but does not necessarily suffer correspondingly when the price is low. They found the typical firm rewards its chief executive as much for luck as it does for good performance.
The effect cannot be explained simply by the increase in the value of managers' share options: it also shows up in their base salaries and bonuses, which are controlled by boards.
There is no doubt in my mind that boards in New Zealand need to avoid many of the mistakes that are occurring in countries like the USA and Australia if we want the loyalty of the company employees and shareholders.
It is critical that there remains some relativity between top executives and the other employees in the company.
From a shareholder perspective, it is vital to see a clear alignment between short, medium and long term equity-based executive rewards and returns to shareholders.
Phil Spathis (executive officer of Australian Council of Superannuation Investors) identifies an "epidemic of short-termism" when it comes to the performance component of CEO remuneration packages.
I agree that there is currently too much emphasis on short-term incentives and would like to see medium- to long-term incentives represent at least 70 per cent of any incentive scheme, so managers focus on growing the business rather than focusing on their own short-term gains.
A major bone of contention has been the lack of stretch in performance hurdles built into option schemes, ie exercise prices that result in options being in the money without shareholders being delivered excellent returns.
Worse still are cases where exercise prices have been revised downwards after a share price fall to make it easier for CEOs to end up in the money.
Generous options grants have also been associated with higher levels of fraud.
Jared Harris, who is assistant professor of business administration and Phillip Bromiley, assistant professor at Brigham Young University, Minnesota, studied hundreds of firms forced to restate earnings after accounting irregularities and found companies that paid out most of their compensation in stock options were more likely to end up restating earnings.
Options, if used in isolation or as too great a portion of a remuneration package, can also encourage undesirable risk-taking.
A recent study of almost a thousand US companies by Pennsylvania State University found that a CEO whose compensation was made up mostly of stock options tended to "swing for the fences", making investments and acquisitions that were riskier than those made by other executives.
As James Surowiecki puts it: "When you make it rational for people to bet the house, you may end up without a roof over your head."
Options have their place, especially in young, cash-poor companies where both shareholders and employees are on the same page in terms of the risks involved.
However, when it comes to providing an equity-based driver for CEO pay, most boards should think very hard about why they are not simply requiring CEOs to invest a proportion of their overall salary and bonus package into ordinary shares.
Then there is the matter of disclosure.
Those attending AGMs and reading annual reports in New Zealand could be forgiven for getting the impression that the board would rather visit the dentist en-masse than present and discuss transparent information about their CEOs' remuneration packages.
A lack of transparency around executive pay means that shareholders are often left wondering if the board really has a clearly articulated set of measures that genuinely reflect the drivers of value for the company in question.
Worse still it raises concerns about whether the board is being ridden over roughshod by the CEO they are supposed to manage, or even worse, colluding with the CEO at the expense of shareholders and other stakeholders.
I do not begrudge rewarding CEOs handsomely for sustained periods of good performance, provided shareholders have similar benefits. But boards of directors should do more to justify CEO remuneration than their current strategy of relying on the reports of "independent" consultants who in every report regurgitate the same justifications about increasing demands on CEOs, the global marketplace and so on, while rarely mentioning actual performance.
* Des Hunt is corporate liaison for the NZ Shareholders Association.
