Archive for March, 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.

The financial reform bill that recently passed the Senate Finance Committee would require among other things that companies report the ratio of their CEO’s pay to that of the average employee. Advocates argue that such disclosure will help to rein in executive compensation by allowing for a more direct comparison across companies and industries.

We disagree. The ratio of CEO to average employee pay is a statistic that gets much media attention but has little practical value. It is likely to raise far more questions than it answers.

Take for example, H. Lee Scott, former CEO of Wal-Mart. According to the company’s most recent proxy, Scott was awarded $30 million in total compensation for 2009. Assuming that the average Wal-Mart employee makes something like $40,000 in salary and benefits, Scott can be said to make 750 times more than the average Wal-Mart employee.

Is this too much? By some measures, yes. Recent studies estimate that the average CEO of a U.S. corporation earns somewhere between 180 and 530 times more than the average employee (measurement and sampling differences account for the extreme discrepancy among results). The ratio at Wal-Mart exceeds all of these. Even Lloyd Blankfein, CEO of Goldman Sachs, makes “only” 140 times his average employee ($70 million versus $500,000). By comparison, Scott looks grossly overpaid.

By other measures, however, Scott’s pay looks much more reasonable. Does Scott create 750 times more in corporate value than the average employee? Probably. Does oversight responsibility for 2.1 million workers and $400 billion in revenue merit 750 times more compensation than the oversight responsibility of the average Wal-Mart associate? Perhaps. Would the company rather eliminate the CEO position or 750 other positions selected at random? We’re guessing the latter.

The problem with all of these comparisons is that they are highly arbitrary and do not contribute to a meaningful discussion about compensation.

From our perspective, the “right” amount to pay a CEO is the lowest amount that it takes to attract, retain, and motivate a qualified executive to lead the corporation. This is the same calculation that is made in setting the compensation of all other employees. From there, a ratio between the two will emerge, and it would be hard to argue that it’s irrational.

The focus should be on these issues, and not on a summary statistic that has no logical point of reference and is likely to stir up more controversy than it settles.

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: Ameriprise Financial, Form DEF 14A, Filed March 19, 2010

To better understand the relation between executive compensation structure and risky behavior, we can look no further than the recent disclosure by Ameriprise Financial in the CD&A section of their latest proxy:

“There are no objective tests to determine whether one type of incentive compensation plan encourages executive officers to take excessive and unnecessary risks while another type of plan encourages only prudent and appropriate risk taking. Nevertheless, we will continue to examine our incentive compensation plans during 2010 to identify any plan features that may be incompatible with our enterprise risk management program. With that said, it is not always easy to categorize risks as excessive or appropriate, except with the benefit of hindsight. […] The question we have been asking ourselves is this: ‘Are the Company’s enterprise risk management framework and internal controls effective to prevent or to identify and mitigate risk taking by our executive officers that exceeds our risk tolerances, regardless of the incentive compensation plan in which he or she participates?’ We believe that the answer to that question is ‘Yes.’ Nevertheless, we will continue to give additional attention to the subject of risk and compensation as we continue to enhance our enterprise risk management program.”

This, of course, is a long-winded way of saying “we really have no idea.” And we don’t blame the company. Although many so-called governance “experts” have stated that excessive compensation was a primary cause of the financial crisis, there is as of now no hard evidence that this is true, or, if it is true, the extent to which poorly structured compensation packages increase enterprise risk exposure.

Until such studies are developed, we encourage a common sense approach. Investors should ask themselves the following: Does management have sufficient exposure to the stock price so that their change in wealth is roughly in line with mine? Do management communications satisfy me that they properly understand risks to the organization? Do I accept management’s explanation of the steps they are taking to mitigate those risks? Does the board of directors have sufficient experience and judgment, based on their background, to understand the risk-level of the corporate strategy and oversee management?

If the answer to any of these is no, it is likely that no compensation structure or internal risk controls will shield the investor from poor management decision making (i.e., sell).

Posted by Professor David F. Larcker, Stanford Graduate School of Business.

Note: This was originally posted on The Harvard Law School Forum on Corporate Governance and Financial Regulation on Friday, March 12, 2010 at 9:04 am

In the paper, Performance-Based Incentives for Internal Monitors, which was recently published on SSRN, my co-authors (Christopher Armstrong and Alan Jagolinzer) and I investigate the choice of performance-based incentives for the general counsel (GC) and chief internal auditor (IA) and assess whether these incentives enhance or impair monitoring.

We use proprietary and public data that provide details about the incentive-compensation contracts of the GC and the IA to identify the determinants of performance-based incentives of internal monitors. More importantly, we also examine the impact these incentives have on either alleviating or exacerbating agency problems within the firm. We draw inferences regarding the implications of compensating internal monitors with performance-based incentives using a propensity score matched-pair research design, which helps address econometric concerns related to the endogenous design of compensation contracts.

We find that internal monitors receive greater incentives when their job duties contribute more to the firm’s production function. Internal monitors also receive greater incentives when they are more highly ranked within the firm and when the firm’s CEO receives greater incentives, consistent with standardization in compensation contracts within the executive suite. In addition, monitors receive lower incentives at firms with greater ex ante litigation risk, consistent with risk-averse monitors demanding less risky compensation when their human capital is more at risk. Finally, we find some evidence that incentive levels are greater when there is more demand for internal monitoring.

To better understand the implications of internal monitor incentives, we examine the association between internal monitor incentive levels and the frequency of adverse firm outcomes, which we use to proxy for unresolved agency problems within the firm. After matching monitors on observable characteristics of their contracting environments using a propensity score approach, we find a lower frequency of adverse outcomes (e.g., regulatory enforcement actions and internal-control material-weakness disclosures) at firms that provide their monitors with greater performance-based incentives. These results are consistent across a variety of alternative measures of incentives and outcomes and appear to be generally robust to omitted variable bias.

Overall, our results support the notion that performance-based incentives enhance the internal monitoring function, perhaps by providing incentives for better monitoring efforts or by facilitating the selection of more talented monitors. These results may allay concerns raised in the economics and legal literatures regarding whether performance-based incentives are an appropriate form of compensation for internal monitors. These results also provide new insights into the implications of providing management with incentive-based compensation by focusing directly on the implications of providing incentives to corporate officers who are responsible for overall governance within the firm.

The full paper is available for download on the Social Science Research Network (SSRN) here.

(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: 3-09-2010)

Compensation Committee – Merits of Shareholder-Sponsored Proxy Proposals requesting that boards disallow more than one current or former CEO from serving on compensation committee

Source: Time Warner Inc., Form DEF 14A, Filed April 9, 2009

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, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.

Source: SunTrust Banks, Form PRE DEF 14A, Filed February 23, 2010

Recent SEC rules require that companies disclose the qualifications of their directors. Specifically, companies are required to explain “the particular experience, qualifications, attributes or skills that led the company’s board to conclude that the person should serve as a director of the company.”

A recent filing by SunTrust Banks reveals a remarkable pattern. According to the company:

“Mr. Correll’s long and varied business career, including service as Chairman and CEO of a large, publicly-traded company, well qualifies him to serve on our Board.”

“Mr. Hughes’ long and varied business career, including service as Chairman and CEO of a large, publicly-traded company, well qualifies him to serve on our Board.”

“Mr. Ivester’s long and varied business career, including service as Chairman and CEO of a large, publicly-traded company, well qualifies him to serve on our Board.”

“Mr. Minor’s long and varied business career, including service as Chairman and CEO of a large, publicly-traded company, well qualifies him to serve on our Board.”

“Mr. Lanier’s long and varied business career, including service as Chairman and CEO of a large, publicly-traded company, and his service as a lead director of another public company, well qualifies him to serve on our Board.”

“Mr. Beall’s executive and management experience well qualify him to serve on our Board.”

“Mr. Crowe’s executive and management experience well qualify him to serve on our Board.”

“Mr. Prince’s extensive management and executive experience well qualifies him to serve on our Board.”

This shows how a company can comply with the letter rather than the spirit of regulations. Perhaps the company should have simplified matters by stating simply that “our directors are qualified because we say they 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.

A recent article in BusinessWeek (“Some CEOs Are Selling Their Companies Short,” February 25, 2010), explains how CEOs and other insiders use hedging strategies to lock in the value of equity compensation (either restricted shares or options). The example cited in the article is Keith Olsen, CEO of Switch & Data Facilities, who entered into a prepaid variable forward contract with an investment bank to hedge the value of 150,000 shares—a quarter of his holdings—following a rally in the company stock price.

Hedging of equity ownership is not illegal. However, it can still be a significant concern for shareholders. When an executive insulates himself from declines in the stock price, the incentive value of equity ownership goes away. Shareholders have to ask: why provide compensation in the form of equity if the value of that equity can be converted to a cash equivalent at the CEO’s discretion. More worrisome, academic literature suggests that the practice of hedging is rife with abuse: CEOs that hedge, either through a prepaid variable forward or 10b5-1 plan, tend to outperform the market. If true, such behavior may constitute a sophisticated form of insider trading.

There are several solutions to the problem, and they are relatively easy to implement. The board should have strict guidelines on the timing and percentage of total ownership that executives are allowed to hedge. The justification for these guidelines should be explained to shareholders. The board should also require that hedged transactions be disclosed through public filings. When such information is disclosed to investors, they are better positioned to evaluate whether hedging behavior is justified.

Related Stanford GSB Research:

Stanford University-Graduate School of Business Teaching Case: 10b5-1 Plans: Mortgaging a Defense Against Insider Trading (CG-10) Authors: David F. Larcker and Brian Tayan

Stanford Business School Research Underpins SEC Scrutiny of Scheduled Insider Trades
Stanford GSB News, July 2009
In the wake of alleged misconduct by executives at Countrywide Savings, Novatel, and Qwest, research by Stanford accounting professor Alan Jagolinzer may be prompting the Securities and Exchange Commission to rethink rules that permit scheduled trading by insiders.

Jagolinzer, Alan D., Yeung, Eric and Matsunaga, Steven R., An Analysis of Insiders’ Use of Prepaid Variable Forward Transactions (May 2007). Available at SSRN: http://ssrn.com/abstract=816945