Paul Hodgson has been studying executive compensation for 13 years, both in the United States and the United Kingdom, and has written many books, spoken at conferences and been quoted widely in the media.
He is past editor of Executive Compensation Review in England, and since 1999 has been senior research associate for board and executive pay at Corporate Library, a research firm in Portland, Maine, founded by corporate governance critics Nell Minow and Robert A.G. Monks.
His new book, Building Value Through Compensation, is aimed at compensation committee members, to help them navigate what Hodgson calls the ``minefield'' that executive compensation has become, with increased public attention, shareholder lawsuits and the possibility that a director's personal assets could be at risk for compensation committee decisions.
In a recent interview with Plastics News, Hodgson said he wrote the book to describe best practices that some companies have taken. In the book, he argues that executive pay is in a crisis situation, and urges compensation committees to take stronger steps, like tying all stock awards more closely to the performance of the company and renegotiating excessive pay packages.
Q: How well do you think executive pay works in the United States?
A: I think it's taken a wrong turn at some point in the past. There are all sorts of people you can blame for that, from academics to consultants to various different people. But the blame doesn't really rest on anybody in particular. It's been a problem that has grown largely, I think, because of academics saying stock options are the be-all and end-all of long-term incentives, without properly thinking that through and imagining what might happen if we have a 20-year bull market.
Q: How have stock options failed?
A: They are too focused on rewarding general stock price increases that are sometimes due to management actions, but that are in many cases due to the market pushing share prices up.
Q: You seem to suggest that compensation committees need to be a lot more aggressive. What are you suggesting they do that they aren't doing now? How should they structure pay packages?
A: I think they need to lock in the thinking about compensation into all of the other jobs that the board does, specifically the strategic planning that they do in association with management. I think we have a divorce, really, between what the board and what the CEO and the other named executive officers want to do with the company, and what the incentive plans are actually rewarding. There's also a problem with the kind of Wall Street expectations and the earnings forecasts that have become almost too influential in what people are trying to do with companies. We've come into a situation where short-term targets have become overly important.
Q: How should pay packages be changed to deal with that?
A: The major area of change, as far as incentive schemes are concerned, is within long-term incentives. There are a number of different ways you can do that, but I think the primary ways probably are tying the vesting of stock options to achievement of targets or awarding index-linked options, which up until now have been rarely used because of the accounting decisions that have been made about those. Obviously those have all disappeared now, with having to account for stock options along with regular compensation, so the barriers to introducing performance-related stock options have been removed. The other thing is to look at the other kinds of awards that are available for executive officers - there's a variety of different names, but they are long-term bonuses of one kind or another
If you're looking at measuring actions that can add value in the long term, if you use metrics like economic profits or return on invested capital, those kind of metrics can be put into place. If you compare your performance to your peers, if you're outperforming your peers in terms of adding value to the company, stockholders can see that and that can be a particularly attractive motivation to invest in you.
Q: You cut your teeth analyzing pay in the United Kingdom, and you wrote about the best practices that emerged from that country's corporate governance revolution in the 1990s. You talked about it being a business-driven, as opposed to a government-driven, activity. Are there some lessons in the United Kingdom or in other countries that should be applied to the United States?
A: Yes, and I draw on them most obviously in the preface to the book, but they kind of feed into my advice on best practices on almost every other element of compensation. What I'm trying to say is that the changes were business-led, and that what companies or what advisory boards did is look at those companies they saw as achieving the most effective compensation policies and try to promulgate those throughout the rest of the economy. It's a group of business leaders getting together and cherry-picking what are the best elements from the various compensation policies they see, and saying these are the ones we want to encourage. These appear to be the most effective in encouraging management to make the right decisions to add value for stockholders.
Q: Any one or two particular items that should be cherry-picked?
A: What I've tried to do is identify those companies I see as embodying best practices and describe their decisions and the results of those decisions in some detail in order to say, if this company can do it without there being a management walkout, then it's probably likely that you can do it, too. Boards are reluctant to step outside the mainstream, I think, in all sorts of different ways, not just com- pensation policy. If they see that every other company out there is awarding market-priced options, then they are less likely to go to management and say, `We think we can do better, and we'd like a compensation policy that ties your compensation more closely to the company and the impact of the decisions you've made.'
Q: Some companies, particularly in the tech sector, argue that stock options are key compensation tools. When you talk to companies, a lot of them argue they need to keep boosting compensation in order to attract and retain leaders. Isn't that an important market factor that companies need to respond to?
A: It is to a certain extent, except that I give examples in the book where boards have said, `We have our eye on what everybody else is doing, but this is what we think is right.' I think that's one area where boards need to be more aggressive, and say, `That's happening there, but we think the most appropriate way of approaching this problem is this way.' There are enough people out there who pay well below the market for both base salaries and incentive payments for companies to realize that what's important here is to reward management fairly, not necessary exactly the same as everyone else.
Q: If you had to look into your crystal ball, are there areas of executive compensation that will get more attention in the next few years that we don't hear as much about now?
A: There's not much that the spotlight isn't shining on fairly clearly at the moment. The crystal ball might tell me that there may be some changes on the way, like changes in long-term incentives. There are also some changes beginning to happen in supplemental executive retirement plans as well, in that there are plentiful examples of companies who are saying we've got this level of benefits, but we're not going to increase those levels, or terminating plans altogether. The other area of significant change potentially is in the area of severance benefits.
Q: How do you think that comp members should interpret the recent ruling in the lawsuit against Disney challenging Michael Ovitz's $140 million severance package? I gather what that said was that even if your corporate governance is less than perfect, you're not liable for good-faith decisions. Does that suggest the pressure is going to come off compensation committee directors?
A: I don't think so, no. I've been following this case from the very beginning. I think that what happened there was, the directors were able to convince the judge they made a good-faith decision surrounding this severance package for Ovitz. I think the pressure is therefore on for compensation committees to do that in every case, so that if management or a consultant or somebody on the board comes to them and says, `We have to do this now because everybody else is doing it,' or, `We need to desperately hire this particular CEO, and we need to give him or her everything they ask for, and it doesn't matter whether everybody else is getting it or not, we can't hire them without it.'
Those kinds of decisions are the ones that are going to come up for particular scrutiny, and unless you can prove you have considered all the angles and really thought about what you're doing, and that's provable in court, then you will be monetarily liable for the decision, if it's believed to be taken in bad faith.