Archive for February, 2010

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.

Did high banker pay cause the financial crisis of 2008 and 2009? Josef Ackermann, chief executive officer of Deutsche Bank, does not seem to think so. In a recent Bloomberg article titled “Ackermann Says High Pay at Banks Didn’t Cause Losses (Update1)” published on 2-19-2010, Ackermann was cited as saying “Is there a correlation between the compensation system and losses? Yes, but it’s negative.” He pointed out that German financial institutions with higher levels of executive compensation were less likely to require aid from the government, whereas those with lower levels (including state-owned banks) were more likely to.

It has become common consensus among the press that compensation either caused or contributed to the crisis. The nature of this relationship, however, is by no means clear. Although the topic is too extensive to be dealt with here, we should point out some important points:

1) There is a difference between inappropriate pay levels and inappropriate pay structure. It is likely that any relation between compensation and the crisis had more to do with the latter (i.e., cash and equity bonuses that lacked deferred payouts, clawbacks, or hold-to-retirement provisions).

2) Most of the companies that created the structure products that led to the crisis believed in their value enough to retain exposure on the balance sheet. The incentive value of compensation only works to the extent that the management and the board understand the risks they are dealing with. In this case, most did not. A change in pay structure therefore might still have led to the same outcome (the difference being that the CEOs would have actually suffered along with shareholders).

3) Compensation is a complex issue that will not be fixed by mandating a one-size-fits-all solution. For example, a recent working paper by Armstrong, Larcker, and Su (2010) finds that wealth effects are an important contributor to the incentive value of compensation. Any serious reform to compensation will likely have to take place at the company-specific level where individual circumstances can be addressed, rather than at the regulatory level where they would apply equally to all companies. (Paper source: Endogenous Selection and Moral Hazard in Executive Compensation Contracts found on SSRN.)

While Ackermann makes interesting points, in all likelihood he is just as far off the mark as his critics are.

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.

Source: Quiksilver, Inc., Form DEF 14A, Filed February 12, 2010

The compensation committee of Quiksilver, maker of surf and beach apparel, has proposed changes to the way it will pay nonexecutive directors. Currently, nonexecutive directors receive a $45,000 cash retainer, 5,000 shares restricted stock, and 7,500 stock options each year. Directors also receive a one-time grant of 5,000 shares and 7,500 options when they first join the board. Under the proposed policy, the company will eliminate the $45,000 cash retainer and increase the stock-based awards. The initial and the annual issuances of restricted stock will rise from 5,000 shares to 15,000 shares, and the issuances of stock options from 7,500 to 25,000.

The company explains the change in policy by saying it is “in our best interest given our highly leveraged position and the need to preserve cash for our operations, capital expenditures and interest expense.” Effectively, the directors are being asked to help finance the company and stand in the back of the line to be paid only if shareholders are also paid.

Unlike exchanges and repricings at other companies, it is interesting to note how small of a premium the directors of Quiksilver are willing to accept for this arrangement (trading riskless cash for risky options and stock). Based on the company’s current share price and Black-Scholes parameters in the most recent annual report, the value of the incremental awards is only around $43,800 (less than the $45,000 cash given up). If more generous parameters are applied, the value increases to $52,500. Although our estimates may be off, it looks like directors are willing to make this exchange for little or no premium. Quiksilver directors are apparently stepping up to the plate when their company needs them the most.

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.

Source: MEMC Electronic Materials, Form 8-K, Filed February 4, 2010

In September 2009, MEMC Electronic Materials announced that it would close two silicon wafer manufacturing plants—one in Sherman, Texas and the other in St. Peters, Missouri. Over 400 employees were laid off and production moved to lower cost facilities.

The company took several steps to ease the impact on the employees affected by the restructuring. These included severance, supplemental COBRA payments, education and training, and the opportunity to work in other positions at the company. The cost of these actions: $18 million.

In January 2010, Ahmad Chatila, president and CEO of the company, decided to make his own contribution to the effort. He would voluntarily forego a $500,000 minimum cash bonus owed to him under his employment contract for 2009. Instead, the company would direct those funds to additional training programs for the employees who were laid off. It is nice to see a leader take a personal, vested interest in the welfare of his employees.

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.

Source: Analog Devices, Inc., Form DEF 14A, Filed February 3, 2010

Regulatory standards in the U.S. focus primarily on the “independence” of directors, but shareholders care most about the qualifications that directors have for serving on the board in the first place. Unfortunately, most companies provide scant disclosure on why individual directors have been selected. Instead, shareholders have to guess this information from the brief biography provided in the annual proxy.
One exception is Analog Devices, the semiconductor company specializing in data conversion technology. In its annual proxy, the company has taken away much of the guesswork by disclosing “each nominee’s specific experience, qualifications, attributes and skills that led our Board to the conclusion that he should serve as a director.” For example, James Champy, an executive of Dell/Perot Systems, was selected for “his expertise in corporate strategy development and organizational acumen.” John Hodgson, retired executive of DuPont, was recruited for “his extensive sales and marketing experience with a global technology company, as well as his executive leadership and management experience.” Kenton Sicchitano, retired auditor of PricewaterhouseCoopers, was brought on for “extensive experience with public and financial accounting matters.”
By providing much needed transparency, investors should be better equipped to understand how individual directors are expected to contribute to specific areas of corporate oversight. They will also be better able to gauge which directors are meeting their obligations and which may be falling short.