With CEO pay, 'peer' gets new meaning

For the shareholders of Regis Corp., 2007 was a bad hair year.

Profit at the hairstyling company, which owns the Vidal Sassoon and Supercuts chains, fell 24 percent on slower sales growth and higher expenses.

But that limp performance didn't stop the company's board from awarding CEO Paul Finkelstein a $1.06 million salary -- up 19 percent over 2006 -- and a $747,000 bonus, up 118 percent from a year earlier.

In an era of increased scrutiny of executive pay practices, it may seem perilous for corporate boards to reward an underperforming CEO with a generous raise. Yet the practice continues, in part because of the long-standing custom of basing executives' compensation on the pay of their peers. Known as "competitive benchmarking," it has contributed to the runaway inflation in executive pay, corporate compensation experts say.

Finkelstein got his compensation package in part because Regis compares his pay with 15 companies, several of which are much larger than the operator of hair salons. Among them is coffee giant Starbucks Corp., which has nine times the market value and last year collected 3.6 times more revenue than Regis. That's comparing coffee and coiffeur.

H&R Block also made it on Regis' list of peers, although the tax preparer has six times the market value and 1.5 times the revenue.

Regis chief financial officer Randy Pearce defended the choice of Starbucks and H&R Block, noting that both are service-related companies with a national footprint like Regis, which has 13,500 hair salons.

And both cater to a "moderate customer" in terms of income and style. "Regis looks for peer companies that appeal more to the masses," Pearce said.

And while Regis uses a peer group as a benchmark, it's not the sole reason that Finkelstein got a raise last year, Pearce added. The company also factored in Finkelstein's long-term performance and its desire to retain him as CEO. Shares of the hairstyling giant have increased twelvefold since he took the helm. "This doesn't happen every year," Pearce said of the pay increase.

Regis is not alone in choosing unusual bedfellows. In calculating executive pay levels, corporate boards often measure themselves against companies that are far larger and more complex than their own. In many cases, these so-called "peers" are not even competitors, and shareholders are left to question the rationale behind their selection.

"There are times when you can look at a company's peer group and say, 'I know exactly why those companies are there,' " said Paul Hodgson, senior research associate at the Corporate Library, a corporate governance research firm in Portland, Maine.

"At other times, they make absolutely no sense."

'Above-average' CEOs

Even murkier than the peer groups is the manner in which they are used. Most public companies set chief executive pay at or above the median of whatever peer group they choose for comparison. The result is an automatic ratcheting up of CEO pay, because the median gets higher each year, compensation experts say.

Last year, 99.5 percent of corporations in the Standard & Poor's 1500 targeted executive pay at or above the median in their peer groups, according to RiskMetrics Group, a Rockville, Md.-based firm that advises big investors in corporate governance issues.

Executive compensation experts say this is the corporate equivalent of the mythical Lake Wobegon, where, as Garrison Keillor writes, "all the children are above average."

"It's a built-in cushion against falling pay," said Carol Bowie, head of the Governance Institute at RiskMetrics. "I could count on one hand the number of times I've seen executive pay targeted below the median" in a peer group.

Though corporate boards have long used peer groups to compare performance and set pay, the benchmarks didn't get much attention until 2003, when the board of the New York Stock Exchange came under fire for paying its chairman, Richard Grasso, about $140 million in total compensation.

It was discovered that the exchange based Grasso's pay, in large part, on the compensation of top executives at much larger entities, including insurance giant AIG and Merrill Lynch. The New York Stock Exchange is a nonprofit organization, but there were no nonprofit groups in its peer group.

The outcry over Grasso's pay has led to more disclosure. In 2006, new Securities and Exchange Commission (SEC) rules required public companies to disclose which firms they use in their peer groups, and to describe how they are constructed. Last year, for the first time, shareholders could see the list of peers.

Yet the additional information merely confirmed what many shareholder advocates had long suspected: That many corporate boards had a very loose idea of what a "peer" is.

ValueVision Media, an Eden Prairie-based company that operates the TV shopping network ShopNBC, has a market value of $143 million and revenue last year of $782 million. Yet among ValueVision's 19 peers is Internet giant eBay Inc. (market value $41.1 billion and 2007 revenue $7.7 billion); and Amazon.com Inc. (market value $31 billion and 2007 revenue $14.8 billion).

ValueVision CFO Frank Elsenbast said it looks to include companies in its peer group that are "very similar to ours in their operation and in how they make money." Amazon.com and eBay qualified, he said, because they are both "direct-to-consumer businesses," like ValueVision.

And like many public companies, the home-shopping company also controls for variation in size when calculating CEO pay. "We're not throwing [larger companies] in to crank up the average," he said.

ValueVision notes in its most recent proxy statement that "we compete with many larger retailers for high-quality executive talent."

While companies often justify their peer groups by saying that they compete with larger companies for talent, that's rarely the case, argued Hodgson of the Corporate Library. "I have some significant doubts that Jeff Bezos [Amazon.com CEO] would accept a job" at ValueVision, Hodgson said. (Bezos' total compensation in 2007 was $1,281,840; ValueVision has set CEO Rene Aiu's 2008 salary at $600,000 plus a minimum bonus of $300,000.)

'Aspirational' peer groups

The rules for inclusion in a peer group can be amorphous. Best Buy Co. Inc., for instance, selects companies that possess traits it admires. "Admiration within their industry" and "track record of innovation" are two of many qualities it seeks among companies included in its peer group, according to its proxy. Best Buy also uses lists of admired companies published by Business Week and Fortune magazines.

Compensation consultants call these "aspirational" peer groups, because they are based on subjective qualities that a company wants to achieve rather than on financial and performance metrics. The danger is that, if the conditions for inclusion in a company peer group become too broad, then boards can cherry-pick ones that have higher compensation packages, thereby pumping up executive pay.

Picking peer groups based on desirable qualities is akin to a professional basketball player demanding the same pay of superstars, argued Paul Lapides, director of the corporate governance center at Kennesaw State University in Kennesaw, Ga., near Atlanta.

"It's like saying, 'I admire Michael Jordan, so I should get what he made at his peak,' " Lapides said.

There are, however, signs that board compensation committees -- facing unprecedented pressure from investors because of outsize pay packages -- are taking these peer groups more seriously now.

Last year, as part of a series of changes made in the wake of a stock options backdating scandal, UnitedHealth Group Inc. hired an independent consultant to evaluate its peer group of 27 companies. The result was that UnitedHealth dropped 15 companies from its peer group that no longer met its size and market-value criteria, and it added 12 new ones, including two large managed-care companies, Coventry Health Care Inc. and Humana Inc. -- both competitors.

While the makeup of peer groups may change, the basic assumption -- that CEOs deserve more than their peers -- remains firmly in place, Lapides said. "Disclosure is infinitely better," he said, "but the basic process hasn't changed much at all."

Chris Serres • 612-673-4308