We thank Professor Bainbridge for letting us post his comments on this blog. The referenced Closer Look is found here.
What would happen if the NCAA adopted Dodd-Frank? Professor Bainbridge, 10/3/2011
Stanford business law professors David Larcker and Brian Tayan have conducted an interesting thought experiment:
In recent years, NCAA football has been rocked by a string of high-profile violations, including those at USC, Ohio State, the University of Miami, and Auburn. In many ways, these violations were similar to the governance breakdowns at financial and other corporations leading up to the financial crisis of 2008 and 2009.
In the corporate world, Congress responded to the financial crisis by enacting the Dodd-Frank Wall Street Reform Act, which among other things imposed various governance requirements on all publicly traded companies.
What would happen were the NCAA to adopt these same provisions and require them of all universities and their football programs?
In this fictitious tale, we explore what such a set of rules would look like. We ask:
* If these requirements would not work in an athletic setting, should we expect them to work in business?
* Why are the governance provisions of Dodd-Frank legally required, rather than voluntarily adopted by individual companies?
* Why does Dodd-Frank place such emphasis on executive compensation and disclosure? Will its compensation requirements reduce governance failures?
The NCAA Adopts ‘Dodd-Frank’: A Fable (September 14, 2011). Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-20. Available at SSRN:http://ssrn.com/abstract=1927108
There is an odd disconnect between the internal logic of Dodd-Frank’s governance provisions and the back story of the financial crisis.
Consider, for example, the question of executive compensation. Regulators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a contributing factor almost from the outset of the financial crisis. As was the case with almost all public U.S. corporations, banks and other financial institutions shifted in the 1990s to a much greater reliance on equity-based pay for performance compensation schemes. The rationale for such schemes is that they align the risk preferences of managers and shareholders. Because managers typically hold less well-diversified portfolios than shareholders, having significant investments of both human and financial capital in their employers, they tend to be much more averse to firm specific risk than diversified investors would prefer. Pay for performance compensation schemes that link managerial compensation to shareholder returns are designed to counteract that inherent bias against risk and thus align managerial risk preferences with those of shareholders.
Shareholder activists long have complained that these schemes provide pay without performance. This was one of the corporate governance flaws Dodd-Frank was intended to address, most notably via say on pay.
The trouble, of course, is that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse, for the reasons just discussed. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders. Accordingly, as Christopher Bruner aptly observed, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”
In sum, the shareholder empowerment measures adopted before the crisis did nothing to prevent it and may well have contributed to it. The new provisions included in Dodd-Frank thus are unlikely to prevent another such crisis and may even increase the odds of some similar crisis induced by excessive risk taking.
Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
The Dodd Frank Financial Reform Act requires that publicly listed companies submit executive compensation plans to shareholders for an advisory vote of approval (say on pay). At issue is no longer whether such votes should be held, but at what frequency (annually, biennially, or triennially, to be decided by shareholders on a company-by-company basis).
While the rules are set, the implications for the board are far from clear. How will the board respond to a say-on-pay vote that garners a simple majority but is not convincingly in the company’s favor? What percentage of dissent would cause you as a board member to rethink the executive compensation program?
One option is to take a hard line. As a board member, you might rightfully claim that 51% approval is majority approval, and the company therefore has the general support of shareholders. But this attitude likely would be perceived as hostile and probably wouldn’t stand over the long term.
On the other hand, you might strive to achieve nearly unanimous consensus. To do so would require extensive outreach to shareholder groups, including those who routinely vote against compensation plans as a matter of principle. This would involve considerable time on the part of compensation committee members, time which may not be well spent.
Preliminary feedback suggests that boards are currently struggling with this issue. According to a recent study by Towers Watson, half of all companies stated that they do not know what level of shareholder support they would consider a “success.” Among those who did have an opinion, the average response was 80%.
Intuitively speaking, 80% may be the right threshold, but the board will have to be prepared for a variety of outcomes. For example, in 2009, the shareholders of AFLAC (which voluntarily adopted say on pay that year) approved executive pay-for-performance policies by a vote of 804 million to 21 million (97%). By contrast, in 2009, the shareholders of Motorola approved executive compensation policies by a much closer margin, 1,244 million to 708 million (64%).
Question: If you were on a board of directors, what level of support would you consider a “success?” How would you respond if this level was not reached?
Let us know, your comments are welcomed!
AFLAC, Form 10-Q Filed May 8, 2009
(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, And Brian Tayan, MBA ’03, Stanford GSB; Date: 9-23-2010)
A new paper by Barth, Gow, and Taylor (2010) calls into question the practice of excluding stock options from reported earnings per share (so-called “non-GAAP” earnings).
Under U.S. accounting rules, companies are permitted to report adjusted financial results, so long as they disclose at the same time the most directly comparable GAAP figure and a table that reconciles the two. Experts have long clashed over the value of these adjustments. On the one hand, adjustments may be done to improve earnings quality when one-time items distort the long-term profitability of a company. In this case, excluding these items would improve the information quality of the reported figures. On the other hand, earnings adjustments may be made opportunistically by management to boost short-term results and beat Wall Street estimates. In this case, excluding certain items reduces earnings quality by misrepresenting the company’s underlying profitability. The evidence suggests that both can occur, depending on the circumstances.
In their paper, Barth, Gow, and Taylor (2010) examine the practice of excluding stock option expenses from quarterly earnings. They find that this practice does not improve earnings quality. Instead, they find that excluding stock options is done opportunistically “to increase earnings, smooth earnings, and meet earnings benchmarks.”
Technology companies tend to be the most enthusiastic practitioners of stock option non-expensing. This may be because they rely heavily on options in employee compensation packages, particularly when the companies are still in high-growth phase. For example, in Q2 2010, Google reported non-GAAP EPS of $6.45 compared with GAAP EPS of $5.71. VMware reported non-GAAP EPS of $0.34 versus $0.18 GAAP EPS. And Salesforce.com reported non-GAAP EPS of $0.29 versus $0.11 GAAP EPS. These are not small differences.
How does such a practice persist, particularly in a circumstance where it is clearly shown to reduce earnings quality? Isn’t this what governance systems are expected to prevent? And yet with stock option expensing, it seems that many members of the system are complicit: the board that approves the exclusion, investors who value the company on that basis, analysts who provide the research, and regulators who write the rules.
Source: Barth, Mary E., Gow, Ian D. and Taylor, Daniel J., Non-GAAP and Street Earnings: Evidence from SFAS 123r (September 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 88. Available at SSRN: http://ssrn.com/abstract=1681144
See also: “Pro Forma Earnings: What’s Wrong with GAAP?” CGRP-09, by David F. Larcker and Brian Tayan,
(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, and Brian Tayan, MBA ’03, Stanford GSB)
Compensation Committee – Merits of Shareholder-Sponsored Proxy Proposals requesting that boards disallow more than one current or former CEO from serving on compensation committee
This proxy season, the AFL-CIO has submitted shareholder-sponsored proxy proposals to companies including Eli Lilly, Goldman Sachs, and Time Warner that would disallow more than one current or former CEO from serving at the same time on the compensation committee.
According to the AFL-CIO, the proposals were based on academic studies that suggest that companies with more than one CEO on the compensation committee tend to have higher pay than companies that do not. In theory, when CEOs serve on the compensation committee, they engage in “back scratching” and other forms of reciprocity by approving larger pay packages with the expectation that other CEOs will do the same for them. As a result, compensation negotiations are not an arms-length negotiation and pay packages artificially rise.
This is likely a simplistic view. Most academic studies on the relation between board structure and executive compensation have weak or inconclusive findings. (One exception is that boards with “busy” directors who serve on multiple boards do tend to award larger compensation on average. These results are robust and widely accepted. [See: Core, J., Holthausen, R., Larcker, D. (1999), "Corporate governance, chief executive officer compensation and firm performance", Journal of Financial Economics, Vol. 51 pp.371-406.]
Still, let’s see how the AFL-CIO proxy proposal would apply to a company such as Time Warner. Last fiscal year, the compensation committee comprised Frank Caufield (co-founder of venture capital firm Kleiner Perkins), Mathias Dopfner (CEO of Axel Springer), Michael Miles (former CEO of Phillip Morris), and Deborah Wright (CEO of Carver Bancorp). If the proposal were accepted and passed, two of these individuals would have to step down. Who would replace them? Only three directors qualify: Robert Clark (professor at Harvard), Jessica Einhorn (professor at Johns Hopkins), and Kenneth Novack (former vice chairman of AOL). Is there any evidence to suggest that these individuals would be more qualified than those who step down? Robert Clark is a professor of corporate governance. Does that make him more capable of setting compensation? Jessica Einhorn serves on the boards of four other organizations, making her a “busy director.” As we just noted, busy directorships are correlated with elevated compensation. Kenneth Novack is a former employee of the company. Insiders are correlated with lower governance quality in certain areas, such as mergers and acquisitions.
When we attach names to the committee, the complexity of the decision becomes clear. Rather than arbitrarily restrict the committee structure, investors should evaluate committee members on a case-by-case basis taking into account their qualifications, objectivity, and independence of judgment. This is likely to lead to much better outcomes than establishing one-size-fits-all restrictions that ignore the importance of relevant details.
(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, And Brian Tayan, MBA ’03, Stanford GSB; Date: 8-9-2010)
Last week, Forbes published a list of the “20 Most Responsible Companies” based on ratings provided by GovernanceMetrics International (GMI). While the list contains many well-regarded companies—such as Colgate-Palmolive, Dover, and PepsiCo—it also has some questionable picks.
The most notable is Occidental Petroleum. Oxy is notorious among shareholder activists for the generous compensation awarded to CEO Ray Irani. Irani was ranked third on a list compiled by the Wall Street Journal of the highest paid CEOs over the last 10 years, bringing in a cumulative $857 million. While Irani has overseen tremendous shareholder value creation during his tenure, many have questioned whether this level of pay is excessive.
For example, the Teacher’s Retirement System of Louisiana has long lobbied to reduce his compensation. Proxy advisory firms RiskMetrics Group and Glass Lewis routinely recommend a vote against the company’s equity plans. Prominent journalist Geoff Colvin of Fortune has called Irani an “excessive-pay hall of famer.” In May, shareholders handed the company defeat in its first advisory vote on compensation (“say on pay”). And just last week, shareholder activist Ralph Whitworth of Relational Investors and the California State Teachers Retirement System launched a proxy fight to gain access to the company’s board. Whitworth described Occidental’s board as “ossified and entrenched” and was critical of the company’s compensation and succession planning.
All of this makes you scratch your head over why GMI would place them on their top 20 list. The only explanation that GMI provides is that Oxy is “responsive to shareholder initiatives, such as special meetings.” We doubt Mr. Whitworth would agree.
Even The Corporate Library (TCL) has been pulled into the fray. TCL merged with GMI last month. In a recent blog posting, TCL wrote: “Several observers have noted the fact that TCL has criticized some firms GMI rates highly, and have asked us how we plan to reconcile the differences. Our answer could apply to any good marriage: we’re going to discuss, explore, and learn more about each other’s points of view, and then decide what to do.”
Sounds like code for: “We have no idea where they came up with this one.”
For our purposes, it gets to the fundamental question: if the so-called experts can’t agree on what constitutes good governance, how can shareholders be expected to rely on their judgment?
- GMI, “Beyond the Balance Sheet: The 20 Most Responsible Companies,” Forbes, August 3, 2010.
- Geoff Colvin, “As Executive Compensation Becomes Topic A (Again), the Real Outrage is How CEOs Are Paid, Not How Much,” Fortune, May 3, 2010.
- The Corporate Library (TCL) Blog, “A Marriage of True Minds,” August 5, 2010.
(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, And Brian Tayan, MBA ’03, Stanford GSB; Date: 7-09-2010)
Source: Bally Technologies, Inc., Form 8-K, Filed August 11, 2009
Much attention is paid to employee compensation contracts for their incentive value. The structure of compensation (in the form of salary, bonus, and equity grants) is important for the attraction, retention, and motivation of executives. Less clear is the incentive value that comes from indirect compensation and other perquisites.
Take, for example, Bally Technologies, a maker of casino equipment (primarily slot machines). In August 2009, the company revised the employment contract of CEO Richard Haddrill. Among the revisions:
-“Haddrill shall be entitled to a lump sum cash payment of $2,500,000 (the ‘Strategic Initiatives Bonus’) upon the first to occur of: (i) the achievement of certain strategic initiatives established by the Board of Directors on or before December 31, 2010 […], or (ii) a Change of Control occurring on or before December 31, 2010.
-“The Company shall pay to Haddrill $998,000 and, if such Change of Control occurs on or before December 31, 2010, an additional payment equal to $1,996,000.”
What incentives are these amendments intended to provide? One obvious possibility is that the board wants to encourage the CEO to find a buyer for the company, or at least position it for a sale. A more cynical interpretation is that a potential buyer has already been identified and this is a sophisticated way of positioning the CEO to profit.
Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
A recent article in the Wall Street Journal highlights changes made to the long-term compensation contracts at AIG. AIG is in the unique situation of being close to bankruptcy and significantly owned by the U.S. government.
Under the program, executives will receive incentive compensation that is more heavily tied to the change in value of its subordinated debt than its stock price. In lieu of restricted stock, executives will instead receive long-term performance units (LTPU), 80 percent of the value of which is based on the change in value of the company’s 8.175% Series A-6 junior subordinated debentures and 20 percent of which is based on the company’s common stock. Interest coupons on the debt are converted into new LTPU shares. This structure is intended to align the interest of employees not only with shareholders, but also with U.S. taxpayers. According to the Wall Street Journal, the U.S. government holds $102 billion in senior debt and $49 billion in convertible preferred stock.
In designing efficient contracts, the board of directors aims to select performance measures that are correlated with management performance. In doing so, it tries to avoid measures that have a lot of “random volatility.” That is, the board wants the measure to be truly indicative of management performance, as opposed to reflecting lots of things that are not under the control of management. When there is too much volatility around the measure, you get capricious rewards—either way too much compensation or way too little, relative to what was merited. This is the common critique of stock option plans during the bull market of the 1990s—many executives got rich simply because the broader market went up, not because their decisions were making the firm relatively more valuable.
Boards tend to select share price as the best indication of long-term performance, although others are often included as well. This makes sense in the case of a liquid, solvent company that is trying to maximize shareholder value. (It is also consistent with the legal duty of the board to serve in the interest of shareholders). Share price is not perfect—it can be subject to changes in interest rates, economic conditions, and market whims that are outside the control of management—but it clearly aligns interests with those of investors.
When a company is close to bankruptcy, however, the value of the share price as a performance measure can begin to deteriorate. The stock becomes extremely risky. Changes in stock price may not be highly correlated with managerial performance. It would be natural for the board of directors to search for either supplemental or alternative performance measures for rewarding executives.
In the case of AIG, the price of debt instruments may become a more informative measure about whether management is adding value. This may explain the rather unusual choice of performance measures by the AIG board. An obvious alternative explanation is that there was implicit pressure from the government to focus direct managerial attention to paying back the TARP funds. In many respects, the government and other debtholders are really “AIG equityholders” because they are fundamentally the residual claimants if the value of AIG is below the face value of debt outstanding.
This raises some questions: holding aside the formal legal duties of the board to maximize shareholder value, when does it make sense to consider changes in the value of debt as a performance measure to evaluate managers? Is this only an issue for companies in dire financial straits? Might there be some reason to use debt to evaluate managerial performance in more healthy companies?
-Serena Ng, “AIG Changes Pay Plan for its Stars,” The Wall Street Journal, June 24, 2010.
-AIG: Form 8-K, Filed May 28, 2010, with SEC
Disclosure of Strategic Performance Measures
(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, And Brian Tayan, MBA ’03, Stanford GSB; Date: 7-02-2010)
Source: The Coca-Cola Company, Form DEF 14A, Filed March 5, 2009
Confidentiality, at what price? In May 2008, the Coca-Cola Company received a comment letter from the SEC requesting that the company improve disclosure on the performance targets used in the company’s bonus plan. Rather than comply with this request, the company decided not to award performance-based bonuses but instead to award discretionary bonuses. The difference matters, because the discretionary bonuses awarded were not tax deductible. The company explained the rationale behind its decision:
“The Company believed that disclosing the ranges would allow a competitor to recreate the matrix of business performance targets and use this information to determine our business strategy. […]The Compensation Committee weighed the additional tax cost versus the competitive harm in disclosing the plan targets and determined that the potential competitive harm significantly outweighed the additional tax cost, which was not material.”
(Commentary by Brian Tayan, Stanford Corporate Governance Research Program, MBA ’03)
The economic stimulus bill passed by Congress in 2009 included a last-minute provision that restricts the compensation paid to executives at companies that have received federal funding. Executive bonuses were limited to no more than one-third of total compensation. Further, bonuses could only be paid in restricted stock, not stock options. The restrictions were intended to alter the composition of pay packages that were deemed to encourage excessive risk taking.
Two companies that fall under these restrictions handled the restrictions differently.
Wintrust Financial, based in Illinois, increased cash salaries for executive officers. For example, the base salary of President and CEO Edward J. Wehmer increased from $800,000 to $1,100,000, with $100,000 of the increase paid in company stock. Wintrust explained, “The salary adjustments are not intended to increase total annual compensation for the executive officers, but instead only to adjust the mix between fixed and variable compensation paid to them.” Wintrust Financial, Form 8-K, Filed August 20, 2009
Wells Fargo increased base salaries for executive officers, with much of the increase paid in company stock. Long-term stock incentives were commensurately decreased. The base salary of President and CEO John Stumpf increased from $900,000 to $5,600,000 with the increase paid in the form of stock granted under the company’s long-term incentive program. Wells Fargo, Form 8-K, Filed August 6, 2009
Investors will have to decide whether either of these changes have a substantive impact on executive incentives or, by extension, corporate risk management.