OIL INDUSTRY ROUNDTABLE
DISCUSSION GROUP
“Trends and Best Practices in Corporate
Governance of Executive Compensation
Post-Enron”
June 4, 2002
Frederic W. Cook
Frederic W. Cook & Co., Inc.
PRESENTATION TOPICS . . .
A. COMPENSATION GOVERNANCE PRINCIPLES
B. BRT PRINCIPLES OF CORPORATE GOVERNANCE
C. FWC SUGGESTED BEST PRACTICES FOR
EXECUTIVE COMPENSATION
D. STOCK OPTION ACCOUNTING
E. COMPENSATION COMMITTEE USE OF OUTSIDE
ADVISORS
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COMPENSATION ISSUES . . .
“In the last decade, management has faced increased
market pressures for short-term stock price performance
and corresponding pressures to satisfy market expectations
on a quarterly basis. This, coupled with increasing grants to
senior executives of stock options and other incentives that
are focused on short-term stock appreciation, may have
created incentives that tipped the balance toward the
promotion of self-interest rather than the protection and
promotion of long-term shareholder value.”
Ira M. Millstein
Weil, Gotshal & Manges LLP
Co-Chair of Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees
Testimony -- Senate Banking Committee
February 27, 2002
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PUBLIC PERCEPTIONS . . .
• Executive greed and duplicity contributed to Enron
debacle
–
Mega-options drove management to falsify accounting to
keep stock prices high and rising
–
Executives used inside information to exercise and sell
options while price high
–
Executives urged employees to buy while they were selling
• Stock option accounting contributed to the speculative
bubble in stocks by inflating the growth rate in EPS
• Stock options cause short-term behavior and are
misaligned with long-term interests of shareholders
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A. COMPENSATION GOVERNANCE
PRINCIPLES . . .
Forces influencing change in executive compensation
practices
• Regulatory
–
–
–
Congress
SEC
NYSE/Nasdaq
• Investor Advocates
–
–
CalPers
TIAA-CREF
–
–
CII
ISS
• “Best Practices” Initiatives
–
–
–
–
–
The Business Roundtable (“BRT”)
Financial Executives Int’l
Frederic W. Cook & Co.
Wachtell Lipton
National Association of Corporate Directors
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B.
BRT PRINCIPLES OF
CORPORATE GOVERNANCE . . .
• Comprehensive statement issued May 20, 2002
–
Replacing 1997 statement
• BRT represents CEOs of 150 large corporations
• Urges adoption of new governance principles by all
U.S. public companies to restore public trust in
American business
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BRT PRINCIPLES -- GENERAL . . .
• Companies should adopt and publicize statements of
corporate governance principles
• Core committees (audit, compensation, governance)
should be composed entirely of independent directors
• Committee members and chairs should be appointed by
Board on recommendations of the Corporate
Governance Committee
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BRT -- COMPENSATION COMMITTEE
GOVERNANCE PRINCIPLES . . .
• Committee should have a written charter, approved by
Board, clearly defining its responsibilities
• Core responsibilities of Compensation Committees
–
Overseeing company’s overall compensation programs
–
Setting CEO and senior management compensation
–
Establishing director compensation
• Compensation and Governance Committees should
evaluate CEO annually on behalf of Board
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BRT -- MANAGEMENT COMPENSATION
PRINCIPLES . . .
• Adopt diverse mix of compensation and incentives
–
Prevent short-term focus
–
Avoid narrow focus on particular aspect of company’s
business
• Carefully design equity compensation to avoid
unintended incentives for short-term market value
changes
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BRT -- MANAGEMENT COMPENSATION
PRINCIPLES (cont’d) . . .
• Directly link interests of management to long-term
interests of stockholders
• Require shareholder approval of all stock option and
restricted stock plans in which directors and executive
officers participate
• Engagement by the Committee of separate
compensation consultants may be useful
–
BRT believes access to outside advisors is an important
element of effective governance system
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BRT -- DIRECTOR COMPENSATION
PRINCIPLES . . .
• Directors should be incentivized to focus on long-term
value
• Meaningful portion of total remuneration should be in
long-term equity
• Equity compensation should be carefully designed to
avoid unintended incentives for short-term market value
changes
• Boards may wish to require directors to acquire and
hold meaningful ownership positions while active
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C. FWC SUGGESTED BEST PRACTICES
FOR EXECUTIVE COMPENSATION . . .
Financially-Driven Incentives
• Pick the critical and conservative measures of operating
performance
•
•
•
•
If formula driven, have audit firm confirm calculations
Preserve discretion to deviate from accounting numbers
Include strategic/qualitative measures
Consider effect on current awards of prior-period
restatements
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C. FWC SUGGESTED BEST PRACTICES
(cont’d) . . .
Suggested Regulatory Initiatives
• Increase frequency of reporting of OD stock
transactions
–
Gain control over shares
• Permit recapture of stock gains in bankruptcy
• Permit recapture of lump sum SERPs in bankruptcy
• Preclude option grants on inside information
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C. FWC SUGGESTED BEST PRACTICES
(cont’d) . . .
“Best Practices” Initiatives
• Adopt policy on stock transactions and conflicts of
interests by ODs
• Adopt stock “retention ratios” instead of ownership
guidelines
• Prohibit 100% “cashless exercises” by ODs
• Use “reloads” only for ownership purposes
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C. FWC SUGGESTED BEST PRACTICES
(cont’d) . . .
“Best Practices” Initiatives (cont’d)
• Prohibit loans for exercising options, purchasing stock or
paying taxes
• Prohibit purchases of stock on margin and use of stock
as collateral
• Prohibit “hedging” or similar techniques
• Encourage (or require) use of SEC 10b5-1(c) selling
programs by ODs
• Prohibit incentives on piece-parts of business where
conflicts exist
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C. FWC SUGGESTED BEST PRACTICES
(cont’d) . . .
Directors’ Remuneration “Best Practices”
• Discontinue stock options*
–
Use deferred stock instead
• Discourage (or prohibit) stock sales while an active
director
* Except for startups or pre-IPO companies
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D. STOCK OPTION ACCOUNTING . . .
• Intense debate underway whether to require P&L
expense for option value:
For
Against
Alan Greenspan
President Bush
Arthur Levitt
Chairman Pitt
Warren Buffet
Walter Schuetze
New York Times
Business Week
CII/TIAA-CREF
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D. STOCK OPTION ACCOUNTING (cont’d)
Concerns of Change Advocates
•
•
•
•
•
•
Present accounting leads to excessive use and dilution
Earnings and EPS growth overstated
Incentives misaligned
Options have value; therefore must have a cost
Expense is not zero
Better design would result from expensing
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D. STOCK OPTION ACCOUNTING (cont’d)
Arguments for Status Quo
•
•
•
•
•
Option “fair values” impossible to measure
Black-Scholes overstates option value
FV doesn’t meet conceptual definition of expense
FV would be only expense estimate never trued up
Cost to shareholders already measured by diluted EPS
–
FV charge would be double counting
• Value of option privilege in financial instruments not
expense
• No other country requires option expense
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E. COMPENSATION COMMITTEE’S USE
OF INDEPENDENT ADVISORS . . .
• (Materials handed out at the meeting; not available for
general distribution or on our website)
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OTHER LIKELY IMPLICATIONS
OF “ENRON”
• More power to board/committees, less to management
• Harder to attract/retain qualified directors
–
Smaller boards
• More staff time spent serving board/committees
• More transparency
• “Best Practices” statements
–
Possible “comply or explain” disclosure
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