EXECUTIVE COMPENSATION ASSESSING THE OPTIONS

Share Grants Spur Debate

By KATE BERRY

Staff Reporter

Has the executive pay pendulum swung too far away from stock options?

Outraged over the lengths executives were going to keep stock prices up often with disastrous consequences investors demanded reform.

They’re about to get it.

Beginning Jan. 1, 2005, the Financial Accounting Standards Board has proposed requiring public companies to expense their options grants, which would take a bite out of reported earnings. Technology companies are resisting the effort, but others have already conceded the change will occur.

Companies in Los Angeles and elsewhere have shifted their executive pay packages toward granting restricted stock, or using other forms of incentives such as payouts based on long-term performance.

But offering restricted stock, a grant of free shares that typically vests over a period of years, has its own drawbacks. Where options tempted some executives to fudge the company’s books just to keep the stock price up, restricted stock goes to the opposite extreme, offering no performance incentive at all.

Until the restricted shares vest, they cannot be sold, and if the recipient leaves the company they usually leave their restricted shares behind.

“With restricted stock, you’re basically handing money to the executive just to stick around, which troubles me,” said Gary Hourihan, executive vice president and president of leadership development solutions at Korn/Ferry International, the Los Angeles-based executive recruiting firm.

Further, the executives receiving restricted stock aren’t lacking in other forms of compensation. Companies issuing restricted stock tend to be ones that are already rewarding executives handsomely in other ways.

Occidental Petroleum Corp. Chairman and Chief Executive Ray R. Irani, for one, was granted $11.4 million in restricted stock in 2003. That’s only a part of a pay package that totaled $25.1 million in company payouts, including salary, bonus and short- and long-term incentives. If that wasn’t enough, the Los Angeles-based oil company’s board saw fit to grant Irani another 700,000 new stock options.

There’s more. During the year, Irani also exercised previously granted options worth another $8.1 million.

Larry Meriage, an Occidental spokesman, defended Irani’s overall compensation by pointing out that Occidental shares rose more last year than the S & P; 500 Index and the Dow Jones Industrial Average.

“Shaquille O’Neal made $25 million last year,” Meriage said. “You have to look at this in the context of professional athletes and actors that are an entity of one and they have no one else they’re accountable to.”

Trend toward restricted stock

According to compensation consultant Pearl Meyer & Partners, chief executives of large U.S. companies took home 23 percent more in cash and restricted stock in 2003 than they did in 2002, while the value of options grants fell on average by 38 percent.

For the nine Southern California companies included in the survey, the use of restricted stock was even more pronounced, surging 74 percent, while the value of stock option grants fell by 30 percent.

“Clearly, the perception in the marketplace is that options are bad,” said Jim Hughes, Los Angeles-based managing director with Pearl Meyer. “We don’t believe they are bad. Though they may be inefficient relative to the accounting charge, they do tie the executive to shareholder value.”

While some of the excesses have been reined in, executive compensation remains a sore spot among investors. Despite earlier reforms that remade the ranks of board compensation committees, it’s still a rare and newsworthy event when a CEO takes a real pay cut after a year or two of poor company performance.

When things do go well, few opportunities to reward the executive are missed.

Last year, Countrywide Financial Corp. paid its chairman and chief executive, Angelo Mozilo, $2.3 million in base salary, plus a $19.9 million bonus. It also granted him 40,001 restricted shares of stock worth $1.1 million and new options for another 1 million shares. Mozilo also cashed in options valued at $34.4 million that he accumulated in previous years.

In response to questions about Mozilo’s pay, the compensation committee of Countrywide’s board issued a statement citing the company’s record earnings in 2003 and stock price gains that outpaced the S & P; 500 and the Dow Jones Industrial Average.

“According to the terms of his contract, Countrywide Financial Corp.’s chairman, CEO and co-founder Angelo Mozilo is compensated in direct relationship to the company’s financial and operational results,” the statement read. “The compensation committee of the company’s board of directors structured the contract in this way in an effort to tie Mr. Mozilo’s compensation to the overall performance of the company and to ensure the best interests of its shareholders.”

(Countrywide’s five-member compensation committee includes Robert J. Donato, an executive vice president for UBS Financial Services; Michael E. Dougherty, founder and chairman of Dougherty Financial Group in Minneapolis; Hall of Fame basketball star Oscar P. Robertson, who is president and chief executive of Orchem Corp.; Keith P. Russell, President of Russell Financial Inc. in Pasadena; and Harley W. Snyder, president of HSC Inc., a real estate firm in Indiana.)

Often, though, it appears to people outside the company that some of the pay windfalls are as much a function of being in the right place at the right time as they are stand-out management practices.

Mortgage lender Countrywide, for example, benefited from persistent low interest rates that fed a refinance boom. While the company has taken market share during the boom and shown resilience to initial rate rises, the real test will come when rates rise significantly for a long period of time.

Likewise, Occidental has benefited from surging crude oil prices.

Last week, state Insurance Commissioner John Garamendi demanded that Thousand Oaks-based Wellpoint Health Networks Inc. and Anthem Inc. provide up to $600 million in health care services to uninsured Californians. The amount is equivalent to what company executives will receive in merger-related payouts.

Leonard Schaeffer, chairman and chief executive of Wellpoint, received no restricted stock last year but exercised $25.2 million in options as part of his $37.1 million pay package.

This year’s flavor

Ten years ago, restricted stock was out of favor as a form of executive compensation. By contrast, stock options were viewed as a way to reward individuals for the rise in the company’s share price.

“Restricted stock was considered a demon vehicle that was looked at as a giveaway,” said Hourihan at Korn Ferry. “Because options require some stock appreciation, they only went out of favor when the stock market started to depreciate.”

Another problem with stock options is that they are hard to value. Because they are typically granted at the current price of the stock, any estimate of future value is imprecise.

Of course, many companies give their top executives a mix of compensation that may include a base salary, bonus, as well as short and long-term incentives such as stock options and restricted stock that can be tied to specific performance goals such as earnings or share price increases.

According to Equilar Inc., another compensation consultant, the number of S & P; 500 companies whose executives received all three forms of incentive rewards stock option grants, restricted shares and long-term incentive plan payouts rose to 11.1 percent last year from 7.2 percent in 2002. The use of options fell, but still 81.2 percent of all chief executives received them.

That’s resulted in a lowering of the risk to the executive.

Among L.A.’s largest companies ranked by market capitalization, 11 executives received restricted stock in the most recent fiscal year, compared with nine last year.

(Richard Gilchrist, co-chief executive of Maguire Properties Inc., received $8.7 million in restricted stock last year. The company, which went public in June of 2003, lost $52.2 million last year, mostly due to a financial restructuring related to its initial public offering.)

“We’re definitely seeing less emphasis on equity for a whole lot of reasons because it seems to be a flash point for more scrutiny,” said Tim Chrisman, principal at Chrisman & Co Inc., a Los Angeles executive-search firm. “If companies had their way, they’d give all stock and no cash at all.”

The Challenge of Setting CEO Pay

Not so long ago, chief executives picked their own compensation consultants and helped create their own pay packages, which were simply rubber-stamped by a company’s board.

Though CEOs still find ways to play an active role in determining their pay, at least one change has cut management out of the loop the direct hiring of pay experts by compensation committees.

In the past few years, compensation committees have begun employing their own consultants, rather than having those experts hand-picked by management. In addition, reports from those same pay experts are more likely to go to the committee first instead of being filtered through top management.

The change is a baby step in the overall universe of corporate reform.

“Compensation committees are rolling up their sleeves and giving greater input,” said Jim Hughes, managing director at Pearl Meyer & Partners in Los Angeles.

Though the Sarbanes-Oxley Act of 2002 did not mandate any changes in compensation other than restricting personal loans made to executives, experts said the legislation has forced companies to adopt more rigorous procedures.

No longer are CEOs allowed on compensation committees, for instance. Certainly the job of being a corporate director has become tougher under Sarbanes-Oxley, with the increased potential for being sued not to mention greater scrutiny by politicians and the media.

While the results of this shifting playing field aren’t final, one thing is sure. Directors’ pay is rising as fast as their increased workload. Last year, directors’ pay rose by 20 percent, according to Pearl Meyer, with another 50 percent jump expected over the next few years.

Few compensation committee members are willing to discuss their decision-making one-on-one. Yet changes are afoot.

“More and more compensation committees are asking tougher questions of both consultants and the management group,” said Gary Hourihan, executive vice president and president of leadership development solutions at Korn/Ferry International in Los Angeles.

Some compensation committees have taken a tougher stance on granting options after facing the onerous task of repricing them when stock prices fell dramatically in 2001 and 2002. Others are holding back on issuing options or are reducing the period during which employees need to exercise options. That’s being done in an effort to reduce overhang and the potential for stock dilution and criticism from shareholders. Overhang, which is calculated by adding up the number of stock options issued as a percentage of total shares outstanding, represents latent selling volume as the holders exercise and then sell the shares. It can exert downward pressure on a stock’s price.

Kate Berry