The November 11, 2011 issue of Canadian Business includes a very interesting article by Richard LeBlanc, a lawyer, corporate governance academic, speaker and an independent advisor to leading Canadian and international boards of director on the proper use of external advisors in conducting a corporate governance review.  Despite some fairly significant differences between US and Canadian governance rules, Mr. LeBlanc makes some good points - the most important of which is to remember that the client is the chair of the governance committee, not the CEO and not the Chairman.  The entire article can be accessed at http://www.canadianbusiness.com/blog/corporate_control/56648. 

In March I had a discussion with TK Kerstetter, President of NYSE/Euronext’s Board Member magazine, on the relationship of corporate governance attributes and stock price performance over the long term. (For the complete interview, go to (http://www.boardmember.com/BRC.aspx?taxid=1040&id=5980).  TK’s premise was that there is no direct relationship between company performance and such check the box attributes as poison pills, staggered board, separate CEO and chair, etc.  Proof of TK’s hypothesis was evident in that the highest performing company over the past ten years was Apple Inc., which is frequently criticized for its lack of “best practices” in corporate governance.

The point I made to TK was that the most important factor in the success of a company is the personal character of the individuals who lead it – management and directors.  The problem, as I described it, is that in a rules-based society that demands everything be objectively measured and evaluated, character doesn’t fit.  Character is a trait that cannot be observed or measured, it cannot be seen, touched or felt.  It cannot be regulated.  It cannot be legislated.  It is only evident when it is in action or when it is missing. 

There are a multitude of individuals and organizations that set forth supposed “best practices” in governance that, in their opinions, should be applicable to every company.  In my opinion, the problem with that approach is that good governance depends on human nature, and human nature doesn’t fit into a template. 

For good governance, the only thing that really matters once you walk into the boardroom is the character of the individuals who are inside the room. If you have honest, quality people who are committed to the company, who are committed to meeting their responsibilities to the shareholders, who are willing to put in their two cents to ask difficult questions in a respectful manner, you will have good governance, regardless of whether you have a separate chair and CEO, a staggered board, or a poison pill.

Character is defined in the dictionary as “moral excellence or firmess”[1].  Character in a board room is exhibited by fully participating in the moment.  By paying attention to what is going on.  By preparing in advance for the scheduled discussion.  Character in the board room is illustrated by asking a question that may not be well received, but must be asked nonetheless. It is reflected in a willingness to do the right thing, for the company, its employees, customers, and communities as well as its shareholders even though some shareholders and pundits (with their own agendas) may be critical.  Character in the board room is making a decision for the right reason even though the optics may not be favorable to the decision-makers.  Character in the board room is exhibited more in the manner in which a decision is made than in the result of the decision itself.  By exhibiting character in the board room a director may very well earn himself or herself “no” votes at their next re-election.  Character allows a director to make difficult choices, take difficult decisions, and sleep well knowing that they have done their best on behalf of the company and its shareholders.

One of the more inconspicuous but far-reaching provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) which Congress passed and the President signed in July 2010 is a whistleblower provision that effectively awards a significant bonus to anyone who is the first to turn in their employer (or anyone else) for wrongdoing with regards to violations of SEC rules (including the Foreign Corrupt Practices Act).  It’s almost like free money – there is no downside to the employee if they are wrong – they cannot be held responsible by their employer for any costs or damages incurred by the company in defending itself against scurrilous or incorrect charges.  In fact, solely by virtue of reporting the allegations to the SEC and becoming a whistleblower the employee is essentially protected from that date forward from any act of discipline for any reason.   Almost no company counsel will recommend terminating a whistleblower for any reason regardless of how long ago the false claims were made and face having to defend against charges of retribution. 

 The business community is in an uproar over the issue.  For years, and especially since Congress passed the Sarbanes-Oxley Act in 2002, companies have spent a great amount of time and money developing internal control, ethics, and whistleblower programs that require employees to follow strict ethical standards and which encourage the reporting of inappropriate behavior to the company so that investigative and corrective action, including self-reporting to the SEC, can be taken.  The new provision in Dodd-Frank completely upends these programs because it contains no requirement that a whistleblower comply with the company’s self-reporting program before contacting the SEC with their allegations.  In fact, by limiting the reward (which can range from 10% to 30% of the amount of any penalty in excess of $1 million assessed upon the transgressing corporation) to only the first person who notifies the SEC, the government is literally telling people to bypass the company and go directly to the government.

 The SEC recently issued preliminary regulations on how this provision will be implemented and they did little to provide comfort to corporate America.  While they did permit whistleblowers to keep their place in line if they first advise the company of the allegations and then, within 90 days, report the same allegations to the SEC, this rings hollow.  In actuality, most whistleblowers first seek the advice of an attorney before they notify the company of their concerns.   Of what possible benefit is there to a contingently paid attorney and their client to bring the allegations to the company’s attention before reporting them to the SEC if they are not required to do so?  If the reward can be protected, along with the confidentiality of the whistleblower by going directly to the SEC, I don’t see any upside whatsoever in saying anything at all to the company.  I would guess that most attorneys and whistleblowers would feel the same way.

 Fortunately though, the SEC did put some limitations on who can qualify for an award.  Your outside auditors and attorneys cannot nor can anyone inside your organization with responsibility for legal, audit, compliance, supervisory or governance programs.  Information provided to the SEC must have been derived through the independent knowledge or analysis of the whistleblower and cannot have been obtained in a manner that violates state or federal criminal law. Finally, the whistle must be blown before the SEC or some other government agency contacts the company relative to an investigation of the same matter.

 The new rules for whistleblowers will become effective early in 2011.  Plaintiff lawyers have already begun advertising for whistleblowers to come forward with their allegations.  The SEC expects to receive thousands of such claims each year.  Companies that are required to comply with SEC regulations or the provisions of the Foreign Corrupt Practices Act would be well served to think in advance about how they can improve their compliance oversight and employee communication programs so as to minimize the costs associated with false accusations, accelerate the internal investigation process of allegations received through their internal reporting system, and initiate programs to avoid charges of retribution.  There is no time to waste – your employees are watching you – and waiting.

It is often said that the most important characteristic of a good corporate director is integrity and the willingness to speak one’s truth when that might not be the most popular or appreciated behavior.  Now, more than ever, we need such individuals not only to serve as directors on the boards of our nation’s companies but also as leaders of our nation.

No better example of such grit, integrity and personal sense of honor and leadership was shown in, of all places, a baseball game earlier this week.  A Perfect Game is one of the rarest of all events in baseball – there have only been 20 such games pitched in the 110 year history of the professional sport.  For a pitcher, there is no greater accomplishment.

So, imagine how Detroit Tigers pitcher Armando Galarraga felt during the ninth inning on Tuesday evening as he ran towards first base to cover, caught the ball with his foot firmly on the bag and began to celebrate his 27^th consecutive out of the evening – a Perfect Game!  The first in the history of the Detroit Tigers!  But wait, the umpire, Jim Joyce, motioned instead that the runner was safe, and that there was no Perfect Game.  A commotion ensued, the Detroit manager argued the call, but the umpire cannot be over-ruled.  Galarraga returned to the pitcher’s mound, got the next batter to fly out, and the game ended – one out short of a Perfect Game.

It was then, after the final scorecard had been signed and the game placed in the history books that the umpire watched a video replay of that penultimate out down in the umpire’s locker room.  And it was then that he clearly saw that he had been wrong – that the runner was out, that Galarraga had indeed pitched a perfect game, and that there was nothing he could do to change the outcome of his decision.

And then, in his first showing of the integrity that is all too often missing in our political, business, and sports worlds, Mr. Joyce asked the Detroit coach if he might speak with the devastated pitcher.  The coach agreed and Mr. Jim Joyce did the unthinkable – with tears in his eyes, he apologized to Galarraga for blowing the call, telling him that he was clearly wrong and that he had robbed him of his Perfect Game.  And that there was nothing he could do to change the outcome of the game.

Mr. Galarraga, the coach and the rest of the Detroit Tigers appreciated this all too rare gesture.  Generally, no matter how grotesquely bad a ruling, an umpire walks off the field at the end of the game and never makes a comment on the validity of his call.  That’s just the way it is.  Mr. Jim Joyce was praised by everyone who heard his emotional apology, and Mr. Galarraga accepted it without reservation, responding with un-noticed but nonetheless great irony to Mr. Joyce’s heartfelt words with “nobody’s perfect.”

Major League baseball, fearing the outpouring of rage from Detroit Tigers fans at the next evening’s game, at which Mr. Jim Joyce was scheduled to be the home plate umpire (the most important umpire slot on the field), offered him an evening off to avoid the unpleasantness.  Mr. Jim Joyce, as you would now expect knowing him a little bit, declined, saying he would accept the judgment of the fans because he had in fact been wrong and had cost their team and pitcher a career-making and life-measuring achievement.  He would stand and take his punishment like a man.

But the strangest thing happened in this city that has the worst unemployment in the nation; is host to an industry that has been collapsing for decades, 2/3 of which has been through bankruptcy in the past year and is now owned by the taxpayers; has more vacant, burned-out homes than any other city in the country; and has just seen its sitting mayor convicted, jailed, released and then re-jailed.  As Mr. Jim Joyce walked out of the tunnel at the beginning of the game and took the field surrounded by tens of thousands of passionate Detroit Tigers fans, he heard the applause.  And as he looked about the stadium, filled with 28,169 individuals, he realized that many, if not most, were applauding him.  He was being recognized as a true sportsman, a man of integrity, one who had the courage, honor and self-esteem to admit that he had been wrong, and that his error had been costly in a way that could never be made whole again.  He was being cheered because he had done the right thing.  He had not equivocated, apologized for “any pain he may have caused”, or sought refuge behind lawyers for fear of being found liable for his error.  He stood up.  He told the truth.  He apologized.  And then he moved on, doing the job he was paid to do, knowing he would always be known for his error.

There are a few important lessons in this story about Mr. Galarraga and Mr. Joyce. The first is that telling the truth, recognizing one’s error immediately and without reservation and being willing to accept the consequences of that error is a character trait that is widely admired and all too often sorely lacking in those who would lead and direct. 

The second was the grace, professionalism, and dignity exhibited by Mr. Galarraga when his Perfect Game was denied him and in accepting the apology of Mr. Joyce.  Life is full of disappointments, and far too seldom are we witness to an individual accepting what will probably be the biggest such event of his life in so gracious a fashion.  In a world full of spoiled athletes (and a host of others) filled with a sense of entitlement and quick to vent their fury on anyone who reserves from them their due, Mr. Galarraga was the epitome of class.  

The third, and perhaps more important and yet more surprising lesson, is that Americans recognize that character trait for what it is, and they admire it.  Americans, even the most down-trodden and unfortunate amongst us, appreciate being told the truth; no matter how painful it may be or what angst it may cause them.   Americans do not long suffer fools and despise being treated as incapable of recognizing the truth or being able to deal with the facts as they really are.  Americans admire, and will applaud, loudly and with forgiveness, those individuals with the strength of character and integrity to look them in the eye, tell them the truth, apologize for an error, and then get right back to work.

As directors or managers of business, as political leaders of our nation, and as parents of our next generation of Americans, we should remember Mr. Jim Joyce.  He has shown more grit and responsibility than anyone I have seen on the public stage in a long time.

I’ve been giving some thought to the whole say on pay issue.  While I don’t necessarily disagree with the concept, I’m not sure how effective the practice will be.  First, current say on pay proposals are for advisory votes only.  Since no one has real skin in the game as to the vote, what’s the point?  How seriously will shareholders take the issue (will they actually read the twenty plus pages of the Compensation Discussion and Analysis in the proxy before expressing their opinion?).  How seriously will boards take a rejection of their pay packages?  What if the board ignores (or seems to ignore) the vote but is only doing so because it does not know what the vote is actually telling them about their compensation system?

If an advisory vote is only an up or down vote on a complex system of compensation that requires twenty plus pages to explain, how valuable can that be?  If a shareholder votes no, how are they to tell the board which aspect of the pay structure they find offensive?  How does a shareholder tell the board that they see a problem with salary, annual cash incentive, annual equity grants (options or restricted stock), long term incentives (cash, options or restricted stock), retirement plans (pension, years of service, SERP), perks (airplane, auto, security, financial and tax advice), internal pay equity, performance metrics, gross-ups, change in control, severance, or sign-on bonuses?  If all a shareholder can say is “yes, or no” to the whole package, it seems a terrible waste of time and resources to me.  How about if every proxy has a “Why?” box that requires a no vote to specify the particular aspect of the compensation plan that they disagree with?  Now that would allow for real communication between shareholders and the board on the matter and make the exercise one of value rather than appearance.

And while we are on the subject, it seems to me that if we are going to ask shareholders to give an advisory vote on executive compensation plans, why not do the same with regard to directors’ compensation plans?  Board members are directly elected by the shareholders and have fiduciary duties back to those shareholders.  Why not allow shareholders to express their opinions on the compensation packages of those individuals whom they are appointing to represent them?  I would not suggest that this become a regulatory requirement, but it strikes me as slightly hypocritical that a company would subject its officers to such a vote but would object to doing the same to itself.  Just a thought.

A new year, and even more change is upon us.  With the revised SEC disclosure rules on director nominees, diversity, leadership structure, risk and certain compensation practices having been adopted on December 16 and made applicable to proxies being filed this season, directors and their advisors are moving at a hectic pace to complete their work.  I have just a few thoughts on the new rules (which can be found in their entirety at http://www.sec.gov.rules/final/2009/33-90899.pdf).

Let’s start with two issues that directly and indirectly are meant to establish director qualifications.  The new SEC rules require that companies provide more background as to why a director is qualified to serve as a director.  Given that there are no published requirements for service as a director other than those that the company issues itself, this might seem to be a bit of a rhetorical question.  It is generally agreed however that, first and foremost, a good director must have a very strong sense of self and a commitment to integrity, ethics, and fair-dealing.  A good director must be independent in thought and action and hold the best interest of the corporation and its shareholders in the forefront of his/her mind.  A good director must have the time available to properly serve the company in the role of director.  A good director must have a reservoir of experience and knowledge to draw upon such that he or she can make a contribution to the board as a whole as it considers important issues before the company.

The SEC asks that proxy disclosure be expanded to include: 1) the particular experience, 2) qualifications, 3) attributes, or 4) skills that qualified that person to serve as a director of the company.  This requirement deals only with the last of my above described characteristics of a good director.  This new requirement may become, as unfortunately far too many rules do, another “check the box” mandate that contributes little real value to shareholders.  The directors of Enron had great resumes, as did those of WorldCom, General Motors, Chrysler, Lehman Brothers.  Would the expanded disclosure requested in the new SEC rules have provided any insight into how those directors would perform?  I think not.

In today’s “all the information in the world all the time at the touch of a button” environment, almost any director’s background can be far more extensively researched by using Google, Linked In, Plaxo, Facebook or one of the other social or professional biographical media sites available for free than can possibly be made available in a proxy statement.  How about if we just ask investors to do a little homework on their own?

Which leads me to a second part of the SEC rules on director qualifications (although not so presented).  The SEC has asked that companies disclose any policy their board may have with regard to “the consideration of diversity in identifying director nominees”.  Yet, the SEC chose not to define “diversity”, leaving it to each company to “define diversity in ways they consider appropriate.” 

Certainly, every board is well served by having a diversity of perspectives, opinions, and experience addressing the issues and weighing the risks facing the business – that is the bedrock assumption behind having a board in the first place.  Unfortunately, in the vernacular “diversity’ has a strong connotation implying the need for a “quota” of one form or another.  My concern is that the need for diversity of opinion, perspective and experience may quickly transform into a demand for diversity of sex, nationality, sexual preference, or race as a result of pressure brought by groups that have agendas different from those charged with the responsibility of overseeing a complex enterprise.  Good people are good people, regardless of their background.  The focus needs to be on the quality of the people who serve on our boards, not their demographic descriptors.  The former characteristics are what we need.  The latter are what we may get. 

Don’t think so?  Look at Norway, which in the interest of diversity and population weighted fairness has mandated that 40% of all publicly traded company’s board seats must be filled by women in order to reflect the make-up of society as a whole or the company must dissolve.  I would hope that in considering the new SEC rules, every public company’s board will establish a policy that considers diversity of experience, perspective and opinion when considering candidates for director and that such policy will be disclosed as one of the company’s corporate governance guidelines and published on its website.  To do anything else would be to shortchange the company and its shareholders from the best possible candidates for director.    

My last thought on the director qualification disclosures.  I see no harm in disclosing former board seats held by director candidates – in fact, I believe it provides a more complete picture of a candidate’s experience and value as a future director (or not).  But, if someone was convicted of mail or wire fraud or violations of federal or state security laws EVER, wouldn’t it be helpful to know that when voting for them as a candidate for director?  Under the new rule (as well as under the old rule) Bernie Madoff could run for director (disregarding the blanket prohibition against his doing so) in ten years and not have to mention that little issue back in 2008.  If we are serious about providing valuable information to investors, re-thinking the ten year reporting limit for felony convictions might be a place to start – they are in the public record anyway.

The cause du ‘jour in corporate governance today, right behind CEO compensation, seems to be Risk Management (I’ve added the capitals because it has become such a big deal).  Don’t get me wrong – risk management and oversight is a very important function of every board of directors.  It always has been.  It’s really nothing new – it just has capital letters now.

I’ve been serving on boards of public and private companies for almost thirty years now.  I think it would be safe to say that every board meeting is a study in risk assessment and management.  Every issue that comes up is discussed from multiple angles and considered under different scenarios.  What if this happens, or that?  How sure are we?   Have we thought we might be missing something?  What don’t we know about this issue?

Risk management at the board level is very complex.  Directors have to look at the company from a very broad and holistic perspective – from the proverbial 40,000 foot level.  Management identifies and deals with risks at the surface.  In times of trouble or uncertainty, the board will drop closer to the surface.  Having both the board and management at the surface at the same time all the time is a recipe for disaster.  Micromanagement, confused leadership and responsibility, and upward delegation are sure to develop. 

That’s why I don’t think Risk Committees (capitalized because they are part of the very big deal movement) are a good idea.  Using a Risk Committee implies that risks can be managed by a sub-group of the board. A long and only semi-cynical view of human nature would lead to the conclusion that those individuals not on the Risk Committee, especially new directors, might think that they are not responsible for the identification and evaluation of risks.  Directors might take the perspective that risk can be compartmentalized, like the SOX functions at the audit committee or the compensation structure in the compensation committee.  Plaintiff lawyers may take the perspective that members of the Risk Committee are personally responsible for not missing any. The deep-seated understanding that risk management is the responsibility of every Director would move to second seed from its current and most necessary first seed position.  I would posit that Risk Committees would actually serve to increase the true exposure of a company to unforeseen risks due to this delegation mentality and the removal of several sets of eyes and a broad experience base from the risk oversight process.

Here’s what I think is a realistic approach to risk management at the board level.  Prepare a profile of the key risks to the enterprise – material ones that can sink the business or cause harm to others.  Break a company’s risks into groupings based on their nature, such as Financial, Operational, Long-shots and Governance groupings. Then go into each risk group and identify the key material risks.  For instance, in the Financial group identified key risks might include the following:

            Financial Risks:

                        Systemic:

                                    Reporting risks

                                       Internal controls

                                      GAAP selection and application

                                      SEC reporting and filing

                                    Fraud risk

                                       Intentional misstatements

                                    Theft of assets

                        Capital adequacy

                                    Availability of credit lines

                                    Access to equity markets

Balance sheet

            Inventory

            Intangible assets

There are of course, many many more.  Each company is unique in the nature and severity of risks it faces.  The list is limitless, but again, at the board level the perspective should be on material risks.  Care must also be taken not to confuse risk with uncertainty.

After individual risks are identified, the board should then consider how it would like to evaluate management’s approach to managing each of them.  Remember, it is not the board’s role to manage risk.  It is the board’s role to ensure that management has identified the material risks facing the enterprise, has an appropriate means of monitoring those risks, and to ask management to provide assurance to the board that these risk management programs are in place and robust.   The board’s primary question is to determine what information it would like from management in order for the board to be comfortable that it is meeting its obligation.

The board should ask management to periodically provide presentations on specific risks identified in the risk profile and the risk management/mitigation programs in place to deal with them.  Visiting facilities and getting first hand knowledge as to how the company operates is a very big piece of the risk management process.  Having rotating board meeting agenda items that deal with specific risks, such as IT security, disaster recovery, product safety, management development and succession (ask Bank of America about that one) provides a useful means for the board to understand and evaluate management’s ability to identify and oversee risks that face the business.

Risk Management is not The New Great Idea.  Effective oversight of management’s programs to identify and control risk has always been a duty of the entire board.  Under Delaware law, tucked within discussions of the Duty of Loyalty and Good Faith, lies the board’s duty to monitor the operations of the business.  Where I come from, that means risk management. That means everybody.

OK – back from a holiday vacation and ready to get back to work. I hope your Thanksgiving holiday was as enjoyable as ours was.  We do have a lot to be thankful for in this country and we should never forget that, even when we approach despair sometimes. There is no other place like it in the world. 

I notice that during my absence the corporate governance scene continued to froth, with more new proposals on compensation (eliminating bonuses completely Mr. Mintzberg?  For everyone or just CEOs?), proxy access, government involvement in boards, and just plain change change change.

Anyway, before I headed out of the country I had promised to address how the cumulative gains and losses from stock bonuses would differ from those in my example of November 13^th if equal annual dollar amounts of stock were granted rather than the constant number of shares over the five year period.  That is today’s topic.

In the November 13^th posting I used a level option award of 10,000 shares per year issued on the last trading day of each of the last four years with a fifth grant on the date of the 52 week low price through 11/11/09.  For comparison, we want to see what would be the impact if level awards of $500,000 were made at each of the same days.  The differences, while dramatic, also show that in most cases fears of unbounded gains are misplaced, as shown by the table below.

What this analysis shows is that while the overall gains recognized as a percentage of the value of the total awards over the five years from level dollar values of awards are significantly higher than the gains realized using constant levels of shares, in most cases all of the cumulative gains come from the award made at the 2009 low point for the stock price.

What does this mean?  On a broad perspective, it means that, in five of the eight cases observed, all of the bonuses awarded to the recipients of these $500,000 awards for four years have been essentially wiped out.  This loss of value is no different from that suffered by shareholders who purchased shares on the same dates and held them through November 11^th.  Were shareholder interests and bonuses aligned?  I guess you would have to say yes and remember that while a rising tide lifts all boats, an anchor dropped through the hull will sink the boat and everyone in it.

That of course begs the question as to the very significant gains recognized from the awards made at the 2009 low point.  Unless a great amount of thought went into the determination of those awards, it is likely that some of the upside from the low point grants would not be warranted.  A couple of observations are probably in order here though.  First, it is highly unlikely that significant awards were made at the absolute low point (how would anyone know it was the low point, especially in the chaos of the proposed nationalization/bankruptcy of some banks/auto companies?).  Second, if you had just lost $2 million of stock in your company and your boss proposed paying you in more stock, how would you react?  Would you see only the upside of great riches (based on a whole pile of “if’s”) or would you think “that’s nuts” and head for the door and a job elsewhere that held more promise?  Would the very real risks of not realizing the potential upside (such as vesting that requires continued employment in a financially unstable industry or company) offset the equally potentially lucrative upside?  Those are questions employees have to answer for themselves on behalf of their families and within the context of their own personal responsibilities and obligations.

The board has to address the issue from a very different perspective.  In almost every company the greatest and most valuable asset is identified as its people – a tenet espoused by many investors and observers of corporate culture up until just recently (where did all of the human capital theorists disappear to lately?).  The board and management know this.  They want to keep their high performing people.  They do not want to lose the institutional knowledge they possess.  They do not want to lose good leaders in a time of crisis where leadership is at a premium.  They do not want to pay premium compensation to attract replacement executives if they do lose a key person. Key people have important customer relationships.  Key people have important process, market, and product knowledge.  Key people think up innovative products that drive growth. Directors have a duty to their shareholders to protect their investment in the company by minimizing the potential damage to the company through the loss of important people.  The only way a board can protect that investment is to provide a means of keeping on board those people identified as being the most important producers.  The only way they can do this is through compensation programs.  And, since in the current environment cash is a scarce resource, equity is the only form of payment available to do the job.

But at the same time, the board has to be careful that the fears of some observers that large equity grants at low stock prices (their fairness always judged in retrospect by the way) will provide unwarranted levels of compensation are not realized.  I would suggest that in making equity grants at times of crisis or in chaotic markets, boards work backwards in determining the value of the awards to be made so that the value of the award to the recipient will be in line with the recovery recognized by the broader shareholder base and will be driven by a future value rather than a current one.

To illustrate, let’s use the case of BOA.  The stock’s 52 week low through 11/11/2009 was $2.53.  The stock’s year end closing prices from 2005 – 2007 ranged from $37.99 to $38.77.  If the board were to say to the management team, at its low point, if you can get this stock price back to $30, then you can earn back the value you’ve lost on your earlier awards by means of an award we will grant you today right alongside the shareholders.  Using actual data for an executive who had lost $2 million from the four previous annual grants in BOA stock would require the grant of 72,807 shares at the low price of $2.53 so that when the share price hit $30 the gain realized by the executive would be $2 million.  As of November 11, 2009, with the share price at $16.43, the executive is a little over halfway there, with a realized gain on the award of $1,012,000 and shareholders have seen an almost eightfold increase in their share price over the same time.

I like this method of determining equity awards because it forces the grantor to consider a number of valuation scenarios and outcomes for both the shareholders at large and the grant recipients.  This method of reasoning also, I believe, places some form of performance metric on the award and a cap on the unlimited upside that comes from using current stock values in determining the size of an award.  

Of course, this all fits in nicely with my three rules of effective equity compensation –

1. Know why you are making the grant, identify the goal you want to achieve, and have a sum certain award in mind for that achievement.
2. Do the math.  Look at multiple outcomes – high and low stock prices – and how they impact shareholders and grant recipients.
3. Be transparent.  Disclose in your CD&A your reasoning behind items 1 and 2 above.

When acting with foresight and being judged in hindsight, it’s better to be determined to be wrong based on the facts rather than embarrassed by innuendo and supposition.

Ah yes, there is always a “but what if ….” question that follows any conversation about compensation, especially the use of stock based pay.  Two questions have come up following my last post on the use of stock-based compensation.

The first - is there a difference in considering the value of stock issued for grants made as compensation for past performance versus stock grants issued as a reward for future performance?

This is a good question, and my answer is based on a business sense of fairness and the assumption that the goal of either program is to match the incentive with a desired behavior.  The basis for the question is that in my post of November 13 I noted that stock-based compensation contained two value components –  1) the actual value of the stock on the grant date and 2) future appreciation/depreciation in that stock following the grant through the payout date and then beyond.  These two value components are definitely factors in determining the appropriate amount of an award under either the past or future performance scenarios.

If stock is to be used as a form of payment for past services rendered in lieu of cash, such as a replacement for salary (as proposed by Mr. Feinberg, the current pay czar, in the instance of banks which have received federal bail-out funds), or as the consideration to settle a bonus earned in the current or prior year, it seems totally appropriate that the only valuation metric that should be considered is the current value component, i.e., its price on the grant date.  What happens to the stock’s value in the future is not relevant to the facts of the situation.  The employee has performed the work requested to earn the salary and/or achieved the goal that merits the reward.  Under that scenario, the employee is entitled to any future appreciation of the stock, even if the stock is required to be held for a number of years before it can be sold.  Any depreciation in the value of the stock during any restriction period following its grant is a risk the recipient accepts and adds a long term component further linking the employee’s reward with those also received by the broader shareholder base.

On the other hand, if the purpose of the incentive award is to motivate the employee to achieve a certain goal (or set of goals), then a more detailed analysis needs to be made as to precisely what level of award is being made.  For instance, if the employee achieves the desired benchmark, is my objective to reward him with $1 million?  If so, then the future value of the award would be $1 million, not the current value.  In this case, I would suggest that it is more appropriate to estimate the future value of the stock, based on internal forecasts, market multiples, and the impact of achieving the desired objectives on the future value of the company.  Then, working backward, determine how many shares will be required to provide a $1 million reward if all of the objectives are achieved.  Of course, there is the chance that the estimates of future market valuation metrics may be off (to the high or the low sides) or that “stuff happens” to throw things off track, mathematically speaking.  In my opinion, those situations can be dealt with on a one-off basis to make people whole for losses not their fault.  There is still a risk of an increase in the value of the grant that is not attributed to the behavior of the individuals being incented, but it should be far less using a future value approach than a current value approach.

Here is a quick illustration of the two differences in approach.

The CEO, with a salary of $1 million, has earned a bonus of $1 million by achieving all of the objectives he and the board had agreed to at the beginning of the year.  Also at the beginning of the year, the board and CEO had agreed that the bonus would be paid in stock, which the CEO would be required to hold (net of taxes) for five years.  The stock currently sells at $25 share and has a PE of 10.  In this case the CEO would be awarded 40,000 shares with an aggregate value of $1 million.

Now, the same board and CEO are negotiating for goals and the related incentives for the next fiscal year.  The board recognizes that the economy and stock market are both unsettled and are most likely at or near historical lows with a higher probability of rising rapidly rather than falling further.   The CEO’s goal is to double earnings in a single year (this is just an illustration, relax), something that most likely is going to be a one-off event and not a trend-setting growth rate.  The board says, “OK, we want to pay $1 million if you can do this,” and the CEO agrees that would be fair.  The board and the CEO further agree that the award will be paid in stock in furtherance of the CEO achieving the stock ownership guidelines set by the board.

Using a future value approach, the board would consider that, if EPS double from $2.50 to $5.00 over that time, and the PE stays the same, then the share price “should be” $50 by the time this bonus is due for payment.  Under that analysis, the CEO would be granted 20,000 shares.  If the share price did not hit $50 by the time payment was due (and it would only be due if the CEO achieved his objectives), the board could consider a cash true up.  If the multiple did go up, to say 12 and the stock hit a price of $60, then the CEO would have received a “theoretically” unwarranted bump of $200,000 in value, but then every other shareholder would also have received the bonus value increase.

Compare that factual scenario to one using a current value approach to incent the future behavior.  If the current value of the stock was $25, the CEO would be awarded 40,000 shares, to be issued if the objective is achieved.  Again assuming that all goes well, EPS doubled and the PE remained at 10 and the stock hit $50, the CEO would receive stock valued at $2 million at the payout date, double the amount considered as the agreed upon reward.   The only question – was it the board’s intention to grant a $1 million bonus or a $2 million bonus?

Now, in my mind either of these alternatives is fine to use – so long as a forward-looking analysis has been performed and the board is aware, at the time the incentive agreement is entered into, what the range of value possibilities is under different outcomes.  And of course, disclosure of all of the facts considered (to the extent possible without giving away business confidential information) and sharing the board’s philosophical approach to this kind of issue in the CD&A will make it clear to investors and regulators that the board has carefully and thoughtfully made a decision, even if the reader might disagree with the result.

Tomorrow I’ll address the second question – how would the cumulative gains and losses from stock bonuses differ from those in my example of November 13^th if equal annual dollar amounts of stock were granted rather than the constant number of shares over the five year period.

I was reading an article in “The Talley Sheet”, Eric W. Hilfers’ blog at BOARDMEMBER.com – “Damned if you do, Damned if you don’t" (11/9/09) (http://www.boardmember.com/blogIndividual.aspx?blogid=474) the other day on how it seems that no matter what a compensation committee does, the press will find a way to fault its compensation practices.  Mr. Hilfers was talking about an article in the NY Times (11/8/09 – “Windfall Seen as Bank Bonuses are Paid in Stock”) bemoaning the fact that since most of the country’s bankers had been paid bonuses or salaries in stock this past year, they now were in the position to reap huge “windfalls” once their companies’ stocks recovered, even though those rewards had “nothing to do with people’s performance.”

Two things in this story make me crazy.  First, did those stocks just go back up, all by themselves, due to a “recovery”.  No one at the company came up with a good idea to help fix the problems?  No one at the company worked long hard hours to reassure customers, employees, suppliers, shareholders, and others (including some of the regulators and media now finding fault) that the company would survive, that it would regain its footing, and that, in time, their jobs, relationships, and investment would be made strong once again?  No one at the company doubled down on the risk of failure and spurned employment offers from safer competitors so that they could be not just part of the problem, but part of the solution?  The stock price just went up, it just happened, all by itself? It “recovered”?

Second, it amazes me sometimes how short sighted and “one-way” we tend be when we look at things that might not benefit us individually.  I didn’t hear a whole lot of sympathy expressed for those very same people who saw several years of bonuses, also paid in stock, vaporize over the past two years when stock prices fell through the floor.  I would wager a bet that, if the past five years are looked at as a whole (isn’t that what compensation practices are supposed to do – look at the longer term?) stock grants made on December 31, 2005 and each year thereafter, on the same date, are still net net underwater.

Okay – I get irritated when people make broad generalizations without backing them up with facts, so here is an off the cuff analysis using real data on a random sample of companies in the news lately.  I don’t know why I included WalMart – maybe I subconsciously wanted a normal business in there.   Each example assumes the award of 10,000 shares on the last trading day of each year for the past five years except for the 2009 award which is made at the 52 week low (aggregating 50,000 shares at 11/11/09).  Because AIG had a 1 for 20 reverse split in July 2009, the grants used in that example are 500 shares rather than 10,000 to keep values comparable. Grants could be either in restricted stock that vests at the end of five years or ordinary shares that are required to be held for five years but the assumption is that the shares are held for the full five years.  Share prices are adjusted for splits (working backwards from today’s price) and all values come from Yahoo Finance historical tables.

The data shows that half of the recipients of these awards have suffered significant losses over the past five years, even though they may have benefited from receiving a grant at the historical low prices of the past year.  In the above case, only one (Wells Fargo) generated enough profit from the 52 week low grant to offset the cumulative losses on the previous grants.  There will always be outliers, positive and negative, but my point is that it is intellectually inconsistent to focus on only one side of the pendulum by excoriating gains but ignoring losses that preceded those gains. 

Now, I don’t worship at the altar of investment bankers, and although I count several amongst my friends, I generally find them to be arrogant, aggressive, and filled with an oversized sense of entitlement.  But please, let’s keep the long term perspective when we talk about compensation programs.  No one knows what the future will bring.  Markets can only be perfectly timed in retrospect, a quality that seems to be in more than sufficient supply these days.

So what lessons can a compensation committee draw from this dust-up?  (The third thing (okay, it’s a long list) that makes me crazy is people who offer opinions or criticisms without suggesting how to rectify or improve whatever it is they are finding fault with).

First, the committee should think through the potential upsides of stock based compensation before it is granted.  One of the significant differences between cash and stock based compensation is that there is no theoretical limit to the ultimate value of stock based compensation, while the value of a cash grant remains constant.  Stock grants are frequently valued based upon the share price on the date of grant with the number of shares granted sufficient to hit a target level of compensation. This practice results in an award that actually has two components – the intrinsic value of the award at today’s price plus any future gain (or loss) in the stock price.  It is the second aspect of stock grants that is generally not well considered and which results in retrospective criticism when the stock out-performs the market or third party expectations. 

For this reason, when considering stock grants (or options) the committee should look at several different valuation scenarios, including outliers such as a stock reaching a multiple of its current value over the long or short term.  The committee should consider what external factors may impact the stock’s value over the term of the grant, such as the business cycle, interest rates, the stock’s position vis-à-vis historical highs and lows, general industry or market trends, or other “rising tide lifts all boats” potentialities.  At the same though, the committee should not ignore those external factors that might drive down the ultimate value of the stock from the grant date through no fault of management.  For each of the non-performance factors listed in the penultimate sentence (I love that word, penultimate) that some might consider making a “gift” of a stock grant, at the wrong side of the cycle it can  present more of an anchor through the hull effect than that of a rising tide.

Secondly, the committee may wish to consider working backward from a set award value and granting an appropriate amount of shares that, assuming the management team drives the company to achieve the prospective results that underlie the incentive compensation program and further assuming certain valuation characteristics of the company’s stock price performance compared to the market as a whole, would provide the employee with a predetermined cash equivalent value of stock.  The actual results may (will) vary from that forecasted, but it would provide a much more thoughtful method of granting stock than the current method.    Simply put, if the stock at grant date is near a historical high, more shares would be granted than if the stock were near a historical low in order to offset the increased probability that the stock would appreciate less in the former instance than in the latter.

Most importantly though, discuss the reasoning and consideration of these factors and analyses in the CD&A section of the proxy.  There is always a 50-50 chance that the committee’s expectations will be wrong one way or the other.  It is much more difficult for (honest) criticism to be leveled in retrospect when all of the factors taken into consideration in making a stock grant are made apparent up front.  Human nature fills a void of knowledge by casting the darkest motives upon those taking action.  Disclosure of good practices and well-considered analysis will go a long way towards removing some of the hysteria about compensation.

November 11, 2009

The 11^th hour of the 11^th day of the 11^th month, 1918 – The Guns Fell Silent

            By Michael J. Berthelot

I’m remembering that today is Veterans’ Day, and I salute my fellow veterans, young and old, male and female, black, white, Hispanic, Asian, American Indian or whatever background may apply and thank them for their service.  Military service is a high calling, one which far too often is subcontracted out to those who hope to pull themselves forward in life but have limited options while those who can find other ways to build a new beginning (or follow upon an old one).  As a proud “night school accountant” who earned both undergraduate and graduate degrees through the GI Bill, I thank this country for giving me far more than I ever gave her in four years of active duty service, including a scary and lonely year in Southeast Asia long long ago.  It is people of our active duty military, and the veterans of forgotten campaigns, who made this country a place where we can safely raise our children, dream dreams that others cannot or may not, and strive to realize our individual potential while still contributing to those around us.  God bless America, and those who serve her.