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Compensation For The Ownership Decade

Forcing share ownership on CEOs may backfire. But voluntary programs strengthen the link between pay and performance, while facilitating empowerment initiatives and an entrepreneurial approach.

As the 1980s was the decade of stock options, the 1990s is the decade of ownership. Securities analysts, institutional investors, and regulators expect increasing levels of CEO and executive share ownership. Companies are looking for ways to meet this expectation. The most popular approach is to force -executives to accumulate stock. But as hierarchical organizations crumble, these mandates will become unenforceable. Companies using them will lose their talented executives and will be hard-pressed to attract outsiders of equal talent.

Ownership guidelines can work, but only in an environment of confidence and trust between shareholders and executives. To achieve this, companies must develop realistic programs that encourage executives to increase their ownership voluntarily.

OWNERSHIP MANDATES: HARMFUL TO SHAREHOLDERS

Many companies today are lauded by the press, analysts, and investors when they force senior executives to own company stock. Kodak and American Express are two such prominent examples.

Companies proudly announce these programs in press releases and compensation committee reports. They outline targeted ownership levels, expressed either as a multiple of base salary or as a percentage of shares outstanding. Executives are given a specific time period (usually three to five years) in which to buy.

It’s easy to understand why so many companies jump on this bandwagon. Boards like it, because they get to tell executives what to do. But these same boards rarely mandate ownership levels for themselves.

Shareholders favor it, because they think it puts executives with them in the same financial boat. But they forget that shareholders can liquidate their holdings at any time, while executives must quit their jobs to enjoy similar liquidity.

Analysts and institutional investors like the policy’s simplicity. However, when questioned more extensively, their views change. In a recent PCA study, we interviewed more than 30 analysts; they considered changes in CEO ownership far more important than the absolute level. The truth is, mandates hurt the interests of shareholders. First, they perpetuate a coercive and autocratic style of leadership. This contradicts the movement toward empowerment and entrepreneurialism.

Second, they alienate executives who can affect stock price modestly yet are forced to invest heavily. Could this explain why Christopher Steffen, Kodak’s new CFO, quit in frustration after only 12  weeks on the job?

Third, they discourage prudent risk-taking. Entrepreneurs can risk their net worth, because most have decades of earning power left to recover from failure. But the typical CEO has only a few years left before retirement and can’t recover from an evaporation of his net worth. If his board forces ownership on him, he will make decisions that preserve capital instead of creating it. If that’s what shareholders want, shouldn’t they invest in T-bills?

Kodak and American Express illustrate how ownership mandates can lead to risk-aversive behavior. These companies have trumpeted their ownership mandates in press releases and proxy statements. Yet neither CEO would take bold steps to turn his company around. Ultimately, the board had to replace them. Did resistance to change stem from the understandable late-career need to preserve net worth? ENCOURAGING

ENCOURAGING OWNERSHIP

Maintaining high levels of executive ownership is a laudable objective. To prevent this pursuit from backfiring, however, companies must create programs that encourage executives to raise their ownership levels. Here are six approaches that work:

Pay part of annual incentives in stock. Some companies boost executive ownership levels by delivering a fixed percent of annual bonuses in stock. Some restrict the transfer of stock; a gross-up in the number of shares compensates for illiquidity. Companies that utilize this program typically fall into two categories: either high-paying industries or ones that need to conserve cash.

This approach has significant advantages. Unlike restricted stock, the number of shares is tied to performance. The restrictions encourage executive ownership, because most employees sell only enough shares to pay their taxes; they keep the rest. Finally, the gross-up increases the number of executive shares.

Every employee participates in New York-based Salomon’s innovative program. The percentage of restricted stock increases at higher total cash levels. The shares vest after five years. To eliminate dilution, a trust buys shares on the open market with dividends reinvested in Salomon stock. To compensate for forfeiture risk and illiquidity, employees “purchase” shares at 85 percent of their fair market value.

Reward holding of exercised options. In our recent survey of analysts, many complained about CEOs who sell all their option shares immediately following exercise of the stock. As a result, executives pocket the after-tax gain but do not increase their ownership levels.

We agree this happens in too many cases. However, it is not always the chief executive’s fault. Most exercised shares must be sold to cover taxes and the exercise price. In addition, the company-paid financial adviser usually recommends portfolio diversification.

Fremont, MI-based Gerber Products has implemented a win-win program that rewards executives who hold on to shares received upon exercise. For every five shares received upon exercise, the executive gets one additional restricted share. If he still holds the five shares three years later, the restrictions lapse, and he owns the “bonus” share. This enables participants to retain control over their investment portfolios and to receive rewards for sustaining their ownership positions; on the flip side, shareholders gain a more strongly committed management team.

Lend executives money to buy stock. This is popular in LBO settings, but public companies can utilize it, also. Typically, the company lends money to the executive to purchase stock, which serves as collateral for the loan. In some instances, interest and even principal are forgiven if the company meets performance targets.

Companies considering this approach should be mindful of two unintended consequences. First, to an outside investor, loan forgiveness looks like a sweetheart deal. Second, the board will face a difficult decision if the stock price falls dramatically; it must choose between forgiving loans or encouraging dysfunctional behavior by executives who take imprudent risks to try to cover their loans.

Adopt performance share programs. Performance share programs have a lot in common with performance-based loan forgiveness programs. If the company performs, the executive receives the shares without paying for them. If performance falls short, the company cancels the shares.

But performance share programs avoid the negative consequences of loan programs. There is no perception of sweetheart deals, and executives are not encouraged to take desperate actions to cover their loans.

Companies can take two additional steps to turbocharge the ownership impact of their performance share programs. They can accrue dividends during the vesting period and reinvest them in additional shares. And they can place post-vesting trading restrictions on the shares, with gross-ups delivered in additional shares (like Salomon’s program) to compensate for the illiquidity.

Extend option exercise to the full 10-year term. Most companies cancel stock options anywhere from 30 days to one year following an executive’s retirement. Conventional thinking holds that retired executives can no longer influence company performance, so they should not continue to be eligible for incentives. This approach hurts shareholder interests. Executives view their company stock as a key component of their retirement savings. When they cannot hold an option for its full 10-year term, its value as a retirement instrument declines.

Extending the postretirement term of an option will encourage executives to take actions whose payoffs are expected after retirement.

Allow executives to exchange cash for options. A few progressive companies enable executives to “buy” options by voluntarily reducing their cash compensation. These include Minneapolis, MN-based General Mills and International Multifoods; Birmingham, AL‘s Torchmark; and Tambrands in Lake Success, NY. These programs can raise executive ownership significantly. If the stock price grows, the resulting shares far exceed the number the executive could have purchased with a comparable amount of after-tax cash compensation.

Companies adopt ownership mandates in a sincere effort to align the interests of executives and shareholders. However, they may fail to recognize the harmful effects these programs have on shareholder value. Programs that encourage ownership do a better job of linking these interests, because both parties have volunteered to pool their capital and grow the company.


David R. Meredith is chairman and chief executive of Personnel Corporation of America in Norwalk, CT, a firm specializing in human resources management. A former principal of McKinsey, he holds a Ph.D. from the Massachusetts Institute of Technology’s Sloan School of Management.

About david r. meredith