Sunday, October 12, 2008

When Lee Iacocca first joined Chrysler in 1978, he lowered his salary to $1 a year. When a shareholder questioned the wisdom of this, Mr. Iacocca responded, “Don’t worry. I’ll spend it carefully.” The “spend it carefully” philosophy is exactly how companies should, but often don’t, approach executive compensation.

In 2007, CEOs of S&P 500 companies received, on average, $14.2 million in total compensation, according to preliminary figures from the Corporate Library. That’s more than 300 times what the average American worker earned in 2006 and six times what the average CEO would have brought home in 1980.

Some point to statistics like these as evidence that executive compensation is out of control. And Congress reflected similar sentiments in the recently enacted Economic Stabilization Legislation, capping the amount of fees for CEOs of firms whose portfolios are assisted by the new powers given to the secretary of the Treasury.

But, in reality, it’s not the amount of compensation that’s a problem; it’s the rationale and methodology behind initial compensation decisions and the processes that companies use to determine whether they’ve received a fair day’s work for their compensation dollars.

There is, and should be, a strong positive correlation between executive compensation and performance. Productive and successful executives ought to be rewarded handsomely. The key, of course, is to make sure they achieve both standards. It’s un-American to lavishly reward someone who performs poorly. The challenge, therefore, is to establish policies and procedures that consistently embrace and further this linkage, as well as corporate and economic reality.

Fortunately, the construction of an effective executive compensation process isn’t enormously complex. The following elements can provide a solid foundation:

Compensation should be linked to legitimate, objective, corporate objectives.

Simply put, executive compensation should always align the interests of management and shareholders. Executives should be rewarded for producing fundamental, sustainable, development measured objectively, in market share, markets served, or other appropriate means - not for achieving some arbitrary, fleeting and easily manipulated earnings target.

The elements and amount of compensation should reflect company goals.

Many companies approach compensation as a rote exercise: “comparable” companies are identified, and senior executives are paid about 75 percent of the range of compensation paid by the comparables. No wonder there’s compensation inflation! Simple mathematical comparables are not, by themselves, a defensible rationale for compensation decisions. It’s better to start by defining the company’s objectives and the specific goals each executive is expected to achieve. Then, the amount and form of each element of compensation can be related directly to the relevant objectives.

Companies should regularly revisit and revise their compensation methodologies.

Ultimately, to ensure company processes and rationale underlying compensation decisions conform to board-developed policies, as well as current company, market and economic imperatives, these processes should be critically reviewed, and revised as necessary.

Compensation committees should be truly independent.

The stock exchanges (and, by indirection, the SEC) require compensation committee members to be “independent.” But, as with beauty, independence is in the eye of the beholder. Each compensation committee member should be independent not only “legally” but also “pragmatically.” Committee members should be selected by independent board members, not by management. And, they shouldn’t be close friends of the CEO or have affiliations, business relations or other interrelationships with senior management. The independent board members should also designate the committee’s chairman.

Compensation consultants have their uses, but they are limited.

Compensation committees often require access to appropriate expertise in determining compensation levels, but it’s inappropriate for them to rely blindly on the advice of compensation consultants, or limit their efforts to the mechanistic process of considering nothing more than consultant-identified “comparables.” It’s especially important that the committee, not senior management, actually selects and hires experts.

Company filings should include a lucid and complete description of compensation decisions.

Companies should craft meaningful disclosures about their processes, and the predicates for compensation decisions, going beyond boilerplate justifications. Amounts are relevant, but so too is how those amounts are tied to performance, and how performance is measured. Investors should understand each executive’s goals and how his compensation is related to exceeding, meeting and falling short of those goals. Disclosure should address the compensation committee’s strategic rationales and methodology, as well as the data they considered.

It isn’t surprising that different constituencies - directors, executives, employees and shareholders - place different values on the services of different executives and on the services of executives in general. What most constituencies share, though, is a desire to achieve a form of rough justice in compensation. To achieve that, compensation committees must develop processes and procedures for determining, and then measuring, objectively, the appropriate level of compensation. That requires an effectively functioning, fully informed, truly independent and completely transparent executive compensation process.

• Harvey Pitt is a former chairman of the Securities and Exchange Commission.

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