Management compensation and corporate failures

Management Compensation in Relation to Corporate Failures

Corporate governance refers to the way in which directors and auditors manage their responsibilities towards shareholders. Common corporate governance measures consist of: appointing non-executive directors, create constraints for management power and ownership concentration, and insure the financial information and executive/management compensation's disclosure to the public. Corporate governance's role is to provide investors and other stakeholders with a clear insight over what is going on the company, so that the former make well informed decisions that affect both them and the company.

Executive compensation refers to the way top executives in business corporations get paid. Their pay may consist of: basic salary, shares, options, bonuses, and other company benefits and it remunerates their work on the board of directors. Studies have pointed out how executive remuneration has risen dramatically in the last three decades, exceedeing by far the average rising of worker's wage (Teather, 2005).

In some cases, executive compensation was linked to corporate failure. Examples are numerous and include large multinationals such as: Pfizer, United Health Group and Exxon. Pfizer CEO Hank McKinnell had $83 million pension plan that took effect in 2008, which added to an additional $65 million that he gained since he become the company's CEO in January 2001. However, the pharmaceutical giant's shares have dropped 46% in value, during his period as a CEO. United Health Group CEO William McGuire got a $1.6 billion option remuneration package, while over 40 million americans don't even have health insurance, whereas Exxon CEO Lee Raymond retired with a $400 million remuneration package, while all consumers have to face fast increasing gasoline prices.

Scott Richardson, a Wharton teacher said that disclosure is key, but even so compensations packages for executives are very generous and shareholders have to accept them. He then used Lee Raymond's from Exxon retirement plan example to make his point: "That type of package is fine as long as [boards and executives] contract up front, as long as it's disclosed to stakeholders and as long as the stakeholders have a right to question the pay structure." He then added that Raymond's terms were known at least six years prior to his retirement and before oil prices skyrocketed and pushed the price of his options to the ceiling. "It's a lucky outcome for him, but that's the way it goes," says Richardson, while specifying that swings in long-term compensation can be somewhat unstable in commodity-based businesses where price elasticity is low.

In 1991, the Cadbury Committee was set up in the UK as a consequence of the rapid increase in executive compensation and alleged failure of compensation being linked to performance and also as a response to "a series of scandals involving Maxwell Communications, Polly Peck and others" (Girma et al. 2007: p. 65). A greater transparency and better accountability of the UK board of directs have been achieved after Cadbury Report (1992), the Greenbury Report (1995), the Hampel Report (1998), the Directors' Remuneration Report Regulations (2002), the Higgs Report (2003) and the Combined Code (2003) were published. However, investors have an increasing concerned when executives continue to be compensated with substantial amounts despite poor company performance. In the early 2000, the interest in corporate governance has increased in response to the U.S. administration's reaction to some cases of major corporate failure. "The U.S. Sarbanes-Oxley Act of 2002 was an explicit response to the Enron, Tyco and WorldCom misreporting scandals" (Girma et al. 2007: p.65). The failure of these corporations has been "allegedly linked to CEO compensation" (Matsumura and Shin, 2005:1). U.S. corporation Enron, which collapsed in 2001 is one the examples in this direction. The giant has since been criticised for contributing to its downfall by resorting to excessive long-term incentive arrangements with its top managers. Enron's executives were largely rewarded with share options which can easily explain the company's focus on creating rapid growth expectations and all the effort spent to inflate earnings, which eventually led to collapse. The example amplified the issues of executive compensation and further need of reform in corporate governance.

Why it is important?

Executive compensation is essential as the goals of executives and shareholders should be aligned by resorting to executive share ownership. Executive compensation is also important because it affects compensation levels throughout the whole organization, from top to bottom. While highlighting the importance of and the need for executive compensation, some authors underlined the importance of separation of onwership from the control of nowadays' corporation as a means to reach an optimal compensation solution (Jensen and Meckling, 1976).

Executive compensation have been subject to major changes in the last twenty years and some of the more important drivers to change included: the shareholder, the regulations, the corporate governance and business considerations.

The shareholders increased pressure on boards and executive teams to increase the use of performance-based compensation on the expense of the use of shares in equity compensation plans. The former also put pressure on companies to reduce the total amount of shares outstanding and reserved for future grants to employees and to improve the management of the number of yearly shares granted to employees. Last but not least, shareholders are asked for compensation plans that are performance-based-intensive. The main challenge is to select the right performance measures that align with the business strategy, and which are able to foster a pay-for-performance relationship that can generate shareholder value creation in the long run.

The new accounting regulations oversee the following:

New rules for the design and tax treatment of deferred compensation - Internal Revenue Code Section 409A, as part of the American Jobs Creation Act of 2004.

The way stock options are accounted for (as an expense now.) - Financial Accounting Standard (FAS) 123-R, voted in 2005.

The way executive compensation is reported in proxy statements - SEC changed the disclosure requirement regarding executive compensation and option grants.

Corporate governance scrutinity increased over the past 10 years as a result of increased regulation of executive compensations and a number of major companies collapses, which were allegedly linked to poor executive compensation plans. Consequently, companies needed to strenghten their governance practices and demonstrate those to investors, regulators, their own employees and other stakeholders. The new governance concept focuses on disclosure and transparency. The new concept also implies that directors get involved more in the decision making process by asking executives challenging questions and by ensuring that the board's supervision is as exhaustive as possible. Corporate governance practices have been subject not only to the board's scrutinity, but also by the shareholders' and regulators', which in turn led to major changes in executive compensation practices. An example in this direction is the voluntary creation of stock ownership guidelines for executives by many corporate boards to make sure that executive compensation is aligned with shareholder interests. As recently as five years ago, in corporate U.S., less than half of the publicly traded companies that such guidelines, whereas todayl roughly two-thirds of them have created stock ownership guidelines.

Finally, the one other important driver to change in executive compensation is the need to align to business objectives. Thus, nowadays, when designing compensation packages for executives, the designers should consider the following:

Shareholder needs

Pay-for-performance needs

Assess the perceived value of incentive methods and the actual cost associated

Executives' attraction and retention needs

What is the current environment / landscape?

The executive compensation landscape is a dynamic one, being subject to change quite frequently. Some of the most recent developments include Sarbanes-Oxley act of 2002 and accounting for stock-based compensation.

Sarbanes-Oxley act of 2002 is also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called SOX and it was a direct consequence of a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom.

The legislation includes new standards for all U.S. public company boards, management, and public accounting firms, raging from additional Corporate Board responsibilities to criminal penalties. Additionally, the Act designates a new semi-public agency, the Public Company Accounting Oversight Board (PCAOB), enchanging it with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies.

Some of the most important components of Sarbanes-Oxley's amenmends include:

Prohibition of company-provided/arranged loans to executive officers and directors

Requires insiders to report stock trades in company stock on Form 4 within two business days of trade

Requires CEOs and CFOs to reimburse company for prior compensation and stock sale gains if financial statements are restated

Prohibits officers and directors from buying or selling any company stock during a benefit plan black-out/quiet period

Criminal penalties for ERISA violations

The accounting for stock-based compensation is regulated in FABS statement No. 123, which establishes financial accounting and reporting standards for stock-based employee compensation plans. Those plans include all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. Examples are stock purchase plans, stock options, restricted stock, and stock appreciation rights.

The statement regulating accounting for stock-based compensations defines a fair value-based method of accounting for an employee stock option or similar equity instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value-based method of accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. The fair value-based method is preferable to the Opinion 25 method for purposes of justifying a change in accounting principle under APB Opinion No. 20, Accounting Changes. Entities electing to remain with the accounting in Opinion 25 must make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value-based method of accounting defined in this statement had been applied.

Stock options are the most frequently used method in executive long-term incentive grants among top 250 companies. However, other methods are popular as well for executive compensation (see fig. 1 & 2).

FIG. 1 - EXECUTIVE LONG-TERM INCENTIVE GRANT - TYPE USAGE % of TOP 250 COMPANIES

FIG. 2 - EXECUTIVE STOCK OPTION VARIATIONS % of TOP 250 COMPANIES

What are the implications for Managers?

The global discussion around executive compensation had a major impact on the way this is done nowadays compared to threee decades ago. Major changes have been adopted by major corporations which focused on increased corporate responsibility, encapsulating here the responsibility to immediate stakeholders, but also towards the society. Executives and the board of directors were exposed to increased transparency and held accountable easier now than in the past. The current trend aims to reduce the compensation gaps between executive compensation and that of the shareholders, to increase shareholder value and increase corporate performance compared to industry peers. More specifically, the executive compensation packages are a mix of long-term incentives (LTI), which tends to include more and more performance-based packages.

Firstly, executive compensation needs to be incentive enough to attract the right person to lead the company and since the average compensation is high, corporations can't afford to lower it significatly for the simple fact that they would lose valuable leaders to the competition. Secondly, poor performance can't justify a high executive compensation no matter what the perception on the leader's abilities is. Finally, a pure performance-based compensation package can be discouraging for any executives especially in economic recession circumstances. Thus, corporations, executives included need to design a mix of executive compensations that is aligned with everyone's objectives: the shareholders', the executives', the corporation itself and why not the public.

Table 1 displays the pros and cons of three long-term incentive plans including: stock options, restricted stock and performance awards.

TABLE 1 - LONG-TERM INCENTIVES

Stock Options

Restricted Stock

Performance Awards

PROs

Pay-for-performance

Align with shareholders

PROs attraction and retention

Efficient

PROs

Combines pay-for-performance with attraction and retention

Linked to corporate goals

CONs of shares outstanding

Perceived value and the cost attached to it

CONs

No link to pay-for-performance

CONs

Pressure on corporate goals

Too streched goals may reduce attraction and retention

How can this be resolved?

Linking CEO remuneration to company performance is quite a controversial topic and has been building up in the last 30 years. A study made by the Corporate Library (2007) highlights twelve of the largest corporations in U.S., which are characterized by high executive compensation and poor performance over a five-years period. During this whole period, the corporations paid out $865 million to their CEOs who in turn lost about $640 billion in shareholder value. The corporations mentioned in this study include: AT&T, BellSouth, Hewlett-Packard, Home Depot, Lucent Technologies, Merck, Pfizer, Safeway, Time Warner, Verizon Communications and Wal-Mart Stores.

Each of these companies paid its CEO at least $15 million in the two fiscal years available, had a poor performance compared to their competition and had a negative return on stockholders over the studied period.

There has been more concern over the past few years about the link between pay and performance," claims Paul Hodgson, senior research associate at the Corporate Library.

In the past few years, Hodgson says, companies replaced more and more often-controversial stock option programs with restricted stock within their compensation plans. "The problem is that many of the restricted share schemes being used are not designed well. There are too many companies out there that are adopting off-the-shelf versions of the plans without considering what they might do to adapt to their own company's circumstances."

Hodgson also adds that the most common metric based on which compensation packages should be designed is total stockholder return. Even though that does not take into account how well the company is doing compared to the competition, these don't incur the risk of rewarding executives for losing shareholder value as some companies that base their payouts totally on performance relative their competition, which is also losing shareholder value.

Hodgson also adds that performance-based packages might be more effective if they were based on a mix of relative standard compensation methods and other methods that focus on absolute target.

Wharton accounting proffessor, Wayne Guay agrees that it is worth paying a lot for the best person possible to manage a global company and since the demand is very high that drives up CEO compensation: "Finding an individual to run these companies is extremely difficult," Guay says. "When you are talking about a $50 billion company, if the difference between the best CEO and the second-best CEO changes the value by half a percentage point, the [best CEO] will have justified his pay for his entire career."

SEC accounting rules will come to add more transparency to the value of total compensation packages, option grants in particular, which are a critical element in performance-based pay and bring disclosure to retirement pay.

Performance-linked compensation is also essential for corporate managers, who are in charge of setting the CEO's pay. For example, in 2006 Coca-Cola company said it would cancel managers' pay if the company wouldn't hit its financial targets. The beverage producer would stop paying its current managers in cash, switching to the issuing of $175,000 "equity-share units." The managers would later on be able to trade in those shares for cash in 2009, provided that the company achieves compounded annual growth of 8% in earnings per share between 2006 and 2008.

After all the focus on executive compensations, cutting edge approaches have been adopted by many companies, including caps to several compensation methods and limitations in executive pay.