Runaway CEO compensation

Directors of US public companies can’t seem to get a break. First it was Sarbanes-Oxley. Lately, it has been options backdating. And now, with the Democrats controlling the legislature the volume on CEO compensation is so high, it could shatter eardrums. Runaway CEO compensation is certainly an issue, but knee-jerk legislation is not the right way.

Bob Nardelli’s recent departure from Home Depot adds fuel to the fire. Last week newspapers reporting his resignation, very typically, simplify the headline to such an extent that it distorts the truth. The directors of Home Depot apparently gave him a $210 million severance package after he did very little to the stock price in the 6 years that he was CEO.

When you read the paragraph above, it seems as if greed and a board full of the CEO’s cronies enriched the ex-CEO at the expense of shareholders. Reality is not that simple, but unfortunately, 90% of those who read this news will go away thinking the Home Depot board was out of its mind or worse if it gave Nardelli that kind of money for poor performance.

The Wall Street Journal had an editorial which attempted to throw light on some of the obfuscation here. It requires a subscription so I’ll reproduce a couple of paragraphs here:

The truth is that nearly all of that $210 million isn’t severance at all but was part of Mr. Nardelli’s original employment contract. In other words, it was part of the package that the Home Depot board offered to lure him in the first place.

And

That contract can’t be abrogated now simply because the board has concluded it made a mistake. Of that $210 million figure, more than $180 million is owed to Mr. Nardelli as part of his original job offer. That includes $77 million in unvested deferred stock awards, another $44 million in vested deferred shares, $32 million in retirement benefits and $9 million in earned bonuses. Even a $20 million cash payment upon termination was part of his original contract.

It seems like a 7 year old contract was responsible for this rich send-off. So the question becomes a little different. Why was such a contract signed in the first place?

There are some straight forward answers to that. One, Bob Nardelli was a star at GE, the most respected company in the country. He was in line to be the CEO of GE. When he lost out to Jeff Immelt, he and the other contenders would have been pounced upon by CEO head hunters. He would have had his pick of Fortune 500 companies to go and lead. Competition raises the price.

Two, Nardelli would have had a whole bunch of unvested, but in-the-money options (stock price is greater than exercise price). Thus, staying put at GE would have been worth X million dollars if he simply waited for the options to vest. It is standard practice for the hiring company to make the new CEO ‘whole’ on any options that he may have left behind. In the case of GE, Jack Welch had convinced his board to give each of the CEO contenders a bucketload of options, knowing that when the losers left for other companies, those companies would have to match it, and GE would never vest those options anyway.

Three, Nardelli would have used a compensation lawyer for the negotiations. They know every trick in the book and then some. For instance, CEO employment contracts are now written in such a way that the reasons for which a board can fire a CEO for ‘cause’ are becoming vanishingly small. If a CEO is fired ‘without cause’ all kinds of severance clauses, acceleration of unvested options and so on, get triggered. That’s what certainly happened here.

But at the heart of the matter, lies the fact that when hiring a CEO, a board has too few options. Interviewing outside candidates for a complex, leadership position is too imperfect. The responsibility of picking a CEO and the risk of making the wrong choice is so great that most directors will make a ‘safe’ choice and pay a premium for that. A CEO candidate with a track record of building businesses and being successful at it, is a safe choice. Unfortunately, successful builders of businesses aren’t generally looking for jobs. They are CEOs at successful companies.

The only good long-term answer to the mess on CEO compensation is good succession planning. Shareholder (and media) ire should be turned on the board, not when the CEO is fired and leaves with a king’s ransom, but when the board and outgoing CEO fail to promote from within and go outside to sign a CEO with an “all-upside” employment contract. If the board does not want to get stuck in a situation where they have to get in a superstar CEO from the outside, they must insist on good succession planning. An insider CEO will not need a king’s ransom to convince him to take the position (though you might have to pay him market to keep him). Plus, he will probably be more successful at what he does. It is no wonder that the GE CEO and top executives have, for the most part, no employment contracts. They serve at the will of the board. GE reaps the benefits of great succession planning.

Succession planning isn’t going to work every time. Sometimes you do have to go outside and look for the right CEO. But if more companies started looking for (and developing) inside candidates rather than going outside, maybe, just maybe, it would ease the whole demand-supply equation enough to change CEO compensation practices. The answer, however, is not legislation, as the Democrats would have it. This is something the market needs to work out for itself.

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13 Responses to Runaway CEO compensation

  1. Sachin says:

    Makes a good and enlightening read. In fact I was among the 90% who dint care to read the detail of the home depoto headline and went away with a notion that these CEOs get a great golden handshake irrespective of whether they produce results or not.

    My only peeve on your article is a very common error lot of people make by using “He” as a preferred pronoun, dis-regarding (probably inadvertently in your case) any possibility that women cud ever make CEOs. I am not trying to nit pick and I am also no feminist, but from someone like you I expect more sensitivity towards such little things. For example use a gender neutral plural “They” all the time or (s)he.

    I enjoy reading your blog and i dint add a comment to the debate on some “Annoyed” fella, but I thought (s)he should have chosen a much more softer way to express his views (which may sound right to some people) rather than the aggressive style of enforcing ones own views on others.

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  2. Siddharth says:

    certainly, i don’t think that many ceo s are worth the money they make. further, a hefty severance package is nothing short of mis management. the variability in pay structure is annoying. this entire corporate structure of hierarchy, control and reward money is on the wrong track. ceos should not be paid other than expenses. i hope there are still many takers for the job. i think of the indian vedic lifecycle – the 4 quarters. between 50 and 75 years, serve the society. why can’t this be applied to company culture worldwide? make money with your sweat 25 to 50 years, and then work only for your passion. if power and money are the only passion, then that’s trouble. i guess the trick and the hard part is to manage the transition at the turn of the quarter. i would love to see a company founded and run on these principles.

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  3. Basab says:

    Good catch, Sachin. I am in general prone to do the ‘he/she’ or ‘they’ bit, but sometimes it gets in the way of getting your thoughts down quickly, and I think I’ll come back and fix it. This time, I didn’t. Guilty as charged.

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  4. Krish says:

    Yes. One has to read between the lines to import the full substance in any media story. Not to go to bed with the view that CEOs get vested with “heads I win, tails you lose” option. The “very ethics” behind fat severance packages to CEOs are being questioned by the Regulators and even by media. Clarifying it-is-not-entirely-true seems to be the rationale behind this post.

    The SOX Act has provisions for pre-approving a CEO compensation for public corporations. What was SEC doing with Home Depots annual filings…? Were the disclosures on CEO’s contract terms not adequate, they have some good reasons. But then the erring management and the corporation can be taken to task separately and the whole appointment could be annulled. Had it not happened before ?

    Succession planning is of course a good measure. But, it doesn’t quite measure up if there’s a paradigm shift in the way industry operates or the flex in market dynamics. Then you begin to look for someone outside who’s already in tune with it. And then one should also factor in “familiarity breeds contempt” phenomenon and the avoidable murmurs that go with when you classify just one as first among equals. [ a la Vivek Paul at Wipro ]

    or am I missing something here…?

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  5. Shashikant says:

    Interesting post, Basab.

    I was under the impression that only the shareholders of Home Depot got a raw deal. But, companies (like GE) building exit barriers for their top execs is news to me. In effect, even the GE shareholder are getting a bad deal.

    May be, it is not exaggeration when Philip Greenspun writes this.

    http://philip.greenspun.com/materialism/money

    “Jack Welch in Straight from the Gut proudly states that during his 20 years as General Electric CEO the “employees”, by which he means
    himself and some other top managers, went from 0% to 31% ownership of GE. Rephrased, Jack and his golf partners stole 31% of GE from the investors who owned the company in 1980. What’s more, thanks to
    accounting rules that enable unlimited stock option grants without any charge to earnings, none of this had to be reported in financial
    statements.”

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  6. Basab says:

    Krish, over-the-top CEO compensation contracts are not illegal, at least not yet. The SEC therefore has nothing to do here. Only enlightened directors and alert shareholders can change things.

    I agree with your point that there are many situations when succession planning does not give you the right CEO candidate. My point was that if just a few more companies found their CEOs inside, it might deflate the demand for superstar CEOs just that little bit required to reform things.

    Shashikant, according to a WSJ article by Herb Greenberg, GE does not have employment contracts for the most part with its CEO and top execs. I attributed this to their success at succession planning and not having to go out for a CEO. This doesn’t mean that they don’t have busloads of options and competitive CEO comp. Just that they serve at the will of the board and if they get fired for poor performance, GE shareholders will not be picking up the tab for any ‘terminated without cause’ clauses.

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  7. Shreyasi says:

    Basab,
    Good to see that you have taken your readers’ complaint and have responded to all of them. Although for me, your reading the comment is good enough.
    On the topic, I think the issue of choosing the leader and the successors is much more potent in India today than developed economies because we are growing so fast. At times it looks like this:there are a lot of us forming the base of the pyramid and then there is a huge void with a few insightful leaders at the top. Which only means that we haven’t been able to plan enough for the not-so-far future. I suppose GE (and in India Infy)became so well respected because of their talent management processes.
    I agree with you that succession planning is always not the option. However it might be the preferred one!

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  8. pushpa says:

    To add to your question as to why such a contract was signed off by homedepot, Bob Nardelli was also one of the blue-eyed boys of Jack Welch. When Bob couldn’t make to the top post, Jack welch himself used his Guanxi(connections/network) to help out Bob.
    I just happened to read an article in chinese weekly and found this bit. Chinese are normally accused of using such networks in their businesses, but its no different in the occidental world either.

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  9. Rosen Sharma says:

    To take a contrarian point of view. Numbers like 210M are blown out of proportion by news media. The pressures on a CEO are very different than those on any employee. When CEO’s are recruited from outside they dont know what they are walking into. There are always skeleton’s in the closet.

    Lets take an example of a a NFL linebacker, 10-15 years career length. They are done after that. How much does the best player make these days over that 10 years … 100M maybe? Michael Shumacher was making about 100M/yr. Why? Because a short playing career and the risks involved have to be put into perspective of what you have to do for the rest of your life.

    Now take high profile job like CEO of Home Depot. What is the average CEO life time? 5 years? If they fail because of all the skeletons in the closet? Who compensates for the rest of the working career? Can Fiorina get another job as CEO? Very few (Eric Schmidt) get a second shot?

    While it seems excess, from my standpoint there is more to the story than the media blows up.

    Rosen
    http://think-smarter.com/rosen_sharma/

    Like

  10. Basab says:

    Rosen, there are a couple of differences between top athletes and CEOs.

    One, the evaluation of an athlete’s performance and contribution to success is much easier to establish compared to a CEOs. In the latter case there are issues of company performance versus market, versus industry peers; CEO contribution versus leadership team’s; mistakes of the past affecting current performance etc. etc.

    Two, the athlete’s ‘price’ is set in a true market. The market for CEOs has too many flaws. Crony boards, too few candidates, the need for secrecy in negotiations etc. etc.

    It’s a tough problem. That’s for sure.

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  11. Pingback: 6 AM Pacific » Blog Archive » More insiders being recruited as CEOs

  12. Pingback: 6 AM Pacific » Blog Archive » Incentive Compensation as a Risk Factor

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