The GMI Blog

Interview: Alfred Rappaport of Saving Capitalism from Short-Termism

Alfred Rappaport's important new book, Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future, has a penetrating diagnosis of the disruptive forces in our markets and powerful prescriptions for addressing them.  He generously took time to answer my questions.

How does the current structure of incentive compensation at the CEO level affect the obsession with short-term performance? How can it be changed? 

Ideally, incentive compensation should motivate executives to maximize long-term shareholder value while avoiding either excessively risky behavior or excessively risk-averse behavior.

Most companies offer CEOs and other senior executives annual incentive plans featuring earnings, revenue, cash flow, and return on investment performance targets. None of these short-term financial measures is reliably linked to long-term value creation. On the contrary, these incentives can encourage reckless risk taking leading to massive value destruction because the long-term consequences of today’s operating and investment decisions are ignored. Executives of major financial institutions demonstrated precisely this type of behavior, with its disastrous consequences, during the housing-price bubble.

At other companies, executives may choose to delay or forgo value-creating investments in order to achieve their bonus targets. These vital investments include research, new product development, brand building, and product and market extensions. By refusing to take reasonable risks, executives boost the company’s short-term results at the expense of its long-term value-creation potential. The bottom line is that annual bonuses fail to achieve any of the three essential objectives of incentive compensation. They do not provide executives with an incentive to maximize long-term value, they can encourage excessively risky behavior, and they can encourage excessively risk-averse behavior.

Multiyear plans employ many of the same performance measures as annual bonuses. Extending the period over which unsuitable targets are measured from one year to three years doesn’t do the job. A company can report three or more years of earnings growth or improving capital-efficiency ratios without creating any value.

Standard stock option plans have limited ability to motivate superior long-term value creation because performance targets are too low (any increase in grant-date stock price) and holding periods are typically too short (3-4 years).   One potential solution is an indexed option plan that requires executives to retain a meaningful fraction of the equity they obtain well after the vesting date. Unlike standard options, which have a fixed exercise price, indexed options have an exercise price that rises or falls with an index of the company’s competitors. 

For companies that are unable to develop a reasonable peer index, there is an attractive alternative which I call an equity-premium option plan (EPOP). EPOPs require a higher level of threshold performance than standard fixed-price options, but, unlike indexed options, they do not require the construction of an index. Specifically, the exercise price of the option rises by the yield to maturity on the 10-year U.S. Treasury note plus an equity-risk premium minus the dividends that the company pays.  Suppose a company’s shares are trading at $50 at the option grant date, the yield on the Treasury note is 2%, and the equity risk premium is estimated at 4%. The exercise price would rise by 6% over the next year to $53.  Assuming a dividend of $1 per share the exercise price would be adjusted to $52. 

The post-Enron backlash against options encouraged many companies over the past decade to move from stock options to restricted stock.  Restricted stock grants vest after an executive has remained with the company for a specified length of time. At the end of the vesting period, executives own the stock and are free to do whatever they want with it. Restricted stock grants are equivalent to options with an exercise price of zero. They are largely guaranteed pay, have no commensurate performance requirement, and are aptly referred to as “pay for pulse.” Stock grants encourage risk-averse executives to play it safe, protect the current share price, and avoid getting fired.

In an effort to blunt the criticism that restricted stock plans are a giveaway, some companies offer performance shares that require executives not only to remain on the payroll, but also to meet performance targets for metrics such as earnings per share, revenue, and return on capital employed. Executives may pursue these short-term targets, which are typically set at undemanding levels, at the expense of the company’s longer-term value-creation potential. Unlike restricted stock grants, performance share plans do demand some performance. Unfortunately, it’s not the right performance.

 

PCAOB calls for more commentary from auditors

By Paul Hodgson, CCO and Senior Research Associate

At a recent open board meeting, the PCAOB proposed a concept release to increase the amount of information provided by a company’s outside auditor.

The alternatives presented in the concept release were:

• Auditor's Discussion and Analysis,
• Required and expanded use of emphasis paragraphs,
• Auditor assurance on other information outside the financial statements, and
• Clarification of language in the standard auditor's report.

The release indicated that these alternatives were not mutually exclusive.

Given the number of risk explosions that have been driven by poor disclosures surrounding non-financial issues, we at GMI are definitely pro-disclosure, pro-transparency, and in full support this initiative.

As Stephen B Harris, PCAOB Board Member, noted in his remarks at the meeting:

First, investors want auditors' reports to include the auditor's assessment of the estimates and judgments used by management to prepare the financial statements. And second, investors want auditors to discuss how they addressed the areas that presented the most significant risks that the financial statements might be materially misstated.

Interested parties can make comments and suggestions here.

While the PCAOB release does not specifically address the inclusion of non-financial issues that might include governance, environmental, and social issues that could increase risk, this is clearly the way forward, especially with the “One Report” movement gaining ground. These ESG & A issues are exactly the kinds of risks that GMI and its predecessor companies have been zeroing in on since their foundation.

Will this increase the need for additional training for auditors so that they can assess such risks? Yes.

Will this increase the fees that companies must pay to auditors? Yes.

But this is a small price to pay to avoid the kinds of massive losses that we have seen over the last few years.

HRH in Support of Integrated Reporting

By Michelle Lamb – Research Associate

A perhaps unlikely spokesperson for “integrated reporting”, HRH The Prince of Wales delivered a speech earlier this month to the International Integrated Reporting Committee (IIRC) in New York – a meeting which our own Bob Monks attended. 

I “daresay” the prince makes some important points about this accounting effort:

“Now you may wonder, I daresay, why a mere historian like myself has helped to instigate an international accounting project. The reason is, quite simply, that I have long been concerned that we are not counting all that counts or measuring all that matters, and, in particular, that annual reports may no longer be fit for purpose. This is because the context in which businesses operate is subject to fundamental change. The recent financial crisis, for instance, has demonstrated shortcomings in corporate governance and in risk assessment and risk management. There is also growing awareness, but happening too slowly, that the earth’s resources are being consumed at a much faster rate than they are being renewed. And there is, crucially, no value, no value at all, given to natural capital. And yet, none of this is reflected in corporate reporting and in the measurement of the future impact of present decision-making. In other words, corporate reporting has not been developed and refined to cover the more complex and interlinked issues – financial, economic, environmental and social – that now determine organizations’ success. The point is that we are not going to make the right decisions and develop a more efficient and durable world economy unless we have the right information on which to base them.”

He considers the IIRC’s work on integrated reporting to be the “cavalry” on the horizon “ready to ride to the rescue” to address this problem.

The IIRC describes “integrated reporting” as follows:

Integrated Reporting demonstrates the linkages between an organization’s strategy, governance and financial performance and the social, environmental and economic context within which it operates. By reinforcing these connections, Integrated Reporting can help business to take more sustainable decisions and enable investors and other stakeholders to understand how an organization is really performing.

An Integrated Report should be a single report which is the organization’s primary report, in most jurisdictions, the Annual Report or equivalent. Central to Integrated Reporting is the challenge facing organisations to create and sustain value in the short, medium and longer term. Each element of an Integrated Report should provide insights into an organization’s current and future performance.

By addressing the material issues for an organization, an Integrated Report should demonstrate in a clear and concise manner an organization’s ability to create and sustain value in the short, medium and longer term.

The IIRC is preparing a comprehensive Discussion Paper on Integrated Reporting for public consultation to be released in June 2011.

For more information about this project, check out the IIRC website.

Sustainability Reporting: Take the Quiz

Securities analysts and issuers are typically well-versed in financial reporting. Many, however, still don't know much about sustainability reporting, which provides information on environmental, social, and governance-related investment risks. To test your knowledge, see whether you think the following are true or false:

• Sustainability reporting is only for dirty industries.
  
• There is a worldwide trend toward more sustainability reporting.
  
• Only large-cap companies do sustainability reports.
  
• Sustainability reports are purely subjective.

To check your answers and to learn more, download our new report, "Ten Myths About Sustainability Reporting."

Kimberly Gladman - Director of Research and Risk Analytics

Did Lehman Hide $200 million in CEO Pay?

Bloomberg Business Week has a shocking story by James Sterngold about allegations from a former Lehman insider that the company's disclosures omitted as much as $200 million paid to then-CEO Richard Fuld.  In a hearing before the House Committee on Financial Services chaired by Henry Waxman,

Fuld, now 64, said his total compensation from 2000 through 2007 was less than $310 million, not the $485 million that appeared on Waxman's chart. He said 85% of his pay was in Lehman stock that had become worthless. "I never sold my shares," Fuld said at one point. At another, he said he had not sold the "vast majority" of them.

But former Lehman associate general counsel Oliver Budde, who was watching the hearing on C-SPAN, thought those numbers, based on those reported when he had still been overseeing them, did not present the whole picture by omitting the restricted stock units worth $250 million.

This is disturbing, but what bothers me most is this: Budde wrote to  the board and never got any kind of response.  This is, of course, the board that included an actress, an admiral, and a theatrical producer, and a board that managed risk so poorly the company became the business collapsed.  We can understand if they are confused by the complexities of derivatives.  But especially after Sarbanes-Oxley, it should be automatic that any reasonably reliable information about a possible problem of this magnitude should immediately lead to an investigation by an independent committee of board members with the assistance of their own outside counsel.  Failure to do that is risk mis-management that is guaranteed to lead to disaster.

Apples to Apples: Stock Options to Stock Options

You may have noticed something a little wonky going on in summary compensation tables this month. The end of February marked a switch in the SEC reporting of stock option and restricted stock awards from a company recognized expense figure to the grant date fair value of equity grants. The change designed to enhance clarity, has also been implemented for the reporting of equity in prior years, making possible an apples to apples comparison of the grant date value of equity grants over a multiple year period. For example, at The Hershey Company, 2008 stock awards for President and CEO D.J. West are noticeably different than the amounts disclosed in the 2009 proxy.

2009 proxy

2010 Proxy

That’s because in the 2010 proxy, the stock and option awards for 2008 have been adjusted and now reflect the aggregate grant date fair value of awards. While $679,071 and $918,335 represent the dollar amount recognized in 2008 for stock and option awards granted, the latest proxy shows us the actual grant date value of those awards was $2,502,599 and $1,500,028, respectively.

Our analysts have entered just over 450 proxies under these new disclosure rules with 135 S&P 500 companies included in the data set. So far, the average grant date values for stock option awards across our coverage universe is $916,741 and the average stock awards are $1,388,898. In the S&P 500, these values climb to $1,973,602 and $2,705,065, respectively. These figures reflect the clear shift to the granting of restricted stock, with its more certain value, over the previously traditional stock options, which can often go underwater when suppressed under a sagging stock price.

Notable option awards so far this season include Tim Armstrong of AOL Inc. who received about $19.1 million worth of option awards in 2009 to go along with $5.6 million in stock awards. James M. Cracchiolo of American Financial, Inc. was granted more than a million stock options in 2009 with a grant date value of $9.1 million. Noteworthy stock awards include John Stumpf of Wells Fargo & Company, who received more than $13 million in restricted stock grants in 2009, independent of the $5.6 million in company stock designated as salary. James E. Rohr of The PNC Financial Services Group, Inc. received slightly more than $8 million in 2009 restricted stock awards.

Prominent CEO’s with no grant date values to report include Kenneth D. Lewis, formerly of Bank of America Corporation, Vikram S. Pandit of Citigroup Inc., John W. Allison of Home BancShares, Inc., and Warren E. Buffett of Berkshire Hathaway Inc.

Greg Ruel - Research Associate

Climate Change? Look out your window

At the end of January, when I wrote about the SEC’s initial moves to introduce climate risk disclosures into company filings, I noted that two of the commissioners opposed the release – Kathleen Casey and Troy Paredes –indicated that they felt the science around global climate change was far from settled.

As readers of my blog will remember, I was particularly unimpressed with this attitude.
With this in mind, I’d like to send this little missive to the commissioners.

Dear Commissioners Kathleen Casey and Troy Paredes,

As you look out of your office windows at 30 inches of snow with potentially more on its way, how do you feel about the science around global climate change now?

Yours sincerely,
Paul Hodgson

New SEC Guidance: Corporate Disclosure of Material Climate Change Risks and Opportunities

The SEC just issued ground-breaking guidance requiring corporate disclosure of material climate change risks and opportunities. A report The Corporate Library authored for CERES last spring, which surveyed current climate risk disclosure and found it lacking, was part of the movement that made this happen.

SEC Announces Hearing on Investors' Call for Climate Risk Disclosure

The SEC has announced it will hold an open meeting on the petition from Ceres and the Environmental Defense Fun (EDF) asking the SEC to provide interpretive guidance outlining climate-related "material risks" - such as new regulations, physical impacts, new economic and business opportunities and other climate-related trends - that companies should be disclosing to investors. The petition was signed by 20 organizations, including leading U.S. and Canadian institutional investors managing more than $1 trillion in assets.

The meeting will be held January 27, 2010.

New SEC Disclosure Rules on Board Leadership Structure

The SEC’s enhanced proxy disclosure rules related to corporate governance and executive compensation matters will be effective for proxies filed after February 28th. The part of these new rules I am most excited about is the enhanced disclosure regarding board leadership.  Companies will have to provide detailed information regarding their board leadership structure, including “whether and why it has chosen to combine or separate the principal executive officer and board chairman positions, and the reasons why the company believes that this board leadership structure is the most appropriate structure at the time of filing.”  If the roles of principal executive officer (AKA CEO) and board chair are combined, the company will have to discuss its decision regarding the designation of a lead independent director.  In July when I blogged about the proposed rules regarding the lead director disclosure, I wrote:

A positive change that we would see if these rules are adopted is more meaningful information about the roles and responsibilities of the lead independent director. However, companies should also have to disclose their reasoning if they have combined the roles of CEO and Chair of the Board and NOT created the position of lead independent director (or a similar position).  Surprisingly, there are many US companies which fall into this category.

Now that the rules are finalized and soon we will see proxies with these discussions regarding board leadership structure, I wanted to see how many companies with a combined CEO and board chair will be in the position of explaining why they do not think it is “appropriate” to name an independent director as lead director.  I was amazed when I searched our Board Analyst database and found that, as of December 28, 2009, more than 700 companies in the Russell 3000 index have one person serving as both CEO and board chair and have not named an independent director as lead director.

To be fair, I should point out that we at The Corporate Library have a high standard for what we consider the designation of a lead director.  We only consider a company to have a lead director if they specifically provide the name of a single lead (or presiding) director for the board.  Only when shareholders are provided the name of an individual who has been given the title of lead (or presiding) director and will be held accountable for serving as the ongoing leader of the independent directors of the board is a company considered to have a lead director in our database.

For example, we do not consider a board to have a lead director if they report that the independent directors or chairs of the board committees rotate in the role of lead director.  This is the case at several large US companies. Similarly, if the board designates someone to be the lead director simply because of their role as the chair of the board or a certain committee, we do not consider that board to have a lead director.  Some boards select the person who will serve as lead director, by leading the executive session meeting, by stating that it will be the person who chairs the committee which has responsibility for the issue to be discussed at that particular meeting.

Our concern with these and other similar approaches is that while they only effectively determine who will lead any given executive session; they do not name a person who is consistently responsible for truly serving as an independent leader of the board and who can be held accountable by shareholders.

Of the more than 1,500 companies in our database which have combined the roles of CEO and board chair, we consider only about half to have named a lead director.  When I narrowed the search in our database to consider only S&P 500 companies, I found that more than 100 companies with a combined CEO and board chair had not named a lead director as of December 28, 2009.  We will be watching these companies as they file their proxies in the coming months to see how they justify this lack of independent board leadership.

Annalisa Barrett - Senior Research Associate