Additional Issues on
Corporate Governance
Professor Alexander Settles
Faculty 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.
2.
3.
4.
5.
Steve Jobs of Apple $1 salary and
realized $647 million from vested
restricted stock last year.
Ray Irani of Occidental Petroleum - $322
million total pay
Barry Diller of IAC/Interactive Corp $295 million
William P. Foley of Fidelity National
Financial - $180 million
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:

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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?

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Incentives
 Going along helps chance of renomination 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


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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


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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

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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.”