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.
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.