FINC312 Exam 1
Nomination Committee
(governance committee) makes recommendations on new members to be elected to the board. If there is none, then all of the board nominates, which is not independent.
The three problems that opponents have against paying CEOs with stock or stock-related instruments are:
#1: CEOs increase stock ownership they also increase their power which in turn allows CEOs to attain a variety of private benefits. (RR #6 Lord Black- owned a lot of stock and picked all board members) #2: Increases in stock prices for which a CEO is being rewarded may reflect gains from economic circumstances beyond the CEOs control Ex: Occidental Petroleum's CEO, Ray Irani: stock rose primarily due to rising price of crude oil which was outside of Irani's control #3: Increase of managerial stock ownership through devices like stock options may allow managers ways to "game the system" through controversial practices like earnings manipulation and backdating stock options. Ex: RR #17: Eugene Isenberg participated in backdating the options given to him by Nabors Inc. Backdating means that companies deliberately falsify stock option agreements so that options granted on one date were reported as if granted on an earlier date when the stock price was unusually low. Billionaire investor Warren Buffett believes that "directors should eat their own cooking" meaning that if you win, they win big and if you lose they lose big. Buffett is a proponent of compensating with stock options because it provides an incentive for the CEO to do their job well due to a direct link between benefits and losses of the company and shareholders.
The four ways shareholders can improve the chances that the board will perform its oversight role with regard to matters related to CEO compensation:
#1: Making sure the compensation committee is completely staffed by independent directors and that the CEO didn't sit on the compensation committee #2: By paying close attention to the portion in the proxy statement in which boards provide a written justification for the link between performance and various components of the compensation that was paid to the CEO. #3: To pay attention to the companies that the board has chosen to include in the "peer group" used by the board to benchmark the CEO's compensation #4: By voting on what is called a "say on pay" proposal when such a proposal is included in a firm's proxy statement -Stockholders must be given an opportunity at least once every three years to vote their approval or disapproval of how much the CEO of their company is being paid Ex: RR #18:
Agency problem and example
-An agency problem is when there is a conflict of interest between shareholders and any other stakeholders in the firm. -The T-Bond scandal at Salomon brothers was Paul Mozer, the head of Salomon's government-bond trading desk, submitted bids for more than the 35% ceiling by bidding 35% underneath the Salomon name, while also submitting bids for another 11% underneath the name Warburg affiliate, a customer of Salomon without their authorization. This is an agency problem between Salomon and society at large because this ruined the credibility of the firm both by illustrating the sneaky tactics creating questionable quality of work and the detrimental loss of money of the firm calling into question their future decisions. Cliff Smith asserts that, "would-be investors might reason that the firm now has greater incentives to put together bad deals just to collect enough fees to stay afloat." Because of this loss in credibility, the firm's share prices decreased by 1/3, representing a $1.5 billion loss in market value.
Three oversight committees are:
-Compensation committee -Nomination committee -Audit committee
The two advisory committees:
-Investment Committee -Finance Committee
The Role of Large shareholders in corporate governance and control
-Large shareholders: . a term often used for a shareholder holding more than approximately 1 percent of a firm's shares • Most large shareholders own 5 to 10% of a firm's stock • Large shareholders holding more than 50% of a firm's stock are called majority shareholders • Split into 2 categories: active and passive investors o In contrast to passive, active investors believe they can influence management of a targeted firm and thereby change corporate policy RR #19-23
Affiliated Outside Directors (BI cont.)
-have personal or business links with the company that can compromise their independence from a firm's CEO. • Most common reasons for affiliation: an ex-employee, consultant, significant supplier or customer, provider of legal or investment banking services, employee of a university that gets significant grants from the firm, relative of management or an interlocking director (on each other's boards) • Case in point- Warren Buffett notes that "too often directors rely too heavily on board fees as a source of income. When this happens, directors are too worried about pleasing management so they can remain on the board and so they get a good reputation in the business community. This good reputation may lead to further board appointments, which is important to the director who relies on board fees as a material source of income. As a result, the main factor in determining director independence is how much their board fees are, relative to other sources of income"
Independent Outside Directors (BI cont.)
-outside directors without personal or business links • Proponents of independent outside directors argue that independent outside directors are the ones most likely to monitor the CEO • Case in point- Warren Buffett's skepticism of such directors is reflected in his statement: "Over a span of 40 years, I have been on 19 public company boards and have interacted with perhaps 250 directors. Most of them were 'independent' as defined by today's rules. But their contribution to shareholder well-being was a minimal at best. These people simply did not know enough about the business."
Fiduciary Roles of the board of directors
1) Advisory role- to assist with strategic and succession planning at the firm 2) Monitoring/oversight role- to assist with aligning the interests of the CEO with those of the firm's shareholders -To perform these roles the heads of the board, the chairman, typically places board directors in one or more committees.
CEO Compensation:
1. A base cash component (salary) 2. An annual bonus which is tied up to annual accounting performance 3. Stock options (which give the CEO the right, but not the obligation, to buy shares of stock at a predetermined price) 4. Restricted stock (shares to be delivered at a future point in time) 5. A long-term incentive plan tied up to multi-year accounting performance 6. Retirement benefits 7. A variety of perquisites ranging from health benefits to club memberships and personal use of the corporate jet
Critical questions to evaluate a firm's board of directors' performance in the oversight role: (9)
1. Are the board and its committees independent of the CEO? (Most important question) 2. How are board directors compensated? 3. How frequently does the board meet? 4. Are the CEO and Chairman of the board positions occupied by the same person? 5. How big is the board? 6. How available are directors for board responsibilities? 7. What are the ages and tenures of board directors? 8. How frequently are directors elected? 9. Can shareholders cumulate their votes in director elections?
Motives for investment policies
1. CEOs pursue with their investment policy decisions to generate a competitive advantage, enhancing shareholder wealth 2. For a CEO to create shareholder wealth by expropriating wealth from the firm's stakeholders 3. For a CEO to invest in pet projects because of private benefits to the CEO that create wealth for the CEO to the detriment of the shareholders
Negotiated programs use the following tactics:
1. Focus list- releasing to the media an annual focus list of underperforming firms in the active investor's portfolio that the investor plans to target or go after a. Case in point - #27 2. Piggybacking campaigns - in which the active investor does not initiate a hostile investment program like a proxy contest but publicly supports the program of another active investor 3. Pay to play- paybacks are made for favors to gain the privilege to engage or play or "get in the game" with certain activities. Payer is the hedge fund or other investment fund seeing money from the CEO of a PPF 4. Shareholder proposals- proposal for inclusion in proxy statements. These proposals are often used to object to actions taken by a firm that are not perceived to be in the best interest of the shareholders. a. Critics - weak tools for bringing any change in corporate policy, bcause even with a majority, it is still only an advisory proposal b. Proponents- when a large number of shareholders vote in favor, it sends a strong signal to the board about shareholder dissatisfaction c. #28 5. just vote no campaigns- designed by institutional investors to withhold votes from directors coming up for election at companies where the investor feels that board members have ignored the legitimate concerns of a majority of the shareholders 6. Counter solicitations- are organized attempts by the active investor to convince other shareholders via letters, press releases, and internet communications to defeat antitakeover provisions proposed by the targeted firm's managers a. #29
Empirical evidence on investment policies
1. Phase one: develop a research question 2. Phase two: develop a hypotheses or predictions about the research question to be addressed 3. Phase three: collect and analyze data; most popular method is an event study- in which a researcher attempts to study the impact of a specific event on the firm's stock prices. In order to conduct an event study the following steps are performed: a. Collect a sample of firms that announced the event under investigation b. For each announcement in the sample, collect a time series of stock returns around the announcement date, Label the time series of daily returns in "event time" according to the number of trading days by which the return precedes or follows the announcement date. c. Also collect a time series of market returns around the announcement date d. The purpose of the study is to isolate the impact of the specific event on firm's stock prices. Because the returns of individual firms tend to move with returns on the market as a whole, individual stock returns need to be adjusted to remove the influence of covariance with market return. The resulting stock price return is called the abnormal return or excess return and constitutes our best estimate of the impact of an event on firm's stock. e. Repeat steps 2-4 for each announcement, determine the average abnormal return and statistically test whether it is significantly different than 0 f. Determine the cumulative abnormal returns by summing up the average abnormal return over same period of time. 4. Based on the results, draw conclusions.
The reasons why the accounting approach fails to measure changes in the economic value of the firm are:
1. Risk is excluded a. Usually a premium for financial risk 2. Alternative accounting methods may be employed a. Different methods (FIFO v. LIFO) may turn up different results but the cash flows remain the same b. Depreciation helps measure value but does not have anything to do with cash flows 3. Investment requirements are excluded a. Increases in accounts receivable and inventories will cause the earnings figures to be greater than the cash flow due to the time difference 4. Dividend policy is not considered 5. The time value of money is ignored.
Pay multiples and example:
A pay multiple is the ratio of CEO pay to the pay of the average worker. Our case in point on Whole Foods market (RR #12) discusses how there is a rule preventing any executive from earning an amount in salary and bonus that's more than 14 times what the average worker makes. It is to foster a sense of partnership among employees. Empirical evidence on pay multiples yields mixed results because the ratio only includes cash and not stock options. Also it depends on where you are in the world. Research done by Bud Crystal shows that pay multiples in the US are substantially higher than those in other countries like England and France. Research by the Hay Group on the other hand says the opposite so information is inconsistent throughout research projects. Also you have to look at how is providing the evidence and why; what their specific reasoning is for finding the evidence. • Proponents argue that CEO pay should be capped at some multiple of average worker pay o Bud Crystal, a pay consultant turned pay critic, asserts, "We are certainly not arguing that everyone should be paid the same. But we do worry when the gap between top and bottom in our society widens to the degree it has. For in that widening, lie the ultimate destruction of the middle class and an increasing polarization of our society. And history teaches, if it teaches anything, that a society cannot remain democratic and stable, if it has no, or miniscule, middle class."
Two views to approach this goal
Accounting approach Finance approach
Friendly Programs
May begin with the purchase of the targeted firm's shares in the open market by the large shareholder; Alternatively commence with a targeted stock placement in which the targeted company sells its stock to a large investor or group of investors at what are often attractive terms RR #25: Billionaire investor Warren Buffett offered help against takeover attacks to USAir, Gillette and Salomon.
"A CEO who has a high ownership of a firm's stock, is likely to engage in decisions that are in the best interest of the firm's shareholders."
As a CEOs ownership of stock increases the performance of the firm also increases to a certain point. This leads to shared benefits meaning that when CEO gains the shareholders of the firm also gain. At a certain point a CEO becomes too powerful in a firm, the performance decreases leading to private benefits allowing the CEO to gain at the detriment of shareholders. RR #6: Lord Black became too powerful and began to reap all private benefits. RR #15: Eisner: CEO of Disney: his compensation was directly tied to the shareholders' wealth so when he was successful in the company the shareholder gain from his performance was enormous. RR #16: Don Tyson, senior chairperson of Tyson Foods Inc. enjoyed lavish compensation in the form of private benefits such as multiple homes, a house and vacations. RR #17: Eugene Isenberg, CEO of Nabors Inc., participated in backdating of stocks as he was too powerful from getting so many options which resulted in the accrual of private benefits for him.
Hostile Programs
Begins with a toehold investment made by the active investor and often proceed with media campaigns and attempts to secure one or more board seats in a proxy contest; Alternatively: active investor attempts an outright takeover of the targeted firm with a hostile tender offer or a leveraged buyout C-I-P: Daniel Loeb, principal investor for hedge fund Third Point LLC, acquired 6% stake in Star Gas then started a media campaign publicly criticizing the way CEO Irik Sevin was running the company. RR #24: Donald Trump owned 9.6% of Bally Manufacturing Inc. and they thought he was planning a hostile takeover the company.
Investment Policy
Decisions concerned with how a firm should spend its money. These decisions are related to investments in capital assets or projects. Investment policy decisions are also known as capital budgeting decisions and are typically associated with substantial amounts of initial capital outlays and can have significant long term consequences for the firm.
Definitions #13
On study guide
Friendly programs (again)
Friendly investment programs may begin with the purchase of the targeted firm's shares in the open market by the large shareholder. May also begin with a targeted stock placement. o Targeted stock placement- where the target company sells its stock to a large investor or group of investors at what are often attractive terms o The attractive terms of the sale are referred to as whitemail payments or sweetheart deals o Made when the target firm is distressed or in takeover play. Such sales of voting stock can offer takeover protection to the target and are referred to as white squire deals o Relationship investing- shareholders pursuing friendly tactics are sometimes called patient investors and this kind of investment program by a large shareholder typically includes a fair amount of "behind the scenes" unreported changes to benefit the company. o White knight- the friendly investor who rescues a target firm from a hostile takeover o Ends with the friendly investor placing the shares on the open markets for a merger or buying the company
One way large shareholders may accrue private benefits is by engaging in an assortment of self-dealing activities like:
Green mail, white mail, political capital and tunneling transactions
Green mail
In a green mail transaction the large shareholder sells the stock of the target company back to the company in a private transaction at a premium price
White mail
In a white mail transaction, the target company sells its stock to the large shareholder at what are often very attractive terms
Negotiated programs (again)
Have active investment tactics that lie between the extremes of friendly and hostile tactics. Unlike the others, the target firm's stocks are already in the large investors portfolio, • Case in point - required additional reading #27 • In 2010, institutional investors owned almost 70% of stock. Institutional investors, especially public like CALPERS, typically pursue negotiated tactics • The use of negotiated programs by public pension funds over the last several decades can be understood by contrasting the so-called "voice" v. "exit" options available to the public pension fund when the fund disagrees with the actions of the managers in its portfolio o "Exit" refers to what is commonly known as the wall street walk. If you do not approve of what the management of a firm is doing, sell your shares and walk away o "Voice" or "jawboning" on the other hand refers to public pension funds responding to intolderable actions by the firm's managers by attempting to undo such actions • Proponents of PPFs assert that they perform an oversight role leading to shared benefits • Critics of negotiated programs claim that these programs can build substantial political capital for the CEOs of funds pursuing these programs o Political capital - the personal capital that a person builds by doing favors for others in the hope of getting paybacks for these favors o Case in point - required additional reading #26
Security Market Line
Higher the risk investors take the higher the return 1. Ri = Rf + B (Rm - Rf) a. Rf = the return on risk-free assets b. Rm = the return on the market portfolio c. B (Rm - Rf) = the equity risk premium- the difference between stock returns and returns on riskless bonds d. (Rm - Rf) = the market risk premium- for bearing risk with investing in the market 2. Speculative or borrowing strategy: B > 1 3. Defensive or lending strategy: B < 1
Tactics employed by active large investors using:
Hostile programs, friendly programs and negotiated programs
Tunneling transactions
In which the large shareholder sells or buys assets of the target firm at non-arm's length (unfair) prices
Negotiated programs
Include active investment tactics that lie between the extremes of friendly and hostile tactics; do not begin with the large shareholder acquiring shares of the target firm in the open markets or private placement but the target firm's shares are already in the large shareholder's stock portfolio; target firm's shares typically remain in the large shareholder's stock portfolio subsequent to the active investment program. RR #28: CalPERS owns 70% stocks and they typically pursue negotiated tactics.
Large shareholders benefit or harm small shareholders:
Large shareholders are shareholders that own more than approx. 1% of a firm's shares. Active investors believe they can influence management of a targeted firm and thereby change corporate policy. This can harm or benefit the small shareholders depending on the intent of the large shareholder. When the large shareholder acts in the best interest of everyone, they reap shared benefits and provide almost a "voice for the shareholders." When the large shareholder acts in the best interest of themselves with no regard for the small shareholders, they reap the private benefits, which can actually harm the small shareholders.
Finance approach
Represent shareholder interest by maximizing cash flows
Accounting approach
Represent shareholder interest by maximizing net income
Audit Committee
Reviews the firm's financial affairs
Is there a link between CEO pay and performance?
Several compensation experts argue that the most critical variable in evaluating the CEO pay is the link between CEO pay and the performance of the company • Weak - because CEOs hold low amounts of stock o Case in point - read additional reading #14 • Some compensation experts believe that with increases in CEO stock ownership leads to shared benefits wherein the CEO gains, as do the other shareholders of the firm o Case in point - read additional reading #15 • Opponents of paying CEOs with stocks or stock related instruments, particularly when this leads to excessive managerial stock ownership, have at least 3 problems with such ownership 1. Critics assert that when CEOs increase their stock ownership, they also increase their power, which in turn allows CEOs to attain a variety of private benefits to the detriment of other shareholders a. Case in point - read additional reading #16 b. Case in point - read addition reading #6 2. Opponents of stock-based compensation also argue that increases in stock prices for which a CEO is being rewarded may simply reflect gains from economic circumstances beyond the CEOs control a. Occidental petroleum - Ray Irani - a lot of critics argue that he didn't do anything to deserve his large compensation rather it increased due to rising oil prices 3. Opponents assert that the increase of managerial stock ownership through devices like stock options may allow managers ways "to game the system" through controversial practices like earnings manipulation and the backdating of stock options a. With backdating, companies deliberately falsify stock option agreements so that options granted on one date were reported as if granted on an earlier date when the stock price was unusually low b. The excessive compensation for Charles Wang and Sanjay Kumar came from a stock options grant worth 1.1 billion that made both of them "poster boys" of excessive compensation and possibly provided the incentives for huge accounting fraud and options and backdating practices at Computer associates c. Case in point - read additional reading #17 • Studies show that the relationship between CEO stock ownership and firm performance is hump shaped. CEO ownership correlates with improved firm performance up to some level of ownership, after that it shows a decline in performance
The highlights of the evidence collected by Michael Jensen and Kevin Murphy on the link between a CEO's compensation and firm performance :
That annual changes in executive compensation do not reflect changes in corporate performance. Accounting for all monetary sources of CEO incentives- salary and bonus, stock and options, shares owned and the changing likelihood of dismissal- a $1000 change in corporate value responds to a change in CEO compensation of just $2.59. The link between a CEO's compensation and firm performance is based on direct ownership of shares by the CEO. The relationship between pay and performance is eroded due to reluctance of directors to reward CEOs with substantial financial gains or to impose penalties for poor performance. A $1000 change in corporate value translates into a nickel in CEO wealth by affecting dismissal prospects. CEO stock ownership is actually declining rather than increasing and CEOs now hold low amounts of stocks.
How frequently are directors elected?
The frequency with which board members are elected depends on whether the firm has a classified or staggered board • Classified- one in which the directors are divided into separate classes with the directors in each class elected to overlapping three-year terms. • Staggering- only one third of the directors stand for election in any one year
Political capital
This self-dealing comes from the large shareholder using his clout with the target company to give favors to others in the hope of getting paybacks for these favors.
Can shareholders cumulate their votes in director elections?
With cumulative voting, each shareholder may cast the total number of votes he or she is entitled to cast for one director, or apportion them among the candidates for director seats • May allow a large shareholder to elect one or more directors of his choice to the board • Dissident directors- directors that often disagree with other directors on a firm's board, usually nominated by a disgruntled large shareholder of the company o Proponents of dissident directors assert that they can prevent groupthink and bring fresh perspectives to the board o Critics argue that dissident directors can be disruptive and pursue special interests to the detriment of the firm's shareholders.
Corporation
a set of contracts, which links employees, customers, suppliers, managers, creditors, shareholders, local community, and society at large.
Capital Asset Pricing Model (CAPM)
can be used to compute the risk-adjusted opportunity cost of capital in an NPV calculation i. Investors hold diversified portfolios in order to eliminate unique (unsystematic, diversifiable, or idiosyncratic) risk associated with an asset. Portfolio risk is the risk that one still bears after achieving full diversification, often called market risk. ii. Empirical evidence suggests to eliminate most unsystematic risk iii. The appropriate measure of risk for a stock is the contribution to risk of a well-diversified portfolio; this is measured by beta, which essentially measures the sensitivity the security has to changes in the market. The market has a beta of 1, no risk = 0, and higher risk than market > 1
Financing policy decisions
decisions concerned with how a firm should raise money to finance capital assets or projects as well as for other purposes
Investment policy decisions
decisions concerned with how a firm should spend its money
Corporate control decisions
decisions concerned with who is in the best position to ultimately control the firm's assets
Investment Committee
function is to review the firm's investment policies and make recommendations about the long-term projects the firm should invest in.
Cases in point
i. Case in point- when asked if he understands the concept behind GAAP, Donald Trump said, "No. I'm not an accountant." When asked if he understands the concept of net present value he added, "Well, to me, the word 'net' is an interesting word. It's really - the word 'value' is the most important word. If you have an asset that you can do other things with but you don't choose to do them - I haven't chosen to do that" ii. Case in point- warren buffet said "there is a crisis of confidence today about corporate earnings reports and the credibility of chief executives. And it's justified. For many years, I've had little confidence in the earnings numbers reported by corporations. I'm not talking about Enron or Worldcom - examples of outright crookedness. Rather I am referring to the legal, but improper accounting methods used by chief executives to inflate earnings."
What does a CEO need to make positive NPV investment decisions?
i. Competitive advantage - typically short-lived that's why NPVs are regarded as a disequilibrium situation ii. A company would need sustained or enduring competitive advantages
Drawbacks of AAR
i. Ignores the time value of money ii. Use of accounting income v. cash flows iii. Uses an arbitrary benchmark
Compensation Committee
makes recommendations to the board on compensation of the CEO and other officers of the corporation.
Evaluating the active investment programs of the world's wealthiest shareholders, it is useful to examine:
o Changes in accounting performance o Changes in stock prices performance o Changes in corporate governance o Changes in the situation with stakeholders other than shareholders.
Sarbanes Oxley Act
o The Sarbanes-Oxley Act of 2002 now requires that publicly traded firms have a majority of independent directors on their boards and only independent directors on their audit committee. • Problems opponents have with this act: • These reforms advocate "one-size fits all" • Regulatory firms may induce CEOs to "game the system" in ways that compromise independence of outside directors. The empirical evidence on board independence reveals in RR #8 that as the number of independent outside directors increased on a board and in the board's audit and compensation committees, the likelihood of corporate wrongdoing decreased. RR #9 shows that when Chairman Edgar Woolard of Dupont Co. joined the board for Apple he was an independent outside director who was able to re-vamp the company's board as the company was in decline. With his help and that of other outside directors it was able to get back on its feet.
This evaluation can help address the following issues:
o What are the gains accrued from active investment programs of large shareholders? If helpful, Active investment programs lead to shared benefits wherein large shareholders gain and so do the small shareholders o What are the losses accrued and the risks from active investment programs? Does the active investment lead to private benefits wherein large shareholders use their block ownership to secure a variety of benefits to the exclusion of other shareholders?
Finance Committee
reviews the firm's financing policies and makes recommendations about raising capital and dividend policy
The Average Accounting Return (AAR) rule
the accounting approach to making investment policy decisions. The average accounting return is the ratio of the average income to the average size of the project's investment. The firm should accept a project if it's AAR is greater than the minimum acceptable AAR (the benchmark).
Net present value rule
the finance approach to making investment policy decisions. Can be defined as a measure of benefits of making the decisions less its costs. If the NPV is positive, accept the project. The goal of NPV is to maximize shareholder wealth.
Set of contracts view of the corporation: Ultimate goal
the ultimate goal of the corporation's CEO is to represent the interest of the firm's shareholder's
How available are directors for board responsibilities?
• A director's usefulness in performing her advisory or oversight role can be weakened by the director's availability to give enough time to the task o Vital factor - the number of boards the director serves on • Observers assert that few, if any, directors would be so capable to effectively do a good job with service on more than four boards and their full time jobs o Vital factor - lack of attendance at board meetings o Case in point - RR #10
Empirical evidence of the effectiveness of independent boards
• Board independence does appear to influence various tasks undertaken by the board including CEO replacement at underperforming firms, responses to hostile takeovers, adoption of poison pills, and occurrences of corporate fraud. • Despite the intellectual appeal of board independence, there is no persuasive evidence showing that board independence is related to firm performance RR #8, #9, #65
How big is the board?
• Critics of large boards allege that such boards are dysfunctional o Professor Michael Jensen argues that "when boards get beyond 7 or 8 people they are less likely to function effectively and are easier for the CEO to control" • The reason - "greater emphasis on politeness and courtesy at the expense of truth and frankness in the boardroom" o Buffet - "it would be helpful if directors could supply necessary discipline, but board congeniality usually prevents that. To maximize board effectiveness in this situation the board should be small in size" o Case in point - RR #11 o Proponents of large boards assert that such boards are more likely to be heterogeneous in terms of expertise that directors bring to the board o Opponents of small boards argue that using a "one size fits all" approach can impair the effectiveness of boards for some firms. For certain firms such as firms with high growth opportunities, the advisory role of the board becomes important and may be advantageous to have a bigger board.
Board Independence
• Inside directors- current full-time employees of the company, its parent or subsidiaries. • Outside directors- all other directors.
Who should amend CEO compensation?
• Proponents of government intervention assert that such intervention is necessary for any reform to take place. Over the last 3 decades, 3 prominent interventions in the area of CEO pay are listed below: 1. The $1 million deductibility cap imposed by president bill Clinton in the 90s. This cap disallowed companies to take tax deductions for any compensation above $1 million paid to the CEO. However, this did not apply to compensation considered to be performance based. As stock options were widely considered as being performance based, this intervention led to an explosion in the use of stock options in CEO compensation plans. This led to an increase in CEO compensation • Opponents of government intervention assert that CEO compensation should be left to the shareholders of the firm or to the representatives of the shareholders o Shareholders can make sure the compensation committee is full of independent directors • Case in point - read additional reading #18 o Shareholders can also pay close attention to the portion in the proxy statement in which boards provide a written justification for the link between performance and various components of the compensation that was paid to the CEO • Case in point - Chesapeake energy corporation - in the proxy statement you could see that the CEO of the company, McClendon, had an increasing compensation by 13.4% per year, while the returns were not increasing that fast. He was compensated $21 million, compared to the peer median of 10.6 million. The increase was related to an increase in allowed restricted stock and was not performance based. o Shareholders can improve chances that the board will perform its oversight role by paying attention to the companies that the board has chosen to include in the "peer group" used by the board to benchmark the CEOs compensation o Shareholders can vote on a "say on pay" proposal, when such a proposal is included in a firm's proxy statement • Where the shareholders get to vote on whether they agree or disagree with the CEO compensation • Only advisory and may be ignored by the board
What are the ages and tenures of the board of directors?
• Some observers of boards assert that after a certain age a director is unlikely to "rock the boat at a board meeting • Proponents of such directors, on the other hand argue that such directors bring useful wisdom to the board • Proponents of having term limits on the exiting directors of a board claim that there are at least 3 advantages: 1. Term limits for existing directors would bring new directors that can bring fresh perspectives to the board 2. Having term limits for existing directors may give a board an easy way to get rid of directors who are doing a suboptimal job 3. Directors with long tenures on the board may be indebted to the firm's CEO and therefore less likely to perform their oversight role. -Professor Charles Elson believes that there should be a mandatory requirement for limiting terms. He also believes that it is important to rotate in good talent however that there are people of advanced years in companies who make terrific directors.
Are the CEO and Chairman of the board positions occupied by the same person?
• The chairman of the board provides the necessary leadership for board decisions related to selecting and replacing the CEO • The CEO supervises the day-to-day operations and policies of the firm • The norm for most firms in the US is to have the same person occupy the positions of both • Controversial issue - appointing a separate, independent as the chairman of the board o Opponents of having the same person occupy both positions argue that such a structure only diminishes the oversight role of the board o Proponents assert that such a structure is necessary to preserve the harmony needed for effective leadership o Many observers of boards have argued that at the very least, it is important to have an independent lead director meet with the other independent outside directors without the presence of the CEO • Warren Buffet - "Social difficulties argue for outside directors to regularly meet without the CEO - a reform that is being instituted and that I enthusiastically endorse."
Hostile programs (again)
• Typically begin with a toehold investment made by the active investor and often proceed with a media campaign and attempts to secure one or more board seats in a proxy contest. o Media campaigns - used by active investors involve public criticisms attacking the management of the targeted company • Alternatively the active investor attempts an outright takeover the firm with a hostile tender offer or a leveraged buyout. o Case in point - Hedge fund third point LLC vs. Star Gas - Loeb, principal investor of the hedge fund began his active investment program with acquiring 6% stake in Star Gas, and then started a media campaign publicly criticizing the way in which CEO Sevin was running the company. Sevin succumbed to the pressure from Loeb and resigned the month following the month in which the hostile investment program began • Proxy fights- attempts by a large shareholder to gain board representation on a firm's board of directors or to gain board control by entirely replacing incumbent directors with a new slate of directors selected by the large shareholder • Hostile tender offers- transactions in which the large shareholder bypasses the target firm's management and directly makes a public offer to the target firm's shareholders to buy their shares • Leveraged buyouts (LBOs)- transactions in which all of the assets of a firm or a division are purchased by the large shareholder. LBOs are typically financed by large amounts of debt and the target firm goes private subsequent to the buyout. • Investment programs using hostile tactics can conclude in a variety of ways: o Targeted stock buyback - the large shareholder sells his stock back to the company in a private transaction at a premium price. The premium paid is referred to as a greenmail payment • May be accompanied by a standstill agreement, where the large shareholder agrees not to attempt to take control of the company for a certain period of time in exchange for the greenmail payment. o The large shareholder may gain one or more board seats in a proxy contest followed by outcomes such as CEO dismissals or resignations, a sale of a target firm, or value-increasing corporate restructurings o Or a complete takeover of the firm with a tender offer or LBO
Board director compensation
• Typically consists of some mix of cash, stock, and other perquisites • Cash usually consists of an annual retainer + a board meeting fee for each meeting of the board attended • The chairman may be paid an extra fee, if not the CEO of the firm • The stock component of director compensation may contain annual or one-time restricted stock awards, stock options, and other stock based compensation o Proponents of compensating with stock argue that directors are more likely to act in the best interest of the shareholders if director compensation is directly related to the firm's stock price • Warren Buffet - "directors should eat their own cooking" • Warren buffet about the company he primarily owns - "the bottom line for our directors: you win, they win big; you lose, they lose big. Our approach might be called owner capitalism. We know of no better way to engender true independence."
