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The average CEO's compensation jumped 47 per cent over the past six years, largely due to a move toward stock-based pay and away from cash. With shareholders beginning to speak out and some Bay Street names taking note, the time for reform could be now – but it won't be easy

In the escalating war over outlandish executive pay, a remote gold mine in northern Quebec was thrust into an unlikely role. The Malartic project, 27 kilometres west of Val-d'Or, is one of the best deposits in the country and it was bought last year for nearly $4-billion.

For wrestling such a precious project from a giant rival, Yamana Gold Corp. paid its chief executive officer and three other executives handsomely. Peter Marrone, the CEO, got a special $2.7-million cash bonus when the deal closed, as well as 450,000 share units that would make him far richer if the mine performed well. Three other officers received $1.2-million combined.

A firestorm erupted when the pay packages were made public by Yamana last spring. The sizable cash portions divorced the bonuses from long-term performance – Yamana's shares have lost two-thirds of their value since the takeover was first announced – and executives at Yamana's takeover partner, Agnico-Eagle Mines Ltd., didn't earn an extra dime for the same deal.

Canadian shareholders are famously reluctant to voice frustrations, but 63 per cent of Yamana's investors expressed disapproval by voting against the compensation practices at the company's annual general meeting in April. They weren't alone. Canadian Imperial Bank of Commerce and Barrick Gold Corp. also lost similar say-on-pay votes this spring, making 2015 the first year three major Canadian companies faced a firm rebuke from shareholders on pay.

Barrick Gold Corp. chairman John Thornton.

Barrick Gold Corp. chairman John Thornton.

Mark Blinch/Reuters

What happened? Not much, because these kinds of votes aren't binding. CIBC stayed silent; Barrick deferred any action, promising to address the issue down the road; and Yamana's CEO gave back the worthless shares but kept his cash bonus. The votes have prompted a debate over excessive executive compensation and concerns by many investors, directors and even some executives that change is needed.

Median pay for CEOs of Canada's 100 largest companies, ranked by market value, rose to $6.3-million in 2014 from $4.3-million in 2008, a 47-per-cent jump over six years. CEO pay also climbed to 130 times the average worker pay in 2014, up from 103 times in 2008. Older statistics are hard to come by because regulators didn't require companies to report the value of all pay elements prior to 2008.

A major driver of this expansion has been the rampant practice of paying executives with equity, such as stock options and share units. This was supposed to ensure CEOs would be motivated to think like shareholders, but the trend has led to eye-popping payments and soaring wealth for the recipients. For example, Cara Operations Ltd.'s CEO was given 3.5 million stock options for taking the company public this year. On the first day that the company's shares traded, those options were worth $95-million.

There are also growing questions about the alignment between CEOs and shareholders, with some critics calling equity-based compensation a "cult" that has pushed pay higher while not necessarily doing the same for shareholder value. Influential investors, and even some directors, are starting to speak up.

"This is a gravy train," argues Catherine Jackson, senior adviser for responsible investing at PGGM, a Dutch pension fund manager that oversees $260-billion (U.S.) in assets.

"We all thought alignment was the way to go; I will confess I was part of that." She now sees the perverse consequences. "I don't think anybody would [say] the types of payments coming out of this 'alignment system' are what we had in mind."

How we got here

For the first half of 20th century, employee bonuses were mostly calculated in a simple manner. At General Motors, then a giant of American industry, workers were given a 10-per-cent cut of any economic profit – that is, any after-tax operating profit above a 7-per-cent return on capital. The thinking behind it: Employees would not get paid extra unless investors did too.

This mentality began shifting after the Second World War. McKinsey & Co. consultant Arch Patton was hired by GM to study its profit-sharing pool, and he found that from 1939 to 1950, hourly pay for the average employee had more than doubled, but compensation for "policy-level" management rose only 35 per cent.

The study had a tidal wave effect. Managers across the country started worrying that they were underpaid, prompting them to hire Mr. Patton to review their own firms. Ever more popular, the consultant started writing books, including Men, Money, and Motivation, spreading the message that companies would benefit from paying the best executives top dollar. It was the start of so-called competitive pay.

Mr. Patton's influential work planted the seeds of the star CEO phenomenon. In the 1980s, brash executives, such as General Electric's Jack Welch, started making themselves seem irreplaceable and executives began getting showered with hefty bonuses and extra perks. The trend exploded: IBM, for instance, gave CEO and chairman Louis Gerstner the right to remain as a consultant for 10 years after he retired, which included access to company aircraft, cars, apartments and an office.

Around the same time, Wall Street started paying bankers and traders astronomical sums. "The merger era doesn't get enough credit," explains Nell Minow, one of the few American critics to successfully challenge executive pay and performance at legendary companies such as American Express and Kodak. "As CEOs were buying and selling divisions, they couldn't help notice that investment bankers were getting paid a lot more than they were," she says. They started to think, " 'This guy works for me; I'm a captain of industry; I should get paid like that.' "

Regulatory changes designed to curb the problem only added gasoline to the fire. With the U.S. economy tanking during the 1992 presidential campaign, Americans grew outraged over excessive CEO pay. Tapping into this anger, then-governor Bill Clinton promised to cap corporate tax deductions for executive pay at $1-million. But because Congress exempted stock options from the deductibility cap, companies started limiting salaries to $1-million and granted scores of stock options to skirt the rules.

The same year, the U.S. Securities and Exchange Commission started requiring publicly traded American companies to disclose pay for their top five officers. The assumption was that full information would help investors keep compensation in line. But the opposite happened: Pay soared higher as CEOs strove to earn as much, or more than, their rivals.

Everything that happened in the United States has had an enormous impact in Canada. This is true for regulation, where changes south of the border are often replicated here – the Ontario Securities Commission mandated its pay disclosure rules in 1993 – and it also applies to equity-based pay. Over the past 40 years, Canadian CEOs have increasingly been awarded sizable chunks of their annual compensation in equity – typically stock options or share units that pay out within three years.

CEO pay, by the numbers

Median CEO total compensation in 2014

Median CEO pay increase since 2008

Median CEO equity grant in 2014 (options and share units)

Average Canadian's earnings in 2014

129 times
Ratio of CEO pay to average Canadian worker pay

Median CEO stock ownership (shares and share units)

Median CEO unexercised stock options

Based on disclosures of pay and equity ownership for CEOs of Canada’s 100 largest public companies by market capitalization

Since stock options came into vogue in the 1970s, partly thanks to Mr. Patton, equity has grown from a minuscule part of pay packages to the dominant feature of CEO compensation. At Canada's 100 largest companies, grants of equity-based pay climbed by 30 per cent in value between 2010 and 2014 alone, providing almost $3-million (Canadian) of the median $6.3-million in total CEO pay.

Most CEO pay packages now include some assortment of stock options, performance share units, restricted share units, deferred share units and performance options. The incentives are layered on top of more traditional pay models such as salaries and cash bonuses, creating complicated pay packages that can be difficult to track.

Even for sophisticated shareholders like PGGM, the Dutch pension fund, the formulas are impossible to understand. "It's overly complex, and I can't identify who benefits from that level of complexity," Ms. Jackson says.

Mutual fund company NEI Investments, whose products include ethical funds, has helped lead a campaign to protest pay design as well as excessive compensation, much of it coming from equity pay practices.

Starting next year, NEI will vote against any CEO pay that totals more than 200 times the median household income in Canada. The threshold is high – around $15-million at current income levels – but NEI wanted to draw a line in the sand.

"We had hoped there would be a wake-up call after the financial crisis and there would be some restraint and also concern about the risk of incentivizing people to take big risks," says Michelle de Cordova, director of corporate engagement. It never materialized.

NEI is especially bothered by the fact that so much pay is described as performance-based, yet appears to be awarded at near-maximum levels year after year. Ms. de Cordova points to performance formulas for annual bonuses or share units that all but guarantee major payouts under most feasible scenarios. Even if executives do not get the maximum possible payout, she says plans are often structured to ensure CEOs receive a large proportion of it.

"You look at the small print, and this seems to always pay out at least 80 per cent," she says. "It's almost inconceivable to imagine a situation in which this cannot pay out at 80 per cent."

Mr. Patton, who died in 1996, spent the last decade of his life embarrassed by what had become of his work. Asked how he felt about the culture it spawned, he answered with one word: "guilty."

Roger Martin, management consultant, is shown in this 2012 photo.

Roger Martin has strong views on executive compensation.

Deborah Baic/The Globe and Mail

Ways to fix the system

There is no shortage of proposals for fixing the most egregious pay problems – everything from tying CEO compensation to the average worker rate, to rewriting federal tax policies on stock options.

But because there's no consensus, and because directors believe in equity pay like they would a religion, boards prefer to tweak the formulas they use to calculate compensation each year. By now there have been so many updates it looks a lot like a dysfunctional IT network that keeps adding new software to sit on top of old decrepit systems.

Which is why, as sacrilegious as it sounds, Roger Martin believes the best option is to blow the whole thing up.

A management consultant who once sat on high-profile boards at companies such as Thomson Reuters Corp. and BlackBerry Ltd., he studied 40 years of North American pay and performance data, concluding that the equity fanaticism is built on "kitchen logic" – it seems like common sense, but actually creates horrible incentives.

Too many CEOs, he says, focus on managing their stock price rather than core business operations. Stock market volatility has also soared because executives pursue strategies, such as relentless acquisitions, to juice quarterly earnings and to boost share prices in the short term. But these tactics rarely build long-term wealth – particularly in the resource sectors. Kinross Gold Corp. paid $7.1-billion to acquire Red Back Mining Inc. in 2010; four years later the deal had been fully written off.

Mr. Martin argues that equity-based pay rewards those executives who foster the most volatility in their share price, allowing them to load up with options or share units in years when prices are low and cash out as they rise, even if share prices stay below the level when the CEO was hired.

"CEO compensation practices are criminally stupid – and you can quote me on that," he says.

His solution involves paying executives in straight cash – which they could then use to buy their own shares, should they so choose. He also wants to tie the metrics that trigger cash bonuses to more concrete corporate results, such as profits or return on capital – not share price performance.

The hard part is convincing others. Two years ago, Mr. Martin attended his last corporate board meeting and now says he is done with being a director, save for non-profits. "I'm never going on another board as long as I live," he says, arguing it is too hard to have an impact, including on compensation issues. "I hate it. I hate it with a burning passion. I hated pretty much every minute."

Leo de Bever, former head of Alberta Investment Management Corp. (AIMCo), Alberta's $75-billion pension fund manager, says he sympathizes with many of Mr. Martin's frustrations, arguing that equity pay practices have steered CEOs toward short-term strategies with quick payouts. Even when stock options have a 10-year payout, many CEOs know they likely won't stick around and still favour shorter strategies, he believes. "Short-termism is an issue, and it keeps CEOs from undertaking anything that doesn't have a payback period of a couple of years," he says.

Some top Canadian directors, who would only speak anonymously because they did not want to upset their peers, admitted to having some sympathy for brash proposals to fix equity pay concerns. But ultimately they argued that these ideas are too theoretical. The system has evolved so much they wouldn't be practical.

Other directors and consultants strongly believe equity-based compensation, despite its flaws, generates the best long-term outcomes. Democracy is flawed, too, after all.

At companies where pay and long-term performance are not closely linked, "the only way to fix it, in my mind, is to continue to push for more stock-based, deferred compensation," says Gordon Nixon, the former CEO of Royal Bank of Canada who is now a director at companies such as BCE Inc.

That's largely because equity-based pay makes executives suffer when shareholders do. Recent debacles at mining companies might best articulate this argument. Their executives made out like bandits in 2011 and 2012 when metals prices soared, but for miners where pay was largely shelled out in shares, the executives' net worths have fallen because many of their stock options are worthless at current stock prices. Their share units are also now valued at a fraction of what they once were.

(It is worth noting, though, that many of their CEOs were paid multimillion-dollar severance packages upon being fired, even though the acquisitions they inked generated billions of dollars worth of writedowns. And others get reloaded with new options as the share price falls so they can reap big gains when it climbs again.)

There's more to it. "Equity compensation is what helps people get rich," compensation consultant Ken Hugessen says. "If you eliminated that from executive pay programs, you're saying, 'If you want to be anything other than a paid employee for life, you have to start your own business.' "

Mr. de Bever, formerly of AIMCo, argues that executives need at least some equity-based pay "because whatever you do to a company that improves its position eventually gets reflected in the share price" – even though he openly admits equity compensation often fosters too much short-term, even quarterly, thinking.

Despite the distance between camps, common ground can be found – particularly on issues of complexity.

Bill Holland is the former CEO of highly successful asset manager CI Financial and is one of Bay Street's wealthiest people because of it. But even he complains about the "total obfuscation" of current compensation models. Complex formulas help executives reap undeserved payouts, so he advocates scrapping them in favour of something much more transparent.

"Formulas are terrible," he says, because they can be gamed; executives always seem to find a way to justify their pay. "The formulas keep changing to be beneficial to whatever the changing times are," he says.

Another of his beliefs that boards may be more likely to get behind: scrapping executive perks.

As a CEO, Mr. Holland says he received no pension and no extra benefits like tax assistance, car allowances or club memberships. Executives can easily afford these things themselves.

"You're a professional manager; you're being paid by the owners of the company," he says. "Why are they paying for all this other crap? It makes no sense."

Ideas for reforming pay

Roger Martin, management consultant:

Stop paying CEOs with equity, which rewards them for creating volatility, and instead rely on cash.

Catherine Jackson, Dutch pension fund PGGM:

Get rid of stock options and simplify pay systems so CEO rewards are based on long-term targets that create sustainable value rather than short-term share price growth.

Michelle de Cordova, mutual fund company NEI Investments:

Tie CEO pay to average worker wage rates so that CEO compensation gains don’t far outstrip the rest of society.

Canadian Centre for Policy Alternatives:

Change tax policy to discourage excessive pay by limiting the amount of compensation companies can deduct as expenses and change the tax treatment of stock options.

Bill Holland, CI Financial Corp.:

Simplify pay structures and unwind the convoluted payout formulas that seem to allow CEOs to get their bonuses in any market environment.

Paul Gryglewicz, senior partner at Global Governance Advisors:

Give boards the ability to redesign pay without triggering negative votes from shareholders who want the design to fit a proscribed model.

Why it's so hard to fix

Because the obsession with equity-based pay is so intense, and because executives are motivated to maintain the status quo, courage is required to even debate whether the system works. Yet none of the major players – regulators, shareholders and directors – seem to have enough at stake to make the effort.

Before he stepped down in November, former OSC chair Howard Wetston stressed that Canada's largest securities regulator is unlikely to get more aggressive on compensation, particularly by forcing companies to hold say-on-pay votes. (At the moment, such votes are voluntary and only 51 per cent of S&P/TSX composite companies now offer them.) The only way the OSC would intervene is if it "becomes a matter of abuse of rights and shareholder opportunity," he says.

Shareholders, meanwhile, rarely speak out. Even though three major Canadian companies lost say-on-pay votes this year, and another, Quebecor Inc., had shareholders withhold the majority of their votes for the board's compensation committee head because of an excessive payment to a departing executive, the actions were anomalies. And even then, they said almost nothing publicly, allowing the issue die down rather quickly.

Canadian investors have long been reticent to talk about pay publicly. In the spring, major institutional shareholders refused interview requests to even explain why they voted "no" to the pay policies, and the country's largest pension funds, including the Canada Pension Plan Investment Board, the Ontario Teachers' Pension Plan and British Columbia Investment Management Corp., which are often held up as Canada's activists on governance issues, all declined to comment about compensation issues for this story.

This is partly a cultural issue. Peter Dey, author of an influential 1994 report that set corporate governance guidelines in Canada and who is now a director on three different boards, argues that "Canadian culture suggests a more consensual approach to these sorts of issues." That lends itself to more sit-downs and meetings behind the scenes.

And multiple people stressed that even when shareholders are silent, advocacy groups such as the Canadian Coalition for Good Governance routinely meet with boards to talk about these issues.

The trouble is, those boards that care deeply about compensation issues are often handcuffed. To outsiders, pay can seem so black and white; in reality, it is a very nuanced issue.

Human psychology, for one, has an enormous impact. In 2009, Ken Feinberg was tapped by the Obama administration to determine how much executives at U.S. companies that were bailed out during the financial crisis should get paid. He quickly realized that more than just a bonus was at stake. "In our society, I've found that compensation is a surrogate for worth," he told a Princeton University audience after he wrapped up his work.

Executives also keep score with each other, which affected the process for setting CEO pay at Hydro One Ltd. In 2014, the leader of Ontario's massive electricity distribution utility made $1.2-million, but this fall the company was taken public in Canada's biggest privatization in decades and Mayo Schmidt was hired to run the company. The new leader has the potential to make up to $4-million annually, in line with the heads of other publicly traded utilities.

Former Toronto-Dominion Bank CEO Ed Clark served as the government's chief adviser on the deal, and he has long talked about social issues, such as income inequality, which are partly propelled by soaring CEO pay. Yet even he defended the raise by arguing that there was no other option.

"No one feels more passionately about this subject of income distribution than I do," he told the provincial government's press gallery in September. But it is very hard to be an outlier when attracting talent. "If you're going to build a great company, you're going to have to pay competitively."

It is easy to sit back and say the system is too complex to fix. But the longer the status quo remains, the more pronounced the societal impacts will be – something many major stakeholders arguably don't have a duty to care about.

"There's no question that people follow the money, and that distorts choices," argues Ed Waitzer, one of Bay Street's top corporate lawyers and a former OSC chair. The more paid to business leaders, the harder it is to convince younger generations to pursue other fields.

When he went to law school in the 1970s, most students pursued the degree to get a good foundation for understanding the world. Today many do it with the goal of going into corporate law – something he sees first hand because he teaches at Osgoode Hall Law School. "Now a significant number of people are single-minded on maximizing their income," he says.

It is the ideal time to try something new. Radical changes are easiest to implement when there is widespread unrest, and boards of directors of resource-based companies are grappling with what to do in this deep downturn for metals and energy prices.

"For me the issue is less about quantum, and more about incentives," Mr. Waitzer says. "The real challenge in compensation is coming up with appropriate metrics and arrangements that promote a longer-term focus. From that perspective, the system is dysfunctional."

"At a certain point," he adds, "compensation becomes offensive."