Regulators Consider Rules That May Scale Back Executives’ Pay

A seemingly unrelated confluence of events--the recession, a rapidly rising stock market, a controversial trade mission and increasing shareholder activism--has sparked the first viable efforts in U.S. history to rein in runaway executive pay, industry experts say.

The chief regulators for both the securities and accounting industries are weighing rule changes that make it likely that at least a portion of executive compensation packages will be scaled back next year. Congressional hearings are starting in two weeks on the same subject. Meanwhile, a powerful shareholders group has won several recent victories in its long-running efforts to curb excessive pay with the help of a handful of irate institutional shareholders.

When the dust clears, many predict that executive pay practices will have changed forever. And that should benefit shareholders, advocates say.

“This will lead to greater management accountability. And that will lead to greater competitiveness, higher profitability and higher stock prices,” said Ralph Whitworth, president of the United Shareholders Assn. in Washington.

Added Graef S. Crystal, a professor at UC Berkeley and a recognized compensation expert: “It may cause some shareholders to rise up and smite the chief executive officer.”

Surprisingly, considering all the hullabaloo, what’s been proposed to date are relatively modest reforms.

Specifically, the Securities and Exchange Commission is expected to propose a plan that would require companies to report how much stock options are worth when they are granted to executives.

Stock options are rights to buy company shares at a particular price at a given time in the future. Companies now don’t place a value on them until the executive exercises--or buys--the stock, which could be many years down the road. Then the value is set at the difference between what the executive paid and what the shares were worth on the open market.

The problem is that it’s very difficult to determine what an option is worth before that point. And that makes it difficult for shareholders and corporate board members, who set executive pay levels, to determine how much compensation an executive is actually getting.

However, the Financial Accounting Standards Board, the primary rule making body for the accounting industry, may help by reviving a long-dormant project that would force companies to account for the cost of stock options given to executives. If the FASB acts, it would likely create an industrywide standard for calculating the worth of unexercised options. It would also require companies to report the cost on their balance sheets, which might cause companies to think twice before granting large numbers of options.

“To the extent that the company’s board has to print a number, somebody on the compensation committee may wake up and say, ‘Gee, maybe that’s too much,’ ” Crystal said.

Meanwhile, Sen. Carl Levin (D-Mich.) will also launch congressional hearings in the next two weeks on the subject of executive pay. He also plans to center on stock option plans, which have become increasingly lucrative for executives, while often having little direct tie to corporate performance.

Finally, the SEC also wants to allow shareholders to vote on a wider range of pay-related matters. Although the government agency refuses to give out many specifics, industry experts maintain that the changes would allow shareholders to approve or disapprove of the way pay packages are derived. Additionally, they would have greater say about who would be able to set executive pay scales. Still, these shareholder votes are expected to be only advisory. They will not carry legal weight.

In other words, the company does not have to follow shareholder dictates in matters of executive pay. But directors who don’t risk being ousted by irate stockholders.

And shareholder activists maintain that they will be able to keep the pressure on because shareholders are becoming increasingly organized and are mad enough to finally start doing something about executive pay. The United Shareholders Assn., thanks in large part to cooperation from giant institutional stockholders, such as mutual fund behemoth Fidelity Investments and the California Public Employees Retirement System, have already won several small victories. Specifically, two companies--UAL, the parent of United Airlines, and ITT Corp.--have agreed to substantial changes in their pay plans because of the shareholders group’s prodding.

There has never been a better time to revamp the executive pay system, USA’s Whitworth said.

The conducive atmosphere has been attributed to a variety of factors.

First, and possibly foremost, is the recession, which has underscored the wide differences between the way executives and hourly workers are treated. Over the past year, companies have implemented sweeping layoffs and often instituted pay cuts and salary freezes. And yet consultants believe that the pay for top officers will soar this year, largely because the raging stock market pulled many companies’ shares to new highs.

Executives benefit from higher stock prices in two ways. Their bonuses are often tied to stock market performance--and it rarely matters whether the individual company’s stock was alone in its rise or if it simply benefited from a strong market. And many executives also get stock options.

If the company’s stock rises, these options become valuable because they essentially allow executives to buy shares at bargain rates. Many executives are expected to post huge paper profits from stock option gains this year, at a time when laid-off workers are likely to be irked by any sign of largess in the executive suite.

Wide disparity between executive and hourly worker pay is nothing new. Executive salary hikes have been substantially higher than hourly worker increases since the late 1970s, according to studies by Sibson & Co. However, now the gap has become huge. Some estimate that rank and file workers earn between 100% and 300% less than top executives.

The issue was a sore point on President Bush’s recent trade mission to Japan. The reason: Japanese executives also earn a fraction of what U.S. executives earn. Consultants estimate that where the chief executive of a Japanese firm will earn $500,000, or about 30 to 40 times what rank and file workers take home, U.S. CEOs get about $3.2 million, or roughly 100 times what their workers earn. Japanese businessmen--and other critics of U.S. compensation plans--maintain that this huge disparity is undercutting American companies’ competitiveness.

“The growing gap between executive and average worker compensation threatens American competitiveness, sours labor-management relations and divides the American work force,” Levin said in a written editorial. “It is a trend that must be reversed for the health of our economy and the strength of our political fabric.”

The proponents for change may just succeed this year too, even though they are likely to run into a lot of opposition from corporate chieftains who like the way things are today.

“There are a number of reforms that will probably come out of this that will be helpful, not only to shareholders but to executives themselves,” said Donald L. Lowman, vice president of Towers Perrin, a compensation consulting firm in Los Angeles. “The system is not bankrupt. But it definitely has its faults and can use this attention.”