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.”