WEEK 3 CORPERATE GOVERNANCE

RESTRICTIONS ON COMPENSATION

Compensation programs may be subject to restrictions: •Stock ownership guidelines: Executive required to own minimum amount of company stock, generally expressed as multiple of base salary (e.g., 5x). •Pledging restrictions: Executive restricted from using shares as collateral for personal or margin loan. •Clawbacks: Company can reclaim compensation in future determines it should not have been awarded. Clawback policies required under Dodd-Frank. The most common triggers for clawback are financial restatement, ethical misconduct, or violation of noncompete clause. Clawbacks tend to improve financial reporting quality.

HOW DOES EXECUTIVE COMPENSATION RELATE TO CORPORATE GOVERNANCE?

Shareholders (Principals) Firm owners then HIRE Managers (Agents) Decision makers AND CREATE An Agency Relationship Risk-bearing specialist (principal) paying compensation to A managerial decision-making specialist (agent)

ELEMENTS OF COMPENSATION

The compensation package includes some or all of the following: •Annual salary: Fixed cash payment made evenly over the year. The IRS does not allow the publicly traded companies to deduct compensation above $1 million per year, unless it is performance driven. •Annual bonus: Additional payment (usually cash) awarded if performance exceeds predetermined targets. Generally expressed as a percentage of salary and includes a guaranteed minimum and a specified maximum. Targets are based on quantitative and/or qualitative factors.

EXECUTIVE COMPENSATION

The compensation program serves three main purposes. 1.It must attract executives with the skills, experiences, and behavioral profile necessary to succeed in the position. 2.It must be sufficient to retain these individuals, so they do not leave for alternative employment. 3.It must motivate them to perform in a manner consistent with the strategy and risk-profile of the organization and discourage self-interested behavior.

COMPENSATION LEVELS

Top 100 $17,209,000 $111,394,000 101 to 500 $11,125,000 $ 21,819,000 501 to 1,000 $ 7,212,000 $ 6,017,000 1,001 to 2,000 $ 4,022,000 $ 1,789,000 2,001 to 3,000 $ 1,849,000 $ 378,000 1 to 3,000 $ 4,098,000 $ 1,789,000

SURVEY EVIDENCE

•70% of Americans believe that CEO compensation among large publicly traded corporations is a problem. •25% of directors believe that CEOs do not receive the correct level of pay based on the expected value of awards when they are granted •30% of directors believe that CEOs do not receive the correct level of pay based on what they actually realize when those awards vest.

TARGET OWNERSHIP PLANS

•A company might adopt a target ownership plan that requires executives to own a minimum amount of company stock. •Ownership guidelines can be expressed as: -Multiple of annual compensation -Fixed number of shares -"Retention approach" (executive retains a percentage of vested awards) •Researchers find positive benefits from the adoption of target ownership plans.

REPRICING AND EXCHANGE OFFERS

•A repricing or exchange offer is a transaction in which employees holding options are allowed to exchange them for new options, restricted stock or (less frequently) cash. (+) Generally all employees participate (+) Provides new incentives when options are underwater (+) Might improve employee retention and reduce turnover (-) Might signal a culture of entitlement (-) Shareholders wonder why employees benefit while they suffer losses •Exchanges generally reduce employee turnover. •Many firms (40%) that reprice exclude the CEO. •Repricings are more likely to occur at companies with greater agency problems.

SEC GUIDELINES FOR REPORTING COMP

•Although comprehensive information is mandated by the SEC and included in the proxy statement, it is not explicitly summarized. •The annual proxy statement contains a Summary Compensation Table that commingles these figures. •From Apple's 2020 proxy statement: -The amounts in the salary, bonus, and non-equity incentive plan compensation columns of the "Summary Compensation Table—2020, 2019, and 2018" reflect actual amounts earned in the relevant years, while the amounts in the stock awards column reflect accounting values. The tables entitled "Outstanding Equity Awards—2020" and "Stock Vested—2020" provide further information on the named executive officers' potential realizable value and actual value realized with respect to their equity awards.

3. PLEDGING

•An executive pledges shares as collateral for a loan, the proceeds of which are used to purchase additional assets. (+) Allows for diversification without lessening equity stake (+) Might be tax advantageous (+) Low interest rate on the loan (-) Changes incentive structure imposed on management •Pledging transactions deserve special consideration by the board.

1. TRADING BY INSIDERS

•An insider is an individual - executive, director, employee, or advisor - who has access to material information about the company that has not yet been released to the public. •Under SEC rules, insiders may only trade when they are not in possession of material nonpublic information. •Trades on the basis of this information is considered illegal "insider trading". •Insider trading cases are prosecuted under Rule 10b-5, "Employment of Manipulative and Deceptive Practices."

COMPENSATION LEVELS (part 3)

•Are CEOs overpaid? -Long-term changes in CEO pay are almost entirely explained by changes in company size. -Long-term changes in CEO pay are no different than changes among other "highly paid" professionals (venture capitalists, hedge fund managers, private equity, lawyers, athletes, entertainers, etc.). •Still, compensation levels themselves might be systematically too high (or too low). Among individual firms, weak governance is associated with excessive pay — pay that is above average based on peers of similar size and performance.

2. HEDGING

•As another mechanism to increase diversification, an executive may decide to hedge the value of equity holdings rather than engage in the outright sale of shares or options. (+) Allows for diversification without an immediate sale (+) Might be tax advantageous (+) Minimizes public scrutiny that comes with outright sale (-) Unwinds equity incentives to perform (-) More costly to company than paying equivalent in cash (-) Difficult to explain to shareholders why this is allowed Hedges tend to follow periods in which the stock price has run up, and precede periods of underperformance.

1. TRADING BY INSIDERS: RECENT EVIDENCE

•Cohen, Jackson and Mitts (2015) found sharp increases in insider trading between the time that a "material event" occurs and the public is notified of that event through a Form 8-K filing with the SEC. •Jagolinzer, Larcker, Ormazabal and Taylor (2020) found increases in insider trading before the disclosure of government bailouts. •Arif, Kepler, Schroeder and Taylor (2019) found increases in trading between the time the board is informed by auditors that they will not be getting a clear audit opinion and the public issuance of that opinion in the 10-K. •Blackburne, Kepler, Quinn and Taylor (2019) used data on non-public SEC investigations and found evidence of abnormal trading once executives are made aware the firm was under investigation.

COMPENSATION MIX - CONSIDERATION

•Compensation risk affects how the manager operates the firm: -Not enough risk = low manager effort -Too much risk = manager avoids risky projects -Goal is to control compensation risk, not eliminate it •Managers are risk averse individuals, and trade off risk and return. •Thus, to motivate the manager at the lowest cost, designers of efficient incentive compensation plans try to get the most motivation for a given amount of risk imposed Or, equivalently, the least risk for a given level of motivation.

EQUITY OWNERSHIP AND RISK (part 2)

•Consider the relationship between pay, performance, and risk incentives for a series of direct competitors in 2009. RELATIONSHIP BETWEEN CEO WEALTH AND STOCK PRICE •Clearly, the board should consider the total effects (both the upside and downside) of investment decisions on the executive's wealth.

EVIDENCE ON THESE CONTROVERSIAL PRACTICES

•Daines, McQueen and Schonlau (2018) demonstrated that these practices do actually occur. -In some instances, they result in only marginal increases in value for executives. -But in others, the dollar amounts can be significant. •Regardless of the cost, these practices run counter to the concept of good stewardship, and they demonstrate that some executives will take advantages of weaknesses in oversight for personal gain.

EQUITY OWNERSHIP AND RISK (part 4)

•Do stock options encourage "excessive" risk taking? •No standard litmus test exists to distinguish excessive risk from acceptable risk. The board must determine what risk-taking incentives are acceptable, given the risk profile of the firm. •SEC requires discussion of relationship between compensation plans and organizational risk in CD&A.

EQUITY OWNERSHIP AND RISK

•Equity ownership also influences risk taking. •An executive's attitude toward risk is shaped by the potential payoff. •Direct stock holdings: -Value moves one-for-one with stock price. -Executive is motivated to grow and protect value.

EXECUTIVE EQUITY OWNERSHIP

•Equity ownership is intended to mitigate agency problems by aligning the interests of managers and shareholders. •Executives have greater incentive to build economic value. •Actions that impair firm value reduce the executive's personal wealth. •However, equity ownership might also foster undesirable behaviors: "excessive" risk taking, earnings manipulation, insider trading, etc. •What outcomes and behaviors are observed in practice?

EQUITY OWNERSHIP AND AGENCY COSTS

•Equity ownership is intended to motivate managers to improve performance, but it can also encourage undesirable behaviors. •Executives might try to increase the value of their equity holdings in ways other than through operating performance: -Manipulate accounting results to inflate stock price or achieve bonus targets -Manipulate the timing of equity grants to increase their intrinsic value -Manipulate the release of information to the public to correspond with more favorable grant dates -Use inside information to gain an advantage in selling or otherwise hedging equity holdings

MANIPULATION OF EQUITY GRANTS

•Equity ownership might encourage executives to manipulate equity grants to extract incremental value. •Manipulate the timing of grants. -Delay grant date to occur after a stock price decline. -Bring grant forward to occur before expected rise. •Manipulate the timing that information is released. -Delay the release of favorable information until after grant date. -Bring forward release of unfavorable information to precede grant date. •In both cases, the executive seeks to maximize value by taking actions not in the interest of shareholders.

EXECUTIVE COMPENSATION: THE STAKES

•Excess pay costs shareholders. •Poorly structured pay arrangements: -Dilute incentives to serve shareholders -Distort incentives E.g., ability to unwind stock early causes executives to focus on short-term earnings, at expense of long-term value

COMPENSATION CONTROVERSY

•Executive compensation has attracted significant attention in recent years. •Two issues are at the forefront: •the absolute size of the CEO pay package compared with the pay of the average employee and •the relationship between firm performance and CEO pay.

EXECUTIVE EQUITY OWNERSHIP (part 2)

•Executives hold considerable personal wealth in their companies. •Although some make direct purchases, most executives accumulate wealth through compensation-related grants.

EQUITY SALES AND INSIDER TRADING

•Executives who accumulate a substantial ownership position in company stock might want to limit their exposure. •The board of directors might allow diversification if it is in the interest of the company (i.e., by reducing risk aversion). •Executives can achieve diversification by: 1.Selling shares outright 2.Hedging a portion through financial instruments 3.Pledging a portion as collateral for a loan that is used to purchase additional assets

EXECUTIVE COMPENSATION AS A GOVERNANCE MECHANISM

•Governance mechanism that seeks to align the interests of managers and owners through salaries, bonuses, and long term.

MANAGEMENT COMPENSATION

•Ideally management compensation must reward current strong performance and simultaneously provide incentives for similar future results. •It should be structured in manner such as to avoid premiums for average or poor performance. •The underlying challenge is the justification of an expensive CEO package to the general public vis- à-vis the threat of losing an impressive CEO to another competing firm. •The challenge therefore for the board in how to find the best deal for shareholders.

EQUITY OWNERSHIP: ACCOUNTING MANIPULATION

•Is accounting manipulation more or less likely to happen in companies where executives hold large equity positions? •The research on this topic is very mixed. -Some have found higher likelihood of restatement -Some have found lower likelihood of restatement -Some have found no association •The board should be aware of the potential for self-gain through accounting manipulation. •The potential for manipulation might be most pronounced when executives hold a considerable amount of options.

LONG-TERM INCENTIVES

•Long-term incentives are added to the mix to encourage long-term investments to increase value. •Long-term incentives are added to the mix to encourage long-term investments to increase value. •Stock and stock options: (+) Increase in value with stock price. (+) Increase in value with stock price volatility. (+) Vesting allows for deferred realization of value. (-) Might encourage excessive risk-seeking to increase value. (-) Rewards can be capricious in a volatile market. •Performance awards tie compensation value to multiple performance metrics, not just stock price.

DETERMINING THE LEVEL OF COMPENSATION

•Most boards benchmark CEO pay against a peer group of companies comparable in size, industry, and/or geography. •Common practice targets cash compensation (salary + bonus) at 50th percentile and long-term pay at the 75th percentile. •There are potential drawbacks to benchmarking: -Might lead to ratcheting. -Is based on size rather than value creation. -Is highly dependent on companies included in peer group. Companies include unrelated firms in peer group, and the inclusion of these firms tends to increase pay.

COMPENSATION CONSULTANTS

•Most companies use a third-party consultant to advise on compensation levels and program design. •Compensation consultants might be subject to conflicts of interest if they provide other services to company, such as benefits consulting or managing pension asset assets. -Evidence suggests conflicts not a big issue CEO pay is higher among companies that use a consultant. Evidence suggests this is due to governance quality, not the use of the consultant.

ELEMENTS OF COMPENSATION (part 3)

•Perquisites: Other amenities purchased or provided by the company (such as personal use of company car or airplane). •Contractual agreements: Other cash or stock payments stipulated in employment agreement, e.g., severance, post-retirement consulting, and change-in-control payments ("golden parachutes"). •Benefits: Other benefits such as health insurance, post-retirement health insurance, 401(k), supplemental executive retirement plans (SERPs), life insurance, payment for use of financial planner, and certain tax reimbursements.

EQUITY OWNERSHIP AND RISK (part 3)

•Research generally shows that executives facing "convex" payoff curves engage in more risk taking. •Executives that receive options increase the risk profile of the firm: -Spend more money on research and development -Spend more money on capital expenditures -Reduce firm diversification -Increase leverage

RESEARCH EVIDENCE: EQUITY OWNERSHIP AND FIRM PERFORMANCE

•Research generally supports the notion that equity ownership is positively associated with firm performance. •Firms with high CEO equity ownership have higher market valuations. •Firms with high CEO equity ownership deliver superior long-term stock market returns. •Managerial incentives tend to be more closely aligned with the interests of shareholders when executives have "skin in the game." -Compensation programs with higher equity portion receive higher shareholder support through say-on-pay-voting.

SAY ON PAY

•Say on pay is the practice of granting shareholders the right to vote on a company's executive compensation program at the annual meeting. üThe Dodd-Frank Act requires U.S. firms to hold an advisory (non-binding) vote at least once every three years. üDespite expectations that shareholders would voice dissatisfaction with pay levels, average support remains high (90 percent).

SHORT-TERM INCENTIVES

•Short-term incentives offer an annual payment (usually cash) for achieving predetermined performance objectives. •The size of the bonus is expressed in terms of a target, with a minimum and maximum level.

COMPENSATION TRENDS

•Since the 1980s CEO compensation has shifted away from fixed salaries and bonuses toward variable pay tied to long-term performance targets and stock options. •1990s-2000s the widespread adoption of stock options accelerated the trends.

MANIPULATION OF EQUITY GRANTS: BACKDATING

•Stock option backdating is the practice where insiders retroactively change the grant date to correspond with a relative low in the company share price. •Practice was discovered in 2006. More than 120 companies were implicated. Abuses stemmed back to 1981. •Stock option backdating largely stopped following Sarbanes Oxley, which requires that grants be reported in two days. Still, the practice violated GAAP, IRS tax rules, and SEC regulations and indicated a serious lapse in board oversight

EQUITY OWNERSHIP AND RISK (part 2)

•Stock option grants: -Value moves in a non-linear fashion with stock price. -Value increases with volatility. -Executive is motivated to increase firm risk. •Stock options introduce "convexity" into the potential payoff and encourage risk. •Performance and risk taking incentives can be evaluated by mapping the relation between changes in wealth and changes in stock price.

ELEMENTS OF COMPENSATION (part 2)

•Stock options: Right to buy shares in future at fixed exercise price, generally equal to stock price on the grant date. Typically vest evenly (e.g., annually over 4 years) and expire at the end of term (generally 10 years). •Restricted stock: Outright grant of shares that are restricted in transferability and subject to vesting. Once vested, economically equivalent to outright ownership of stock. •Performance units (shares): Cash (or stock) granted if specified targets met over 3 to 5 year period. Size of award generally expressed as percentage of base salary. Performance units similar to a longer-term version of annual bonus.

RATIO OF CEO PAY TO MEDIAN EMPLOYEE PAY

•The Dodd-Frank Act requires that companies disclose the ratio of CEO pay to that of the median employee. •Recent estimates peg this ratio between 200 and 500 times. •Results vary based on: -Industry, size, location, and workforce composition -Mean v. median calculations -Expected v. realized compensation CEO-to-employee pay ratio among commercial banks, 1995 to 2012: •Median: 8.4 times Mean: 16.6 times •90th percentile: 32.8 times •Highest observation: 821 times

1. TRADING BY INSIDERS: 10B5-1 PLANS

•The SEC created Rule 10b5-1 to protect insiders whose positions regularly expose them to inside information. -Insider enters contract with a third-party broker. -Insider must not know material nonpublic information at the time. -Insider specifies program by which trades (purchases or sales) are made. -Once in place, insider may not interfere with trades. -Broker executes trades, even during blackout window. -Insider may amend or terminate at any time. •Research suggests that 10b5-1 plans are abused: •Insiders using 10b5-1 plans outperform market by 6% over six months. •Trades earned under plans are higher than trades made outside plans. •Sales precede periods of underperformance and purchases precede outperformance.

SO WHAT'S "RIGHT" MEASUREMENT?

•The answer depends on what you're trying to calculate. •Expected compensation is a forward-looking view of the rewards available to an executive. -It therefore provides insight into the incentive value of compensation. •By contrast, earned and realized compensation are backward-looking views of the rewards an executive actually received for his or her efforts, with earned compensation still somewhat "at risk" and realized compensation entirely "cashed out." -These values can be compared to corporate performance during measurement period to assess relative pay-for-performance.

FACTORS TO CONSIDER IN FORMING COMPENSATION STRATEGIES

•The basic philosophical issues to consider in forming the foundation of compensation strategies include: -Does management make a difference in performance? -Does compensation make a difference in getting good management? -What constitutes good performance? -How much, if any, of management compensation should be at risk?

UNDERSTANDING COMPENSATION FIGURES

•The biggest mistake an investor can make in calculating executive compensation is to confuse expected, earned, and realized amounts. •Investors should always keep in mind that the dollar amounts promised might never be realized, and •The dollars realized might be very different from what was originally promised. •You should be aware that journalists do not consistently distinguish between expected, earned, and realized compensation.

COMPENSATION MIX

•The board also determines the structure of CEO pay. •The mix of compensation should be appropriate to attract, retain, and motivate executives in the short and long terms.

DESIGNING THE COMPENSATION PROGRAM

•The compensation committee of the board recommends compensation of the CEO and other executive officers. •Packages are approved by the independent directors of the full board. Shareholders approve equity-based compensation. •Details are disclosed in the annual proxy: COMPENSATION PHILOSOPHY ELEMENTS OF COMPENSATION TOTAL COMPENSATION AWARDED TOTAL COMPENSATION REALIZED PEER GROUP, COMPENSATION DESIGN PEER GROUP, PERFORMANCE CRITERIA FOR AWARDING VARIABLE PAY

RATIO OF CEO PAY TO OTHER TOP EXECUTIVE PAY

•There is a large pay differential between the pay granted to the CEO and the pay granted to other senior executives. •On average, the CEO earns 2.0 times the pay of the 2nd highest officer. The 2nd highest earns 1.2 times the 3rd. (+) Might reflect relative value creation of these jobs. (+) Pay inequity provides incentive for promotion. (-) Might reflect management entrenchment. (-) Discourages executives who feel they are not paid fairly. (-) Might reflect lack of internal talent development. Internal pay inequity is positively associated with firm performance, but also risk.

COMPENSATION LEVELS (part 2)

•Three basic ways to measure executive compensation: 1.Expected pay. The value of compensation promised in a given year. 2.Earned (realizable) pay. The value an executive "earns the right to keep" as cash is delivered and vesting restrictions removed. 3.Realized pay. The value an executive takes home in cash, as cash is delivered and vested awards are sold. •The ultimate value of compensation will depend on CEO's ability to achieve performance goals, based on changes in stock price and operating performance.

1. TRADING BY INSIDERS: BLACKOUT WINDOW

•To prevent executives from violating insider trading laws, companies designate a blackout window in which insiders are restricted from making trades. •Blackout periods occur when material information (earnings, new product, acquisition) is not yet released to the public. •The median length of a blackout window is 50 calendar days. •Despite these restrictions, evidence suggests that insiders still have an information advantage in making trades. •Insider purchases precede periods of market outperformance. •Insider sales precede periods of market underperformance. CEO and chairman have greater trading advantage than other insiders

Ways to Measure Pay: Harley Davison CEO, 2010

•Total compensation figures disclosed in the company proxy statement rely on a combination of these measures: $ 975,037 0 1,381,199 1,636,681 2,340,090 0 83,490 $6,416,498

SHORT-TERM INCENTIVES (part 2)

•When setting targets, the board should consider the following: -How difficult are the performance targets? -Does the plan encourage a short-term focus? -Does management defer investments to achieve targets? -Are earnings deferred after maximum targets are met? -Are earnings manipulated to increase payouts?