Motorola and H-P were not alone in assessing some of the blame to management–but clearly they were in the minority in a year during which there were more stories of unmet expectations than of success. According to Mercer Human Resource Consulting, 22% of the 356 CEOs used in its annual compensation study received no bonus in 2001, compared with 13% in 2000, and 26% got no base salary increase last year, up from 22% a year earlier.

If executive compensation increases as a company does better and gets bigger, shouldn't it fall as the business bombs and shrinks? The logical answer would be yes. But this is the country that pays some of its movie stars $200 million to make a mediocre film, so logic and income have little to do with one another. In fact, even in the midst of the brouhaha over executive misdeeds and indignation over the massive liberties allegedly taken by certain CEOs, such as WorldCom Inc.'s Bernard Ebbers and Tyco International's Dennis Koslowski, few have dared asked the real question underlying the tumult: What constitutes reasonable compensation for top executives?

Up until now, conversations about executive pay have centered on corporate America's heavy use of stock options as incentive tools (See page 22), company perquisites like executive loans and the need to dial back the use of both. To an extent, some of the vilification of stock options may be justified. The heavy reliance on options by many companies has enabled their executives' take-home pay to reach stratospheric levels and encouraged corporate leaders to pay closer attention to their company's stock price than its overall, long-term financial health. In some cases, options would appear to have played a significant role in spurring rogue executives to do everything from bending accounting rules to hiding billions of dollars in expenses or debt–all in an effort to secure fatter paychecks.

Congress has moved to stem large corporate loans to top executives in response to charges that companies, without the knowledge or approval of shareholders, gave top officers low- or zero-interest loans to buy stock, art and even lavish estates and then went on to forgive those loans. Among the most conspicuous users: WorldCom's Ebbers, who is in the hole to his former employer to the tune of $408 million.

But if executive loans are outlawed and companies are forced to expense options or perhaps limit their use altogether, what does that mean for executive compensation? Will it actually go down? And if so, will it go down significantly?

Most experts say no–although it probably will be kept in check over the short run, if only for public image concerns. First, cutting compensation now could cause a good deal of restlessness among the most talented top officers–an instability most companies already in somewhat perilous positions wish to avoid. What's more, companies feel as if they can settle for no less than the best and the brightest, given the current economic and political climate, to help them ride out jittery markets and marketplaces.

In fact, corporate governance experts and academics don't seem that interested in the outright level of compensation. Instead, they argue that what's critical for the health of U.S. corporations is to link executives' pay to the performance of companies in ways that give them a reason to work hard, but not an incentive to cook the books.

For years, stock options were supposed to be that performance-based incentive. Now, the conventional wisdom is shifting: Experts, such as Diane Doubleday, a senior compensation consultant for Mercer Human Resource Consulting in San Francisco, are predicting higher base salaries, but say overall packages will probably remain relatively flat. "Instead of relying on significant stock options, companies are saying, 'Let's look at other vehicles, such as long-term incentive plans and [other] financial performance metrics,'" besides stock price, she says

Calling All Compensation Committees

Diane Posnak, a managing director at compensation consulting company Pearl Meyer & Partners in New York, agrees. She expects stock options to become a less dominant piece of the pay puzzle than they have been. Prior to the current shakeout, nearly 70% of an executive's package was tied up in restricted stock and options, a practice that encouraged executives to focus solely on pumping up stock prices, Posnak says.

But where executive compensation is headed in the future is a question sitting squarely in the laps of once passive boards of directors and, more precisely, executive compensation committees. Indeed, many compensation experts say that that if blame is to be laid anywhere, it's clearly at the feet of weak corporate boards. Some economists suggest a "looting" theory of compensation, which says, "a lot of the payouts top executives have gotten don't really reflect improved firm performance, but instead reflect the fact that executives, specifically CEOs, have the ability to make boards of directors give them whatever they want in the form of compensation," says Rajesh Aggarwal, an associate professor of business administration at Dartmouth College's Tuck School of Business.

He says there is some evidence for that, noting that the highest paid CEOs in 1999 were those at Qwest Communications International Inc., Global Crossing Ltd. and Tyco International Ltd. with an average compensation that year of $170 million. "It's clear that at those companies, something was wrong," he says.

Motorola's West believes that the recent scandals should make boards and compensation committees more wary of meeting every request of the CEO. "Compensation committees have become more focused and are conscious of the disquiet that people have about excessive compensation," he says.

Shareholders may have had a role in this predicament as well. West points out that the idea behind using stock options as a tool to push executives to improve shareholder value–in other words, push stock prices up–got its start from institutional investors demanding that management be paid according to performance. That led to management and shareholders alike caring more at times about a single quarter's performance than the company's five-year outlook.

As it turns out, though, keying off of stock prices was not a perfect solution, either. Besides encouraging short-term strategies and prompting executives to tweak numbers just for a big bang in one quarter, it also proved too much temptation for some, given the new value of their inside information. "Certainly, if managers have information that the markets don't have, stock-based pay can create some dangerous incentives," says Kevin Murphy, a professor of finance and business economics at the University of Southern California's Marshall School of Business. "To withhold that information until you dump your own stock, or to exercise your stock options and sell before bad information is revealed or to wait to reveal good information until you've gotten all your stock options–those are the abuses we've got to find ways to curtail."

The key in performance-based pay is focusing it on a date in the more distant future, concludes Murphy. "I don't want [executives] to be worried about the stock prices tomorrow, I want them to be worried about the stock price six months from now," he says. "Somehow you want to back load incentives, so they're still looking for something that's out there a ways." But Murphy is reluctant to see the period that an executive holds stock prescribed by law. "That's a compensation issue, not a government policy issue."

Sticking It Out

Some institutional investors also think options should be structured to compel executives to hold stock longer, says Ann Yerger, director of research at the Council of Institutional Investors. Institutional investors "are in these assets through thick and thin," she says. "There are concerns that executives aren't holding their awards for the long term. A significant percentage of shares that are acquired either by exercising options or stock grants should be held until an executive leaves the company."

Another common suggestion is to structure options programs so that executives are rewarded not on how well the company performs, but on how well it performs relative to others in its industry. Yerger notes that indexing options in that way would be a plus for executives in periods when stock prices are falling; they could be rewarded even if their stock declined, as long as it declined less than their competitors' stock prices.

Murphy also suggests that companies should avoid tying compensation to budgets. "The criminal here is the budget process," he says. "If, instead of using budgets, we could use some external measure of how peers performed or just use 10% return on assets–something that's not reset every year based on what you did–you can improve the accounting-based plans a lot." He adds, however, no one is talking about such a system.

So change of sorts is coming. But no matter how you add up all the various components, it doesn't sound as if many executives are going to have to hock the Mercedes to make ends meet.

Expensing Options: The Tech Sector's Big Chill

Never mind the latest round of babble over the expensing of stock options. Mark Link, vice president of finance at EMC Corp., a Hopkintown, Mass.-based computer hardware and software provider, says his company can attract some of the best and brightest even if EMC is forced to curtail this employee incentive. "Options are obviously only compensation," he says. "There's a number of reasons that make a person join a company like ours."

Technology companies like EMC better hope that's the case. Because if expensing of options becomes a permanent fixture on the balance sheet, most would face substantially more red ink than they already have if they continue the practices of using options as the carrot for ambitious employees and handing them out to the bulk of their workforces. Just one example: EMC, with $698 million in operating losses on $7 billion in revenues, would have had to accommodate more than $500 million in 2001, almost doubling the loss.

The Billion-Dollars-Plus Group

According to a Bear, Stearns & Co. study on expensing options, the companies affected most by the accounting change–those with $1 billion plus options price tags–are almost all from the tech and telecommunications sectors-in fact 11 of 13. Among them are the obvious suspects: Microsoft Corp., Cisco Systems Inc., AOL Time Warner Inc. and Lucent Technologies Inc., to name four.

This makes sense since these companies used options liberally as the main compensation for top and even mid-level executives as New Economy upstarts grew into market-cap behemoths during the 1990s. Back then, everyone wanted a bite of equity, since a slice seemed likely to grow to pie-size in short order. In 2001 and this year, that was less the case–even if these companies had still been hiring.

Now, however, many believe the economy could begin reviving over the next year and job creation could accelerate. With equities markets potentially bottoming out, the options chase at companies that took the biggest hit but still have reasonable prospects–certainly, many techs and telecoms fit that description–is likely to begin anew.

The problem is that bad habits this time around might cost a lot. If you take the tech and telecom companies identified by Bear Stearns with more than $1 billion in options expense, the cumulative hit to operating earnings would have been a staggering $21.7 billion. Cisco, for instance, would have seen its $21 million in 2001 operating income turn into a $2.8 billion loss.

Old Economy Not Immune

So-called Old Economy businesses would feel the pinch as well, but not quite as badly. Bear Stearns, which has been tracking this issue for five years, says that 141 of the S&P 500 would each have seen a pro forma decline in operating income of 10% or more. The investment bank estimates that the switch to fair value expensing of stock options would have lowered the diluted EPS of the S&P 500 by 20% last year.

Still, the more established companies can often take the hit because their offers of options were not so widespread and their balance sheets not quite so precarious. Consequently, they have been among the first to step up to the expensing challenge with the likes of the Coca-Cola Co., Citigroup Inc., The Washington Post Co. and General Motors Corp. among those voluntarily beginning to expense options.

On this issue, the political fire is hot. Even after the likes of Federal Reserve Chairman Alan Greenspan and Berkshire Hathaway Inc. CEO Warren Buffett came out strongly in favor of expensing, lobbying against such a rule has been so intense that Congress found it impossible in July to move forward on a stock options expensing plank. Feeling the heat, the Financial Accounting Standards Board decided not to wait for its international counterpart and passed a draft regulation in August that would require more prominent footnotes and allow companies that choose to expense to a few methods for doing so.

"Options clearly are an integral part of our compensation scheme," says John Cox, CFO of BMC Software Inc., a company that would have seen pro forma earnings turn into losses last year with expensing. Like several tech companies, BMC has decided to issue options footnotes in its quarterly filings. "My personal belief is that disclosure is adequate," Cox says, and expensing will prove less of a problem "once Wall Street understands the numbers."

Perhaps. But what institutional investors seem to understand now is that earnings have been artificially bolstered by the failure to expense options and that stock options, over time, dilute the value of their holdings. Elizabeth Fender, a director of corporate governance at TIAA-CREF, also points out that because companies have not been forced to expense fixed at-the-money options, they have been discouraged from using more innovative compensation vehicles, such as restricted options, which might actually produce the performance-based compensation they say they desire.

So, regardless of whether they are forced to expense, companies may discover that Wall Street–institutional investors and analysts alike–may simply decide to recalculate earnings taking options expensing into account. The problem may come when they decide not to do it across the board, putting some sectors at a disadvantage. In other words, there may be no way to get that darn proverbial horse back into that darn proverbial barn.

– Ed Zwirn