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Additional Issues on Corporate Governance
Professor Alexander SettlesFaculty of Management, State University – Higher School of Economics
Executive Compensation Package
Can either be a motivational tool encouraging executives to pursue strategic decisions that are in the best interest of shareholders or it can be designed to reinforce the wrong strategic choices
Paying for the right things and paying for performance
Compensation programs should be designed to drive a company’s business strategy and objectives and create shareholder value, consistent with an acceptable risk profile and through legal and ethical means
Significant portion of pay should be incentive compensation, with payouts demonstrably tied to performance and paid only when performance can be reasonably assessed
Corporate Governance Practices
Credible board oversight of executive compensation Compensation committees should demonstrate
credible oversight of executive compensation. To effectively fulfill this role, compensation committees should be independent, experienced, and knowledgeable about the company’s business.
Transparent communications and increased dialogue with shareholders Compensation should be transparent,
understandable, and effectively communicated to shareholders. When questions arise, boards and shareholders should have meaningful dialogue about executive compensation.
The Role of Risk in the Executive Compensation Contract
Employment risk - the possibility that the executive will be terminated either due to unsatisfactory performance or due to change in control
Compensation risk - the potential unpredictability in the executive’s future pay represented mainly by the proportion of stock options in the total pay package
Business risk - the uncertainty surrounding the firm’s competitive environment
Components of the Pay Package
Fixed pay – salary and benefits Typically smaller than variable pay Firms can only write off one million
dollars in fixed pay Most companies top off salaries at
about one million dollars
Components of the Pay Package Continued
Variable pay – bonuses and stock options Draw the CEO’s attention to
performance results and can serve to align the goals of the company and its shareholders with the personal goals of the executive
Executive Compensation
Principle – agent theory Incentives – key performance
indicators Earnings EBITA EVA
Signaling
Stock Options
Stock options are the right to purchase stock at a predetermined price
Restricted stock is a right granted to purchase during a specified period, at the market price on the date of the option, a specified number of shares
Stock Options Continued
Restricted stock is replacing stock options in executive benefits packages due to changes in accounting standards
Restricted stock is not as tied to organizational performance as stock options
Pay for Performance
Tying executive compensation to specific performance guidelines can be counterproductive
CEO performance should be tied to broader metrics that go well beyond financial measures such as leadership and innovation
Change in Control Provisions to Manage Employment Risk
Golden parachute clauses have increased in popularity
Golden parachutes are payments in the form of cash, an acceleration of vesting or other benefit that occurs in connection with a change in the ownership or control of a company's stock or assets
Golden Parachute Provisions
Typical golden parachute provisions include: a lump-sum payment equal to typically
three times the base salary plus bonus accelerated vesting of deferred
compensation and supplemental executive retirement plan (SERP) benefits
Golden Parachute Provisions Continued
Additional golden parachute provisions include: Additional age and service credit during
the severance period (typically three years) for purposes of pension calculation
Accelerated vesting of equity awards
Linking Pay to Performance
Individuals in positive contexts can become risk averse while individuals in negative contexts can become risk seeking
An ideal level of risk needs to be determined for the executive and the extent that pay is tied to performance
Highest Paid US CEOs 2006
1. Steve Jobs of Apple $1 salary and realized $647 million from vested restricted stock last year.
2. Ray Irani of Occidental Petroleum - $322 million total pay
3. Barry Diller of IAC/Interactive Corp - $295 million
4. William P. Foley of Fidelity National Financial - $180 million
5. Terry Semel of Yahoo! - $174 million
Disclosure –Exxon Mobil
Google 2010
CEO Pay to Workers’ Pay
International Comparisons
Executive Compensation
Widespread recognition: many boards approved executive pay deals that did not serve shareholders
“Rotten apples” view “Paying for performance” view “Transient lapses” view “Independence is enough” view
Compensation as a Health Check on the Governance System
Executive compensation provides a window for examining our corporate governance system
The corporate governance system: Depends on boards to serve as
guardians of shareholder interests. Largely insulates boards from
intervention and removal by shareholders
“Rotten apples” view: Concerns about executive
compensation have been exaggerated: Flawed arrangements have been limited to small number of firms
Conclusion of research: It’s the barrel, not a few apples:
Problems have been widespread, persistent, and systemic.
“Paying for performance” view: Current pay levels might seem high -- but are necessary to provide executives
w/ powerful incentives. In practice
Current pay arrangements not designed to tightly link pay and managers’ own performance.
“Transient lapses” view: Even if flaws widespread, they resulted
from boards’ mistakes and misperceptions Boards can be expected to self-correct
with time and better understanding. In practice:
It’s bad incentives, not lapses. Problems stem from defects in underlying
governance structure – governance reforms needed.
“Independence is enough” view: OK, reforms might have been necessary –
but recent moves to increase director independence will adequately address past problems.
In practice: Strengthening independence is beneficial,
but falls far short of solving problems. Additional reforms that make boards more dependent on shareholders are necessary.
Results of Excess Pay
Excess pay is not only or principal cost. Managers’ influence over compensation arrangements: Dilutes incentives to serve
shareholders Distorts incentives – e.g., ability to
unwind equity gives incentive to improve short term earnings reports at expense of long-term value
Why does this happen?
Incentives Going along helps chance of re-nomination
to board CEO’s power to reward directors
Social factors Collegiality and team spirit Deference to company’s leader Loyalty and friendship Cognitive dissonance (directors who are
current/former executives) Personal costs of favoring executives are small
Relationship to other Governance Issues
Indeed, there is empirical evidence that pay is greater/less sensitive to performance in firms with More anti-takeover provisions Weaker shareholder rights CEO who is also chair of board Directors appointed under current CEO Compensation committee has little company
stock More interlocking directors Without large outside block-holders
Problems with equity-based compensation
Devil is in the details: Equity-based pay delivers much less pay for performance than believed
Windfalls: Rewards for general market and industry-wide movements. Most of value in conventional options and restricted stock rewards managers for “luck” – no down side
Re-pricing, “backdoor repricing”, back dating – all further weaken link b/w pay and performance
Broad freedom to unload vested options/restricted stock Rewards for short-term price increases that
may not last while Producing perverse incentives
Possible Reforms
Non-executive directors on compensation committee
Understandable incentives aligned with shareholder value (complex)
Accounting for stock options (real cost to the firm on its balance sheet)
Shareholder Activism
Proxy resolutions sponsored by union and public pension funds, aimed at cutting CEO pay, are winning extraordinary victories
If shareholder activism keeps spreading it will ignite a good amount of reform
US SEC Regulation
Annual Shareholder Approval of Executive Compensation by TARP Fund Receipts
Disclosure of Executive Compensation, Compensation Consultant usage, director compensation
Sunlight as a disinfectant – shame CEOs on compensation issues
Shareholder Proposals - Exxon Mobil 2010
This proposal was submitted by The Needmor Fund, 1270 North Wolcott Street, Chicago, IL 60622, as lead proponent of a filing group.
“RESOLVED – the shareholders of Exxon Mobil Corporation recommend that the board of directors adopt a policy requiring that the proxy statement for each annual meeting contain a proposal, submitted by and supported by Company Management, seeking an advisory vote of shareholders to ratify and approve the board Compensation’s Committee Report and the executive compensation policies and practices set forth in the Company’s Compensation Discussion and Analysis.”