Since the recent high-profile bankruptcies of Enron, WorldCom and other companies, the public has been bombarded by stories of corporate executives reaping millions of dollars in profits before delivering their companies to the bankruptcy courts and leaving the shareholders and employees holding the proverbial bag.

Other stories have detailed the opulent compensation and retirement packages granted to corporate CEOs. These sensational stories have tarnished the image of corporate America and corporate executives in particular and have focused the attention of the public, the investment community and the regulators on the usually low-profile subject of executive compensation.

Although the headlines have focused on the most extreme cases, the factors contributing to the environment that fostered those excesses apply to the compensation systems of many American corporations. Companies that prefer not to repeat the mistakes of others may want to examine their own compensation practices to determine if any changes are in order.

No single factor or practice has brought about the current upheaval.

Certainly, the recent and fondly remembered long-term bull market played a considerable role, in part by blurring the distinction between general market trends and fundamental corporate performance and in part by magnifying the scale of gains to be reaped by executives from stock options. However, the end of that bull market does not mean that the problems have been corrected. Other contributing factors remain: Stock options have become the subject of particular scrutiny due to their widespread use and the increasingly large size of grants.

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Reliance on options increased during the recent technology boom when start-up dot-coms with little cash for salaries began using large stock option grants to attract workers. The size of those grants and the spectacular rewards they produced in turn led to a perceived need by more traditional businesses to increase the size of their own option grants in order to attract or retain executives.

A leading executive compensation consulting firm recently examined data from more than companies in 10 different industry groups and found that, while there was a positive correlation between corporate performance compared to the industry group and the level of executive ownership of company stock, there was actually an inverse correlation between corporate performance compared to the industry group and the ratio of stock options held to company shares owned; i.

Although stock option grants to executives clearly create a performance incentive, the absence of any downside risk that accompanies actual stock ownership may create a management focus on short-term stock price increases sometimes achieved by cooking the books rather than long-term fundamental performance.

Fortune magazine recently reported August 11, that, since , executive and director insiders at U. Clearly the interests of the executives and the shareholders of those companies were not in alignment.

During the past several years, the pay for senior corporate executives has been increasing at a rate exponentially higher than that for the average worker. In , average CEO pay at the largest U. Instead, they have too often been influenced by the very executives whose pay they are to administer or by the recommendations of compensation consultants whose ongoing relationships are with management rather than the compensation committees.

Committees which have decided that bringing onboard a free-agent CEO is the answer to corporate problems have been willing to accept whatever demands the target executive has made.

Not infrequently, the same committees have then agreed to lucrative separation packages for the same executive when the expected performance was not achieved and bringing in yet another CEO was thought to be the answer. To some extent the response of corporations to the current state of affairs will be determined by the actions of regulatory bodies.

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Congress was the first to act, addressing some of the more egregious problems highlighted in the headlines with the Sarbanes-Oxley Act that became law last year. For example, the Act prohibits loans to certain executives and requires those executives to reimburse the company for equity compensation profits if financial results must be restated due to misconduct. For more information on the provisions of the Act, click here to view the Winter issue of Trust The Leaders.

Suggestions for changes to existing practices have also come from a variety of other sources, including the New York Stock Exchange, Nasdaq and the Financial Accounting Standards Board. The NYSE and Nasdaq proposals expected to be approved by the SEC in the near future would require, at least for listed companies, that shareholders approve any newly adopted stock option plan and that compensation committees be composed of independent directors.

The NYSE and Nasdaq proposals will increase the opportunity for shareholder input on stock option issues. While institutional investors have been concerned for some time about the dilutional effect and economic if not accounting cost of large option grants, the attention on options brought about by recent events has broadened that concern.

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As a result, shareholder opposition to stock option plans has been on the increase, and stock option issues are expected to be a major subject of shareholder proposals during the proxy season. Of even greater potential significance is the move toward the mandatory expensing of options for financial accounting purposes.

It is widely expected that proposals from the Financial Accounting Standards Board to require the expensing of options, previously unsuccessful due to loud protests from business and Congress, will soon be implemented. A number of companies including Coca- Cola and Wachovia have announced their intention to begin treating option grants as compensation expenses even before that treatment becomes mandatory.

Should that accounting rule change take effect as expected, the financial statement bias favoring options over other forms of equity compensation would be eliminated, although the tax incentive for the use of options would remain unless the tax laws are also changed. However, regulatory actions alone will not be sufficient to prevent the problems from continuing.

Corporations will also need to take action on their own, examining their compensation practices and asking difficult but essential questions.

What type of incentive are we creating with the present structure and policies? Does the present structure reward short-term performance at the expense of long-term fundamentals? Is the incentive consistent with the interests of the shareholders and effective to advance the goals of the company? Is the company getting value for its money? Is the process objective and independent? Does the process create a competitive advantage or disadvantage for the company?

The answers to those questions will determine whether and to what extent changes may be advisable. The logical starting point for that process would seem to be a review of the corporate compensation committee. However, if the members of the committee are knowledgeable and objective, understand the role of the committee and the goals of the corporation, and have access to necessary and appropriate information including, perhaps, the assistance of consultants and advisors answering to the committee rather than management , problem areas are more likely to be identified, effective solutions implemented and decisions made in the best interests of the company.

In reviewing the appropriateness and effectiveness of existing incentive programs, corporations should keep in mind the recent research indicating that relying too heavily on stock options for the equity component of a compensation program may actually create an incentive for top executives to maintain a short-term focus on option spread, resulting in lower corporate performance. A compensation policy that encourages a meaningful and long-term financial stake in the corporation through minimum stock ownership levels and minimum holding periods for compensatory stock whether received directly or through option exercise may be better suited to align the interests of management with those of the corporation.

Performance-based compensation tied to specific long-term goals of the company e. The circumstances and events behind those stories and headlines suggest there may be some truth to that perception.

Just as no single factor has been responsible for creating the current problems, no single change will fix them, and the appropriate set of solutions will vary from company to company. About The Firm Careers Contact. Executive Compensation Since the recent high-profile bankruptcies of Enron, WorldCom and other companies, the public has been bombarded by stories of corporate executives reaping millions of dollars in profits before delivering their companies to the bankruptcy courts and leaving the shareholders and employees holding the proverbial bag.

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