The Impact of Compensation on Effective Corporate Governance

By Blake                                                                                        August 7, 2013

Professor: XXXXX

 

Final Exam: Wed August 7, 2013 3:15-6:15

 

Material Covered: June 25, 2013- August 7, 2013 M,W 3:15-6:15 and beyond

Lorsch; Mallin; Articles on Corportate Governance, Schleifer and Vishny, et al.

 

Questions: Choose 3 of 6.

 

 

§     I.        Question  1:  The Impact of Compensation on Effective Corporate Governance

 

References:    Brickly, Bhagat, and Lease:  “The Impact of Long- Range Managerial Compensation Plans on Shareholder Wealth,” 1985

                   Lorsch, “The Future of Boards,” HBS 2010

                    Mallin, “Corporate Governance” 2010

                    Vishny and Schleifer, “A Survey of Corporate Governance,” 1997

                   Moran and Beggs, Various Articles and In Class Discussions on Corporate Governance, Harvard, 2013.

 

(Introduction to part a, b, c)

The escalating compensation packages paid to a CEO (or other top senior manager), dysfunctional behavior associated with taking inordinate risk and being paid bonuses in spite (or perhaps because) of it, and the all too often lump-sum payments made to a CEO that are often not tied to performance (i.e. golden parachutes) have been under the spotlight. Since 2007 at the start of the Financial Crisis, the aforementioned highlight some of the worst features of American corporate governance structure. There needs to be a rethinking of the manner in which CEOs and other senior executives are compensated, because the way compensation is allocated can be a powerful signal not just to shareholders but to corporate culture in America and wider society (Lorsch, et. al., 2010).  In the following paragraphs, we will address the current structure of the corporate executive compensation plan (and how it got that way), whether or not corporate executives and corporate boards are paid appropriately, and recommendations for reform based on what was learned in this course.

(Part a and b). First, there is no right answer as to whether or not corporate executives and corporate boards are “paid appropriately,” indeed, some shareholders and stakeholders would argue that they need to be paid more. In attempting to answer this question we must explore what they are paid, how we got here, and concerns of the current compensation structure. In most countries with Common Law (U.K, U.S) and some with Civil Law (rest of Europe) CEOs are paid in the millions of dollars and in the many multiples compared to the average worker: in the U.S. the CEO was paid 44 times the average worker in 1980, and 344 times the average worker by 2007 (Lorsch, et.al as shown in a long survey on compensation, 2010). What is clear is that compensation for the CEO (and other senior management) has spiraled higher and higher, and for board members, though normally not nearly as high as the CEO, more stock options and other pay bonuses has also lead to an all-time compensation high. One concern that this spiral for executive’s and board’s compensation is not appropriate is the following: there exists a market fallacy that there is senior level competitive talent flow. However, the evidence is clear that there is not a sufficiently established correlation between executive compensation plans and the company’s economic performance. With regards to the board: the board is often composed of individuals who do not properly hold the CEO accountable, who may be staggered, who may be spread too thin in their committee assignments and outside obligations, and who do not meet enough or ask the necessary questions to warrant a high salary and high stock + option bonuses. Often, the compensation committee just pays management, and perhaps even directors, more and more just to be in the “top-quartile” in their 10-K CD&A report so they can look good in front of other companies and in front of their shareholders. What’s concerning is that board compensation is arguably inappropriate because committees do not properly do their job since they do not meet enough nor ask searching questions and since boards all too often do not do their job of holding executives or directors who take inordinate risk accountable (Mallin and Moran 2010). All in all, the argument is clear: widely accepted compensation plans for directors and for executives are not appropriately justified because they do not properly link the management’s and the Board’s bonuses to the company’s long term economic performance, are inherently dependent on the “market fallacy” of talent flows, compensation committees and boards as a whole do a poor job in holding others (and themselves) accountable, and executives and boards often have little to no control on macro economic outputs of a company as individuals but have better control as a group.

(Part c) According to Lorsch, Mallin, et al., compensation for boards and executives can be changed to better align their interest with the interest of shareholders by being more inclusive in their accountability to stakeholders as well as more effectively addressing the agency theory (as well as agency costs) to maximize shareholder value. The key driving forces of the economic theory surrounding reforms of the management compensation system is to first ensure institutional arrangements that designate independent directors or committees to communicate with shareholders. Additionally, the directors should be paid in stock (holdings should equal 5-25% of net worth) and the nominating committee should elicit suggestions from large shareholders and consider suggestions from all shareholders. Second, there should be management compensation reforms by: having accounting and compensation systems based on creating shareholder value and long term corporate health via the actions of qualified individuals on the boards. (Mallin, 2010). Compensation should be tied to marginal changes in performance and long-term objectives (i.e. 35% expected bonus, 25% long term objectives- with downside risk, etc.). Additionally, director compensation should mostly come in stock based on company’s short term and long term performance (Vishny and Schleifer, 1997). Lastly, to address the problem in the agency theory of misaligned interest, directors and executives should have significant stakes in the company, or “skin in the game” (Miller and Modigliani, 1978-1985).

(Conclusion to parts a, b, and c)

In summary, we need to recognize that the term “appropriately paid,” when referring to the compensation of executives and boards alike, could be tricky to define, since the assumptions underlining it must first be better understood. First, there is a need to recognize that incentives only have motivational power if they reward outcomes over which executives have control (Lorsch, Brickly, Bhagat, and Lease, 1995, 2010). Corporate leaders and boards (because they receive the bulk of their compensation in stock and options) should be provided with company economic outcomes (which they may affect), not for gyrations in the stock market, (which they can’t truly affect). For both boards and executives, incentive plans in their compensation package should have “lines of sight” between the effort of the executives, the accountability level (especially of the compensation committee) of the board, the results they achieve, and the rewards they are paid. (“Lines of sight” is a term attributed to Lorsch, 2010). The executives, and in particular the board as a whole, not just the compensation committee, positively affect  their corporate governances if they send a message to all connected to the company that the ultimate purpose of its board and management is to focus on achieving corporate health. The compensation package should be a means for that, not an end. According to Moran, however, some companies may very well outlast their function and stakeholders are better served if resource are not spent in keeping a dying elephant alive (Moran, Harvard, 2013). All in all, compensation improves corporate governance within the company if the board recognizes and acts on the fact that: long term health depends on a collaborative effort of a group of senior executives, rewarding group behavior as well as individual behavior (when appropriate) is beneficial; compensation packages should include not only monetary awards for board members and executives, but also non-monetary awards such as promotions to more responsible positions; tie compensation to long term performance, a minimum bench mark of several years, not one year or less, and eliminate lump-sum payments not tied to performance (golden parachutes, make whole payments). The compensation committee must recognize that its job in creating compensation plans for “outside” executives is a matter of negotiation, not just acquiescence so the board and company looks good. Therefore, when talking about compensation, all parties should be prepared for processes of negotiations.

 

 

Steve Jobs: Bullet Points on How He Created Shareholder Value

"Return to Profitability": 1997-2011.

Presented, as part of a group of three, in Economics S-1476, Harvard University. Summer 2013.

How did he create shareholder value?

1. Returned from Pixar, created numerous products such as iPod, iPhone, iPad.

• Literally ousted Nokia as the ‘King of Phones’
• Closest competitor was Blackberry but even their concept of using emails and BBM (free messaging) was losing the publics’ interest as these concepts were easily Replicated by Apple (iMessage)).
• Revolutionized  the way phones are being used. Made everything so convenient with just a click on the phone.

      2.   Cons about Jobs

• Very similar characteristics with Lawrence Harding (but Steve gets things done)
• Dictator, no one dared to challenge his opinion (indication of a weak board maybe?)

Exercise: Look at Stock Chart from 1997-2011 and Notice the Below: 

•       Ex. 10,000$ investment in 1997 worth approximately $200,000 in 2011.

•       Shareholder value

•       Discuss stakeholders: thousands more employees hired domestically and thousands abroad (apple criticised for labor practices abroad, but not in the scope of this presentation)

•       Regulators? Apple become largest tax paying company in the world during this time; government benefited.

•       Board? Rubber stamp of approval. Jobs influential and had pull on the board; elected chairman in late 2010.

•       ‘Profitable Dictatorship?’     

                                                         And the Board of Directors? 

Structure of the Board? Most decisions were made by Steve    Jobs because he was so domineering and employees were afraid of getting fired for fear of going against him the structure of the board could almost be as weak as that of Lawrence Harding’s tenure at Braniff

Word Count: 260

Apple (and Microsoft): A Short Essay On Corporate Governance

§     II. Question 4: A Look at the many Dimensions of Corporate Governance in Apple

Refernces: Mallin and Lorsch (see Question 1 for full reference), Vishny and Schleifer and “America’s Worst Boards,” 2000.

                Moran, and Beggs Harvard “Class/Section Discussion and In-Class Articles”, 2013

             Preentation refernces: Reuters, Yahoo Finance, Google Finance, Bloomberg, Isaacson “Jobs”, 2011. Apple Corporate Governance Reports and 10-K.

            (Introduction)

For our group project (group 3) we identified Microsoft and Apple as potential companies we wanted to present on, but ultimately chose to focus on Apple.  Specifically, we focused on two parts: CEO Succession at Apple— the successes of Steve Jobs from 1997-2011 and the passing of the torch to Tim Cook—  and evaluating the Board of Directors. Ultimately we found that: first, Steve Jobs is in the category of very few CEOs who, because they have complete control, are extremely effective in creating shareholder value due to their visionary qualities; second, Tim Cook has seen Apple’s stock fall, but is yet to be truly tested as CEO as Apple struggles to define itself in terms of its future product lines after the death of Jobs; and third, that the Board of Directors needs to take on a better supportive role for Tim Cook, particularly in having fewer people who overlap in their committee assignments and in possibly instituting a “Risk,” and “Culture” committee, with properly vetted directors, that would make for a “more cohesive board.” This “more cohesive board” would not get in the way of Tim Cook (i.e they would allow him to still have a fair amount of country since he was personally picked by Jobs to succeed and since we believed there is no better alternative to Tim Cook currently) but would better understand the cultural dimensions (particularly abroad) and risks that Apple currently faces and will face in the foreseeable and not foreseeable future.

(Part a)  The features of a good board are tied to how the board sees itself within the development of corporate governance: since the development of corporate governance is a global occurrence, and, as such is a complex area including legal, cultural, ownership, and other structural differences, a good board qualified directors who properly implement and monitor mechanisms that appropriately and timely address the aforementioned complex areas concerning their business. The mechanisms properly establish key board committees (particularly audit and compensation) as outlined by the Cadbury Code of 1992, that are independent from management’s tentacles. Furthermore, the Board should always see itself as an agent to their owners (shareholders) and responsible for the various other stakeholders, including employees, environmentalists, local communities, etc. A good board will hold the CEO and management accountable when shareholder value is jeopardized and when stakeholders are poorly and unjustly treated; if not, then the long term corporate health of the company is severely jeopardized (Moran, 2013). Additionally, a “robust” size of the board  (i.e. less than 7 may be too few, more than 12-15 may be too many because of competing of interest) is a characteristic of a good board, as well as high degree of independence of a majority number of outsiders (in a unitary board) and one supervisory board of all independent directors with one unitary board of management insiders (in a dual board—see the question 5 part b for further note). The bottom line is that ta board of directors has a high of responsibility, and the above mentioned characteristics all contribute to a good, responsible board.

Apple’s Board received a mix grade from our group. First, we note that apple has 9 members, many of which are above the age of 65 (nothing wrong with age in itself but it is a probably if older members have been retired because of the fast pace changing landscape of the business world). On the positive side they are clearly experienced and most have been there since Jobs, so they’re good at giving the CEO breathing room. On the negative, though all members have advanced degrees, many of them are spread too thin, include several who are chairman of other boards, and the current CEO of Yahoo, Marissa Meyer, who most certainly has her hands full  at the troubling tech giant.  Additionally, we note that apple has three committees: the audit and finance, compensation, and nominating committees, who may not necessary have a high degree of independence because many of them, as mentioned, are spread too thin, have overlapping committee assignments, and may be working too closely to always support management, not necessarily asking probing questions (one indication of this is the fact there there is virtually no public information in the SEC filings about Apple’s Board other than the bare minimum requirements of committees and the member’s names and assignments).  Lastly, we note that Apple’s committee, though compromised of people most definitely spread too thin, is at a good size of 9 members and doesn’t have an executive committee, which is a positive thing because, as discussed at length in class, all too often, executive committees foster a culture of a exclusivity and outright hierarchy (Moran, 2013).

(Part b)

As a potential shareholder we believe that the Board will be able to maximize shareholder value because (a). it has a good CEO who had over a decade of experience at Apple with Jobs and years and years elsewhere and who has a very meticulous approach to realizing product lines, and (b). because many directors come from disparate backgrounds, such as biology and biotech, which brings a fresh perspective of thinking in the board room (Moran, 2013). HOWEVER, there needs to be several changes before we can conclusive say that the Board will improve shareholder value: a. we argue for the addition of a “Culture” Committee, composed of independent and qualified outsiders who aim to understand  the cultural context of the country or region apple plans to expand into (i.e. perhaps a culture committee and directors who understand and speak mandarin Chinese would’ve been able to better advise Apple in their Chinese operations) and a “Risk,” committee composed of independent and qualified professionals with appropriate backgrounds in business/finance or other areas that would help apple to understand, assess, and thus mitigate risk. Lastly, we believe that having a board that is not spread too thin and having members that are properly informed and not busy with other commitments outside the boardroom will better serve us as potential investors and maximizing shareholder value. (Personally, I believe a Dual Board will do this best, as addressed in class and discussed with professor Moran. For further explanation on the Dual Board please see Question 5, part b).

(Part c)

Because the board is spread too thin, because the committees do not have a high degree of independence, and because Tim Cook still remains untested after Jobs’ passing, we do not believe that the Board would be able to protect from a Harding Lawrence type CEO. However, Tim Cook is like Harding Lawrence in many ways: first, he wasn’t an outside hire (as Lawrence was from Continental), he was selected by Jobs himself; second, he is focused on product lines and has not  made any overstretched acquisitions, like Lawrence did (expanding too fast without proper risk assessment). In hindsight, it’s easy to fault Lawrence, but back then he was seen as the “smartest guy in the room,” as well as the most able and knowledgeable within the airline industry (Moran, 2013).  We believe, though, that although Tim Cook has a lot of power and free reign that, since he has avoided the bad actions of Lawrence (known to us now) he does not post a significant risk in stepping on the Board and burning apple to the ground. Personally, I believe another CEO poses that risk: Steve Ballmer in Microsoft. Ballmer is “undoubtedly biggest overhang to shareholder value in Microsoft” (David Einhorn, Greenlight Capital, 2011). Though once a great COO in Microsoft, Ballmer has fired the fast majority of executives in Microsoft since the time of Bill Gates, single handily eliminated his competition, and has derided then subsequently missed out on key technological innovations, including the smartphone and tablet industries. Talk about an inept board combined with a control-freak and subjective and single minded, however smart and talented, CEO. Ballmer or Lawrence? Doesn’t matter, it’s all the same here.

(Conclusion)

            All in all, we believe that Tim Cook has the appropriate experience to lead Apple: whether or not he has the appropriate vision remains to be seen. We also believe that Board members who are spread too thin, such as Marissa Meyer and others who have other chairmanships, and members who may be more focused on their golfing and retirement activities, may not be the best directors for Apple’s long term corporate health. We gave Tim Cook a rating of “B” or “good”, for still maintaining positive cash flow and strong balance sheet, we gave regulators “F” for arcane and hurtful corporate taxes that encourage Apple to not bring money back into the United States from foreign operations, and the Board of Directors a “C” for needs improvement. If there is more transparency, independence, and cohesion in the Board Room, we believe that management will be more efficient and Apple may once again become the inspiring company it once was when Jobs was in charge.

Word Count: 1450