Emerging Issues in Management (Mgmt 440) Professor Charles H. Smith Corporate Governance (Chapter 18) Summer 2009

Case Study – “Backdating With Dr. McGuire” UnitedHealth is a successful health care company and William W. McGuire was its chairman and chief executive. Like many publicly-traded corporations, UnitedHealth gave stock options to its executives as part of their compensation packages. Dr. McGuire had made $450M by selling some of his options and held options with unrealized gains of $1.6B. His profits were due to options grants on historical days when UnitedHealth stock was at yearly or quarterly lows.

Backdating cont. But, how had Dr. McGuire been so fortunate? Coincidence or back-dating? Backdating – options granted on one date but priced as if they had been granted on historical date when market price was lower. This is legal if disclosed to shareholders but illegal if no such disclosure. Investigations by SEC and UnitedHealth followed.

Backdating cont. Ultimately, Dr. McGuire forced to resign when his story did not check out about the historical option date of October 13, 1999 (yearly low). Also, “this improbable series of coincidences abruptly ended” when Sarbanes-Oxley Act went into effect in 2002, because new law required companies to notify SEC within two days of an options grant. Dr. McGuire settled actions by SEC and UnitedHealth in 2007 – cost him 100’s of millions of dollars... but he was allowed to keep options worth more than $800M!

Introduction to Corporate Governance Corporate governance is the exercise of authority over members of the corporate community (shareholders, directors, officers and employees) based on formal structures, rules and processes. Sources for these formal structures, rules and processes include articles of incorporation, by-laws, federal, state and local laws, and other pertinent guidelines.

Corporate Personnel Shareholders – owners of the corporation. Directors – appointed/elected by the shareholders; set policy and create vision for the corporation; must have at least 3 under California law; no qualifications required by law but many corporations have qualifications in by-laws. Officers – managers hired by the directors to implement policy and vision; have day-to-day responsibility; in California, must at least have CEO, Secretary and CFO. Employees – hired by officers to work on corporation’s behalf. All except shareholders must be people; can fill one or more roles.

Corporate Documents Articles of incorporation (sometimes called “corporate charter”) – very general document; filing date marks birth of corporation. By-laws – very detailed document; describes rights and responsibilities of corporate personnel. Statement of information by domestic stock corporation – pre-printed form provides basic information about corporation; must be filed annually.

Corporate Governance Scandals Enron – see pages Tyco International, Adelphia Communications and WorldCom – see page 595. These scandals led to the passage of the Sarbanes- Oxley Act of 2002 (“SOX”), which imposed many requirements for corporate oversight and accountability – see pages SOX has caused many executives to decline appointments to other companies’ boards of directors since these executives (1) need to spend much more time fulfilling SOX requirements and (2) want to avoid being held liable under SOX if other companies have problems.

Executive Compensation Executive compensation based on –Free market – what competitors pay their executives; need to pay market price to attract good executives. –Individual and company performance. –Aligning interests of executives with shareholders in long-term value creation.

Executive Compensation cont. What makes up the compensation package? –Base salary – usually capped at $1M (amount IRS allows as tax-deductible). –Annual cash incentives – bonuses often based on meeting financial targets. –Long-term stock-based incentives – stock options, performance shares, restricted stock (see pages ). –Retirement plans. –Perquisites (“perks”) – extra “executive lifestyle” benefits (e.g., parking, financial services, use of corporate condo or Lakers tickets).

Criticisms of Executive Compensation Extraordinary payouts – see examples on page 607. Large amounts paid to executives who are new to the company. Lucrative golden handshakes given even if executive leaves under bad circumstances. Compensation committees made up of friends or others inclined to approve generous compensation packages. Executive compensation levels not in shareholders’ best interests. Stock option grants too lavish. Misuse of stock option grants (e.g., backdating).

Defenses of Executive Compensation Congress effectively imposed $1M limit on salary; led to widespread use of stock options to attract executives. Stock options became popular during time of long rises in stock market. Justified by shareholder gains. Must pay market value or will lose executives. In reality, most executives do not earn lucrative compensation packages.