Corporate Governance and Compensation - Research Paper Example

? Economics/ Finance/ Risk Management White Paper Brian Giuliano Texas A&M Commerce This white paper discusses the topic in Chapter 14, executive compensation as an issue under good corporate governance, and the risk the firm faces when the setting of compensation is attended by lack of transparency and executive power plays. A brief review of current and relevant academic theory is followed by a detailed discussion of the case of Walt Disney Company concerning executive compensation. The case study revolves around the hiring and firing of Michael Ovitz in 1995, as president and successor to Michael Eisner after the death of Frank Wells. For a decade, Eisner and Wells shared a balance of power and authority in Disney Company, during which time the firm enjoyed a period of profitability and strong growth. Upon the demise of Wells and a quadruple bypass for Eisner, the urgent matter of succession prompted the hiring of Ovitz under circumstances that were at best grossly careless, at worse unethical and sinister. The terms of compensation given Ovitz by Eisner, without the knowledge of the board or the compensation committee, were onerous to and clearly against the interests of the shareholders, resulting in Ovitz being given a severance pay of $130 million after only 14 months in service. The courts found nothing illegal about the deal, prompting an examination of the failure in ethical standards and norms of good governance which had caused Disney stakeholders, and shareholders, significant damage. Corporate Governance and Compensation Introduction According to Sir Adrian Cadburdy, chairman of the Cadbury Committee, corporate governance is defined as “holding the balance between economic and social goals, and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources.” The Cadbury Report focuses on the control and reporting functions of the boards and the role of auditors in relation to financial reporting and accountability (Chartered Institute of Internal Auditors, 2012). On the other hand, the Organisation of Economic Co-operation and Development (OECD) defined corporate governance as “the system by which business corporations are directed and controlled…[specifying] the distribution of rights and responsibilities among different participants in the corporation such as the Board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs” (OECD, 2004, 11). A third definition is articulated by economists: “Corporate governance is a field in economics that investigates how to secure/motivate efficient management of corporations by the use of mechanisms such as contracts, organizational designs and legislation” (Fernando, 2006, 13-15). More recent literature has expanded the coverage of corporate governance to include management and financial discipline, corporate social responsibility, business ethics, stakeholder participation in decision-making, and more recently, sustainable economic development in the country in which the business operates (16). Presented in the appendix is a figure showing the comparative descriptions of the OECD and UK’s Good Governance Standards for Public Service, as they measure up to the generic principles of good governance. Executive compensation as a concern of corporate governance Before the financial crisis, there was little reason for doubting the rising pay of chief executives as set by board. The general public perception is that the board acted in a regular and informed manner when they agreed in setting the compensation level of the CEO, and that corporate governance was implemented optimally from the top of the organization. The issues that arose out of the financial crisis, however, led to the belief that the process of determining CEO compensation is not as efficient as the public were led to believe, and that significant distortions exist between the compensation the CEO is awarded, and the company’s performance. The developments during the crisis brought about the realization that corporate governance impacts upon the risk management of the enterprise, particularly with respect to corporate board diversity, the duality of the CEO and chairman of the board, and the matter of executive compensation (Tarnatino & Cernauskas, 2011,229). Academic literature on executive compensation Most studies on executive compensation and its implications on corporate governance are based on the principal-agent framework, wherein it is assumed that executives provided sufficient incentives will be effective agents of the shareholders and yield above-average performance. One such study is that of Cyert, Kang and Kumar (2002), which determined that from an agency perspective, the factors that impact upon the determination of CEO compensation include default risk and ownership of the majority shareholder; BOD ownership and the strength of executive pay-performance relationship; board size; and the ratio of equity-based compensation relative to fixed compensation. The agency theory had come into question in the 2008 financial crisis where the firms – mostly financial institutions – had gone bankrupt despite hundreds of millions in bonuses paid to the top executives. Filatotchev & Allcock (2010) suggest the adoption of an alternative framework, which they termed the contingency-based framework. The framework is anchored upon three concepts: organizational context, complementarity/substitution between governance factors, and impact of institutional environments. Organizational context involves the fluctuations in the internal and external strategic resources, and the stage of the firm in its organizational life cycle. Complementarity/ substitution pertains to the alignment of sets of corporate governance practices which mutually enhance each other to effectively attain corporate governance (21). Finally, institutional impact emphasizes the degree to which executive compensation is social embedded and path dependent – that is, executive compensation must be considered as legitimate by social standards and sensibilities, and relative to prevailing normative, regulatory, and cognitive impacts on the organization (21-22). The study conducted by Laksamana (2008) explored the links between voluntary disclosure, specifically on the matter of compensation-related items, and corporate governance. The study found that the frequency of meetings of compensation committees and the size of the committees are positively related to the transparency of board disclosure practices. Furthermore, boards tend more to provide disclosures if they have the power to act independently of top management. Overall, board and compensation committee effectiveness were proven to be directly related to greater communication to shareholders concerning board practices (Laksamana, 2008). Increasingly more firms hire compensation consultants to address the complexities of determining executive pay. Since the top executives themselves hire the consultant, the situation opens itself to abuse in favor of CEO. Previous studies pointed out that company executives are able to acquire excessive remuneration based on the power that they have within the company. They then hire consultants to assist in “camouflaging” and justifying their pay, through the use of remuneration surveys, compensation peer groups, and other tools used by consultants to determine executive pay. However, recent studies have shown that compensation consultant have positively influenced the pay-performance sensitivity. In the UK, compensation consultants were found to play a role in the determination of the corporate governance structure; evidence shows that consultants advance equity-based compensation while negatively influencing basic (cash) pay (Voulgaris, Stathopoulos, and Walker, 2010, 512). The existence of equity-based compensation schemes, however, does not necessarily mean that the firm will perform better, because some past studies failed to establish a robust relationship between equity-based compensation and firm performance (Filatotchev and Allcock, 2008). Another means by which the pay setting process is corrupted is when the CEOs unduly influences the board of directors. In a principal-agent setting characterized by moral hazard and adverse selection, there are three tiers that dominate the firm’s hierarchy, namely the board of directors, the CEO, and the shareholders. Typically, the board provides information to shareholders on whether or not the CEO may contract with them concerning his pay, while keeping the shareholders’ interest at heart. At the same time, however, the board is subjected to potential influences from the CEO whose interest is still to extract the highest rent possible. The balance is restored, however, by other stakeholder groups who could likewise exert influence on the board when distorted incentives for the CEO are perceived (Doscher & Friedl, 2010) Case Study: Disney Probably the leading recent case on executive compensation as it pertains to corporate governance is that of Walt Disney Company, concerning the circumstances surrounding the hiring and firing of its former president, Michael Ovitz. After only fourteen months on the job, Ovitz left the company with over $130 million in severance pay, causing stakeholders to question the propriety of the terms under which he was hired. The facts of the case were drawn from the legal discussion in Lederman (2007/08), and are summarized as follows: Two events motivated the hiring of Ovitz under the terms that led to his large severance after only fourteen months. The first event was the sudden death in April 1994 of Disney’s president and chief operating officer (COO), Frank Wells. For ten years prior to his death, Wells and Michael Eisner, Disney’s chief executive officer (CEO), had run Disney profitably. While there was a need to replace Wells, it could not immediately be done as a matter of succession because there were no qualified candidates from within the company. For the next three months after Wells’s death, Eisner assumed both the posts of president and COO, while retaining his position as CEO. It was at about this time that the second event occurred. Eisner was diagnosed with heart disease that required quadruple bypass surgery. Because of his illness, a successor was deemed necessary, thus during the following year, the board of directors (BOD) and Eisner discussed the matter of succession. Early negotiations. As early as 1995 Eisner had already considered Ovitz as a possible choice for president. The two had known each other for twenty-five years both on a professional and social basis. At the time, however, Ovitz was offered by Music Corporation of America (MCA) a compensation level which could not be matched by Disney. Discussions fell apart on the possible hiring by MCA, though, and so negotiations between Disney and Ovitz began in July 1995. The negotiations were in two phases, the first being Ovitz’s foreseen role in Disney, and the second concerns the financial terms. Concerning his role in the company, Ovitz was told that Eisner expected him to address the two weaknesses then current in Disney, which were poor talent relationships and stagnant foreign growth. During the talks, Ovitz wanted to be assured of the sincerity of Disney’s offer, which Eisner apparently provided. Ovitz came to understand that Eisner and he would be running Disney as “partners”, meaning that they were to function as co-CEOs. This was acceptable to Eisner, although it was understood that Eisner remained the chairman and was superior to Ovitz. In terms of their working relationship, the two were to work in unison, similar to “one that existed between senior and junior partners” (Delaware Supreme Court, 2005). This understanding became the foundation for the negotiations on the financial compensation that followed. Leading the negotiation at this level was Irwin Russell, a member of the compensation committee as well as personal lawyer to Eisner. Russell may have led the negotiations, but under the direction and control of Eisner. Prior to joining Disney, Ovitz headed his own company, Creative Arts Associates or CAA, of which Ovitz owned 55 percent and from which he earned $20 to $25 million annually. At the outset, Ovitz clarified that he would not relinquish his position and control at CAA unless he could obtain from Disney a comparable consideration as his current earnings with a mandatory “downside” protection for himself and all his own clients. In order to meet these conditions, the contract that was drawn was for a five-year term and with various stock option arrangements that allowed for upside opportunities and downside protection. As early as this point, Russell already mentioned to both Ovitz and Eisner that he thought the negotiated terms involved “an extraordinary level of executive compensation” (Delaware Supreme Court, 2005), and warned that Ovitz’s salary would be one of the highest salaries typical of CEOs, and would exceed that of Eisner himself. Furthermore, the stock options offered Ovitz exceeded the standard terms that ordinarily applied in Disney and are certain to draw attention and adverse criticism. To help with the crafting of the terms of compensation, Russell recruited Raymond Watson, compensation committee member and former Disney chairman of the board, and Graef Crystal, expert and consultant on executive compensation. Watson was considered particularly competent because he was instrumental in the negotiations for both Wells’s and Eisner’s own contracts. Both Watson and Crystal were thus highly competent in the matter of executive compensation, and there is no reason to doubt that they were aware of the implications of the severance arrangements and the amounts involved should Ovitz be terminated prematurely. Final negotiations and announcement of the deal. As negotiations were winding up in August 12, 1995, Eisner told Ovitz that a large Disney shareholder will be arriving at Aspen where the two men and their families were vacationing, and that was to be the crucial point at which an agreement on Ovitz’s hiring should be finalized. Eisner told Ovitz he had until 6 p.m. to agree to the financial terms. There was a second ultimatum, however; Eisner required that Ovitz abandon the expectation that he will share CEO power with Eisner, and was even to give up a great deal of operating authority. Instead of being hired as both COO and president as Wells had performed prior to his death, Ovitz was to occupy only the position of president, while Eisner retained the COO position which he was holding since Wells’s death. To these terms Ovitz agreed, but this was not the end of the controversy. The following day, the general counsel to Disney, Sanford Litvack, and chief financial officer Stephen Bollenbach, expressed their dissent against reporting to Ovitz, and insisted that operating decisions falling within their sphere of control be separated from Ovitz, and that they report directly to Eisner. Eisner supported the position of the two executives to report directly to him, which in effect strengthened his power and diminished that of Ovitz. At this point, with the rebellion of Bollenbach and Litvack tolerated and approved by Eisner, hardly any officer with material responsibilities will be reporting to Ovitz. Despite the sudden diminution of the terms of his appointment, Ovitz nevertheless accepted them. Prior to publicly announcing the deal, Eisner apprised his directors of it, three of whom voiced their objections. The deal nevertheless pulled through, and the announcement caused a $1 billion buy-up in Disney stock. Post-announcement: first meeting of compensation committee. After the public announcement had been made, on 26 September 1995 the compensation committee met for the first time to discuss the terms of Ovitz’s employment, as well as the $250,000 compensation for Russell in negotiating the deal. During the meeting of the executive committee, the board was informed of the new reporting structure but without mentioning Litvack’s and Bollenbach’s rebellion, a matter Eisner intentionally left out of the discussion. The agreement was signed on 1 October, 1995. The controversy. Ovitz’s relationship with Eisner began to deteriorate and by the middle of September 1996, Eisner sent word to Ovitz through Litvack that he (Ovitz) was “not working out at Disney, and he should start looking for a graceful exit (Lederman, 2007/08). This initial message was not well taken by Ovitz, who informed Litvack that he would stay and commit to make the job arrangement work. This prompted a second message from Eisner, in no uncertain terms, that Ovitz was no longer wanted by Disney. Ovitz again refused to leave, and dared Eisner to inform him personally. At the end of September, Eisner informed his board during executive session, with Ovitz absent, that he was dissatisfied with Ovitz’s performance. That same evening, however, Ovitz and Eisner appeared together on Larry King Live, a television talk show, and publicly declared that contrary to Hollywood gossip, there were no problems between them and things at Disney were running smoothly. The next day, Russell and Watson each received a letter from Eisner telling of his lack of trust for Ovitz, and of the latter’s failure to alleviate Eisner’s workload. The letter purportedly was to prevent Ovitz from succeeding him as Disney’s CEO. Eisner unsuccessfully sought to get Ovitz to join Sony, after which he met personally with Ovitz on November 13, 1996, to tell him that he was no longer welcome. Ovitz rejected Eisner’s rebuff and insisted that he would “chain himself to his desk” to continue at his job in Disney (Delaware Supreme Court, 2005). Throughout these developments, Eisner worked with Litvack to explore the possibility of dismissing Ovitz for cause, but none could be found by Litvack. Besides, for Disney to try to avoid a costly severance to facilitate Ovitz’s exit by resorting to trumped up charges would damage the company’s reputation. On November 25, 1996, Eisner informed his board (sans Ovitz) that he will be firing Ovitz without cause by the year’s end. The failure of the legal case. Because of the circumstances of Ovitz’s extremely large severance compensation, the shareholders of Disney brought a derivative suit against the company due to “the excessive payout, and the bungling that let the corporation treasury substantially depleted and the executive ranks without a talented president and successor to Michael Eisner” (Lederman, 2007/08). The grievance of the shareholders was very real, because the stock value, which had jumped by $1 billion with the announcement of Ovitz’s appointment, fell precipitously with the announcement of his separation from the company, causing real pecuniary loss to many investors. Discussion of the facts of the case The thesis expounded by Lederman (2007/08) in this case study is Michael Eisner’s desire, common in many CEOs, to retain power in the corporation by installing a successor whom he felt could sufficiently influence or even control. The following points appear instructive in the determination assessment of this case: (1) Eisner was empowered by the board of directors to choose his own successor. This is clearly improper and a dereliction of duty of the board to protect the interests of the shareholders, pursuant to the model conceived by Doscher & Friedl (2010), where the board should be in a position to respond not only to the influence of the CEO but also that of its other stakeholders. (2) Eisner informed the compensation committee of the terms of Ovitz’s hiring only after an agreement was arrived at between them and after the public announcement. This effectively pre-empted the compensation committee and the board from deciding otherwise or disapproving the deal altogether, particularly since the stock value rose significantly at the instance of the announcement. (3) Eisner actions were clearly unethical, but not sufficient to meet the legal standard of bad faith. He initially baited Ovitz by enticing him with the prospect of sharing CEO status, only to withdraw this offer and diminish his (Ovitz’s) power when the agreement was practically perfected. Further agreeing to the rebellion by Litvack and Bollenbach after he had informed them of the deal, and eliciting negative reactions by three directors after he had similarly informed them, raise suspicions that Eisner may have presented the terms of the deal to them in a negative manner to continue to shore up the directors’ personal loyalty to himself. This suspicion is buttressed by the actions of Eisner during the entire process of hiring and firing, including withholding information from the board and dealing less than candidly with Ovitz, particularly in baiting him with a high compensation package and then pressuring a quick agreement while eroding the power earlier negotiated. There is strong indication that Eisner engineered Ovitz’s eventual dismissal, particularly since there was no cause for separation despite Eisner’s pronouncements that Ovitz performed poorly. (4) Hiring executive compensation expert Russell, who was eventually paid a huge sum by the firm for his role in negotiations, was clearly unethical of Eisner because Russell owed him professional and personal loyalty, rather than to the company, and clearly was committed to advancing Eisner’s personal agenda (Filatotchev and Allcock, 2008; Voulgaris, Stathopoulos, and Walker, 2010). While Russell was a member of the compensation committee, he cannot decide for it and acting without its knowledge betrays a conflict of interest between the company’s shareholders and that of Eisner and Russell himself (since he received an agency fee of $250,000 for the negotiation, Russell was clearly acting as agent for Eisner rather than as member of the compensation committee). Russell’s membership in the committee was a mere ploy to evade legal bad faith issues; it does not detract from the fact that the compensation committee was not informed of the terms of the deal, although Russell was well aware that it was well beyond the standard level and practice. (5) Less than open voluntary disclosure on the part of Eisner to all parties involved. Although Eisner announced to the board the terms of Ovitz’s appointment, he intentionally left out the matter of reporting structure. From the outset, Eisner intended to maintain operational control, and therefore was not justified in later arguing that Ovitz did not significantly relieve him of some of his duties. Eisner withheld material information from the board and the compensation committee. It must be recalled the board and compensation committee effectiveness are directly related to greater communication to shareholders (Laksamana, 2008), not only by them but likewise by the CEO, which was absent in this case. Conclusion The case of Disney’s derivative suit involving Ovitz’s morally untenable compensation package highlights the huge discrepancy between what the law requires and what is required by good corporate governance, as far as executive compensation is concerned. Presently, in determining liability and propriety the law measures executive action by the minimum standard of due care and good faith, but this case shows that it is possible for a powerful CEO to meet the minimum and still cause severe pecuniary and organizational risk to the company and its shareholders. After Ovitz’s 14-month service, Eisner was able to serve another nine years as CEO, COO and president under a new mandate (thanks to Ovitz’s one-year service), wielding near absolute power over the company and its board of directors. Legally, the courts decided against the derivative suit filed by the shareholders, because the board of directors were deemed to have met the minimum standard of due care, and not to have acted in bad faith as defined by the law. This does not clear Disney executives, particularly its CEO and those directors who evidently connived with him, from meeting their moral and ethical responsibility towards their shareholders and stakeholders, and is an evident display of poor corporate governance. Executive compensation and the hiring of a successor must not be left to the whims and designs of a CEO who manipulates these matters in order to retain power for himself. The terms of executive compensation and succession should be considered as legitimate by social standards and the norms and cognitive impacts on the organization (Filatotchev & Allcock, 2008). Reference: Chartered Institute of Internal Auditors (2012) “Corporate Governance”. Retrieved 18 July 2012 from http://www.iia.org.uk/en/Knowledge_Centre/Resource_Library/corporate-governance.cfm Cyert, R.M.; Kang, S-H; & Kumar, P. (2002) “Corporate Governance, Takeovers, and Top-Management Compensation: Theory and Evidence.” Management Science, 48(4), 453-469 Delaware Supreme Court (2005) In re the Walt Disney Company Derivative Litigation, 907 A.2d 693 (Del. Ch. 2005) Doscher, T & Friedl, G (April 2011) “Corporate governance, stakeholder power, and executive compensation.” OR Spectrum, 33(2), 309-331 Fernando, A C (2008) Corporate Governance: Principles, Policies and Practices. Dorling Kindersley, licensees of Pearson Education, Delhi. Filatotchev, I & Allcock, D. (February, 2010) “Corporate Governance and Executive Remuneration: A Contingency Framework.” Academy of Management Perspectives. 24(1), 20-23 Laksamana, I . (Winter, 2008) “Corporate Board Governance and Voluntary Disclosure of Executive Compensation Practices.” Contemporary Accounting Research, 25(4), 1147-82 Lederman, L (2007/08) “Disney Examined: A Case Study in Corporate Governance and CEO Succession”. New York Law School Law Review, 52, 558-582 Organization for Economic Cooperation and Development (OECD) (2004) OECD Principles of Corporate Governance. OECD Publications Service, Paris. “Summary of the Nolan Committee’s First Report on Standards in Public Life” . Retrieved 18 July 2012 from http://www.archive.official-documents.co.uk/document/parlment/nolan/nolan.htm Tarnatino, A & Cernauskas, D 2011 Essentials of Risk Management. John Wiley & Sons, Inc., Hoboken, New Jersey Appendix: OECD, UK Independent Commission for Good Governance, and General Principles (Chartered Institute of Internal Auditors, 2012) Read More