The Rumble Over Executive Pay

By Daren Fonda; Daniel Kadlec

Wall Street would love to see Eliot Spitzer realize his immediate political ambitions--becoming, say, Governor of New York or possibly landing a role in a Kerry Administration. Not that financial types wish him well; they just wish he would move on. As New York's attorney general, Spitzer, 44, has pushed through reform of stock-research and investment-banking practices, lobbied for a reduction in mutual-fund fees and left a trail of disgraced executives in his wake. Spitzer carved another notch in his belt last week. After drawn-out negotiations, Richard Strong, the former chief executive of Strong Capital Management, agreed to pay a $60 million fine and accept a lifetime ban from the securities industry to settle charges of improper trading. Spitzer will be at it again this week. He's expected to file a lawsuit seeking to force former New York Stock Exchange (N.Y.S.E.) chief Richard Grasso to return most of the $140 million in accrued pay he received shortly before resigning under pressure last year.

Those are high-profile enforcement efforts, and yet they're only two of the 10 cases that Spitzer is personally working on. His caseload isn't entirely about corporate wrongdoing. He's also challenging a federal attempt to pre-empt states from enforcing predatory-lending laws, and a few months ago won a ruling that forced the Bush Administration to reverse its rollback of pollution regulations that applied to big utilities. "The EPA [U.S. Environmental Protection Agency] cases are huge," he says. But Spitzer clearly sees Wall Street as his bailiwick; an avid and aggressive tennis player, he keeps a tennis ball with the Merrill Lynch logo on it, occasionally palming it as he chats. The crush of activity in his office speaks volumes about how much opportunity presents itself for someone who makes it a personal crusade to clean up the business world.

Certainly, the run of greed-inspired scandals beginning in 2001 with Enron has brought about meaningful changes. The accounting industry now has a federally chartered oversight board. Stock analysts are no longer permitted to shill for investment bankers at road shows. Bankers at Goldman Sachs can't talk to analysts on the phone without a corporate chaperone listening in, and e-mails between their departments automatically bounce back. The compensation committees of public companies must now be composed of independent directors, reducing the chances for cronyism. There's legal basis for forcing executives to give back bonuses when accounting fraud is proved. Mutual-fund fees are coming down. And the Grasso flap is riveting attention on the thorniest issue of them all, one that seems unlikely to be resolved in a definitive way: Just how much is a CEO worth?

In a sense, Spitzer is taking on the whole clubby system that keeps driving CEO pay higher. Boards stacked with cronies too often still rubber-stamp excessively rich packages. In most cases, CEO pay is a question not of what is legal but of what is right. "The nature of CEO compensation is something that deserves additional scrutiny. One of the things that will emerge from the Grasso investigation," he says, "is the failure of compensation committees to fulfill their obligations." The Grasso case involves some of the most high-profile executives on Wall Street--the people who approved his payout in the first place.

Spitzer's view enjoys broad support among institutional shareholders. "Excessive executive pay undermines the very principles of free enterprise," says Phil Angelides, the California state treasurer and a board member of the California Public Employees' Retirement System. He endorses recent efforts to rein in those eye-popping stock-option grants but notes that CEOs still seem to find a way to get richer at their employer's expense. Grants of restricted stock have in some cases replaced the value of options for executives. Retirement benefits and deferred-compensation packages can also amount to millions of dollars and yet remain relatively invisible to investors.

Then there are the perks that simply aren't disclosed. Jack Welch's retirement package from General Electric included such booty as a Manhattan apartment and use of the corporate jet, worth some $2.5 million; it was discovered by investors only after the perks were disclosed during his divorce proceedings. "Essentially, CEOs talk to their compensation consultants and say, 'What is it that would get me in the cross hairs of my shareholders?' They then avoid that and come up with another way to get a big raise," says Sarah Teslik, executive director of the Council of Institutional Investors.

Indeed, while you may not have noticed your raise last year (if you even got one), senior executives felt theirs. Median compensation for CEOs of companies in the S&P 500 rose 27% in 2003 on top of an 11.4% hike in 2002, according to the latest pay survey by the Corporate Library. Other surveys, which don't account for exercised stock options, found just single-digit increases in salary and bonus. And, yes, corporate profits rose sharply during 2003, up 18%. But that wasn't the case in 2002, and the gap between pay for the average worker and the typical large-company CEO has widened further. The typical CEO now makes $301 for every $1 paid to the typical employee. That's up from $42 to $1 in 1982.

Pay experts point out that CEOs are like free agents in sports, and that you can't fault them for taking big packages (within legal boundaries) any more than you can wonder why A-Rod cashes his paychecks. Over the years a few companies have put CEO pay caps in place, but many have either abandoned or raised them in the face of competition. Socially progressive Ben & Jerry's, which for a decade capped executive pay at seven times the salary of the lowest-paid worker, dropped the provision in 1994 when it sought a CEO to replace co-founder Ben Cohen. Whole Foods Market, the popular organic supermarket chain, has raised its cap twice--from 8 to 1 in 1997, to 14 to 1 today, though that's still considered low.

Some companies are adopting more sophisticated formulas that peg CEO compensation to benchmarks other than the stock price in a bid to align pay more closely with performance. During each of the next three years, Hewlett-Packard CEO Carly Fiorina can accrue up to 150% of a nearly $2 million cash award if she meets certain criteria for operating cash flow. But she will collect the full amount only if at the end of the three years HP stock has outperformed at least half the companies in the S&P 500. IBM is now granting its top 300 senior executives stock options that are priced 10% above market value, an uncommon practice that makes it harder for execs to cash out. Compensation committees, partly to shield themselves from lawsuits, are also taking a tougher stance, hiring consultants to evaluate employment contracts.

The Grasso suit will probably name former directors who approved Grasso's pay, the most prominent of whom is Ken Langone, Grasso's longtime friend who chaired the compensation committee during the years that Grasso received his biggest compensation deals. Spitzer was in talks with Langone's lawyers late last week in one of those 10 cases the tireless New York attorney general was on.

Langone has steadfastly defended Grasso's pay, appalling though it might have been by the standards of a not-for-profit institution like the N.Y.S.E. In fact, the basis for Spitzer's suit is a New York not-for-profit law dictating that pay be reasonable for services rendered. From 1999 through 2002, Grasso was paid more than $76 million--more than a third of the exchange's net income in that period. Langone has argued that Grasso was worth every dime, in part for getting the markets running after the Sept. 11 terrorist attacks. Grasso's lawyer has said that the N.Y.S.E. board went through all the necessary legal steps in approving his compensation.

The N.Y.S.E., meanwhile, is reforming. The Big Board has split the positions of chairman and CEO, overhauled its board of directors and created the post of chief regulatory officer. In Washington the SEC is developing proposals that would tighten regulation of U.S. stock exchanges--the first order of business being that they must abide by the same disclosure rules they impose on publicly traded companies. But the changes afoot aren't enough for Spitzer. In a recent interview with the Harvard Business Review, he noted that "we have board compensation committees that are self-selected and interwoven. It's a rigged marketplace." Asked what it would take to right the playing field, he tells TIME, "I have no idea what the solution is. But I do believe that the first step--shedding light on these issues--is important." It looks as if the fight has just begun.

--With reporting by Barbara Kiviat, Julie Rawe/New York, Eric Roston/Washington and Sonja Steptoe/Los Angeles

With reporting by Barbara Kiviat, Julie Rawe/New York, Eric Roston/Washington and Sonja Steptoe/Los Angeles