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Directors Determine CEO's Worth


Wonder how KB Home Chief Executive Bruce Karatz got to be one of Southern California's highest-paid executives last year? It's no secret.

The alchemy behind Karatz's pay--as well as the pay of the most-highly compensated officers at any public company--is spelled out in company proxy statements, which are filed with the Securities and Exchange Commission and sent to shareholders each year.

KB Home aims to pay its executives more than the average big real estate firm, the proxy said. And it links executive pay to shareholder returns with several incentive compensation plans.

Karatz, 56, received a $895,833 salary, plus a performance bonus of $6.6 million in 2001. That big bonus was part of an incentive plan that promises to pay Karatz 1.25% of the pretax profit of the L.A.-based home builder, provided the company hits certain earnings goals. Karatz also is entitled to a stock bonus equal to one-half of 1% of the company's pretax profit exceeding $50 million, according to his employment agreement, which is included in the company's proxy statement.

Because he signed a new seven-year employment agreement, Karatz also received 350,000 shares of restricted stock as a retention bonus. Restricted shares are a gift with strings attached--executives can keep the shares only if they meet certain conditions.

In Karatz's case, he must stay at KB Home through 2008. The market value of those restricted shares: $12.1 million.

In addition, Karatz exercised $23.4 million in incentive stock options during the year, and he also received $1.3 million in long-term incentive pay. Total direct compensation: $44.4 million--roughly one-fifth of KB Home's 2001 net income of $214 million. That secured Karatz the top spot in a survey by Mercer Human Resource Consulting of CEO pay at 100 of the largest Southland public companies in 2001.

"There were some special circumstances this year that affected Karatz's pay," said Debra Hotaling, director of public relations at KB Home.

Take out the one-time signing bonus and the $23 million in stock options and the package "becomes more in keeping with how compensation really works here."

While Karatz's cash pay soared 46%, the company reported that the average KB Home employee received a 4.3% merit increase in 2001, according to the proxy.

The decision on how much to pay Karatz--and most other top executives at U.S. public companies--is made by the board of directors.

This year, with outsize executive pay packages coming under mounting criticism from shareholders, directors and their pay-setting rationales are drawing increasing scrutiny.

"Pay is the symptom, not the disease. The focus is on the board of directors," said Nell Minow, editor of the Web site Corporate Library, which tracks executive pay. "They are writing a check on somebody else's bank account."

Corporate governance reformers say a significant percentage of a company's board should be made up of independent directors--people who don't work for the company, consult for the company or have some other economic tie to management. Within the board, there should a compensation committee, which looks at pay policies and determines what the company's top execs will earn. Ideally, every member of the compensation committee should be an independent director and experienced in executive-pay matters.

KB Home has 11 directors, only two of whom work for the company. The compensation committee is made up of four directors, none of whom works for KB Home.

Corporate directors may determine their executives' pay by looking at pay packages offered to executives at similar companies, and couple that knowledge with incentive plans designed to reward the executive for hitting particular performance targets.

Typically, companies say they want to pay top executives more than the average company as a means of attracting top-level talent.

But when everyone's trying to pay more than average, the average tends to move up at a rapid clip.

Certain types of compensation--such as stock options--are not easy to value and don't need to be accounted for on company income statements. That can cause boards to give stock options willy-nilly without considering the long-term effect on shareholders.

And that's in the best cases. In the worst cases, directors are so close to the executives they are supposed to oversee that they simply rubber stamp the CEO's suggestions for his own pay, leading to top managers earning more than the companies they operate.

Unrealistic executive paychecks are a symptom of a board that's not doing its job of representing shareholder interests, Minow said. If the board is not vigilant, shareholders must rise up and oust the directors, she said.

"Shareholders are a key component in holding companies accountable," said Simon Billenness, senior analyst with Trillium Asset Management in Boston. "Since this money is coming out of the pockets of shareholders, I think it's important that they support a movement for greater sanity in executive pay."

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