2. By: 1. Kenneth A. Kim John R. Nofsinger And 2. A. C. Fernando

3. Lecture 4

4.  Lecture Outline ◦ Problems related with incentive based compensation. ◦ Normal perception about how stock market works. ◦ Basic problem related with executive stock options. ◦ Expensive executive options- An easy solution. ◦ Other compensation to management. ◦ CEO club membership qualifications. ◦ Retirement (or resignation compensation). ◦ Crime and punishment. ◦ International Perspective

5. Potential “Incentive” Problems with Incentive based Compensation  Dilution can be disgustingly costly over the long term. Many companies routinely issue stock options and shares, which can easily dilute shareholders by 10% over a 10-year period.  Stock option is only affected by price appreciation. Therefore, the CEO might forego increasing dividends in favour of using the cash to try to increase the stock price.

6.  CEO is more likely to go for the risky business to increase the stock prices.  Stock options lose some incentive for the CEO if the stock price falls too far below the strike price.  Price manipulation can be used by the CEOs for their benefits.

7.  Example: Management Behaviour at Xerox ◦ Xerox management improperly accelerated leasing operations revenue from 1997 to 2000. ◦ The accounting manoeuvring increased revenue by $3 billion and profit by £1.5 billion over that period. ◦ That’s wasn’t the actual financial position of the company. ◦ This artificial profit helped drive the stock price from $13 at the end of 1996 to more than $60 in 1999.

8.  Cont:- ◦ Xerox CEO Paul Allaire sold stocks and profited by $16 million. ◦ In April 2002, Xerox admitted to the SEC that they improperly recorded the earnings and agree to pay a $10 million fine. ◦ Obviously, that fine was paid by the firm. ◦ So, Xerox management earned millions of dollars by doing accounting manoeuvrings.

9.  Cont:- ◦ The stock price fell to less than $10 per share. ◦ So, who are the ultimate loser? ◦ The stockholders……

11.  Incentive Stock Options are generally not tax deductible for companies. Incentive Stock Options (ISOs) are often a key component of option plans issued by companies to employees. If a company and employee follow basic ISO rules, the company CANNOT claim a corporate income tax deduction at any time for the ultimate value given to an employee.  Economy plays a vital role in controlling the stock prices-CEOs always keep this in mind.

12.  Normal Perception about how stock market works ◦ Stock market boom is the reflection of the progressive economy. ◦ As the economy improves, companies make more money and their stock value rises in its accordance. ◦ In fact, the only real force that ultimately makes the stock market or any market rise or fall, over the longer term is simply changes in the quantity of money and the volume of spending in the economy.

13.  Stocks rise when there is inflation of money supply (i.e. more money in the economy and in the markets).  Similarly, stock markets can fall by having decline in the quantity of money and spending.

14.  Another problem with Executive Stock Options ◦ Aligning managers incentives with the stockholders goals constitute a major problem ◦ Employees will work their best unless the stock prices are higher than the strike prices. ◦ But if the stock prices get down than the strike prices (may be because of poor economic condition), its very hard to re-establish the motivational level of executives. ◦ As a result, we’ll see again the race between the owner and controller and no aligned goals.

15. Expensive Executive Options: An Easy Solution  Treat it as an expense, should appear in the financial statements.  Granted options must now be deducted from the firms reported income.  Three advantages ◦ Would identify that there is a cost to the firm for issuing options. ◦ It may reduce the amount of options executives receive and thereby reduce their total compensation. ◦ Contribute to corporate scandals.

16.  What happens to these compensation systems if options are expensed?  The reduction in reporting earning may cause the companies to curtail option programs. This could inhibit the growth of new companies  It could even have an impact on the economy.

17. Other Compensation  CEO’s club membership ◦ CEO Club Membership Benefits  Free access to an online forum allowing executives to post questions and share insights and resources on strategic business issues.  Explore collaboration and business opportunities with other senior executives  Find job candidates or look for the next career move.  CEO Club members receive free access to quarterly executive seminars that address strategic management and leadership issues.

18. ◦ CEO Club Membership Qualifications  The membership is limited to senior executives including the following level of managers:  Board of Directors  Chief Executive Officer (CEO)  Chief Operation Officer (COO)  Chief Finance Officer (CFO)  Chief Marketing Officer (CMO)  Chief Information Officer (CIO)  Chief Technology Officer (CTO)  Chief People Officer (CPO)  Vice Presidents (VPs)  Directors

19.  Retirement (or resignation) compensation ◦ E.g. Chairman of FleetBoston, Terrence Murray, receives a pension of $5.8 million per year.  Executives receive millions of dollars as company loans at extremely low interest rates, sometimes even interest free.

20. Crime and Punishment  Increase the penalty for managers ◦ E.g. In July 2005, Bernie Ebbers, founder and former chief executive of WorldCom, was sentenced to 25 years in prison for his involvement in WorldCom’s $11 billion accounting fraud.

21.  International Perspective- CEO Compensation around the world: ◦ Paying the top officer in the company with long- term incentive awards is most common in the US. ◦ Normally, compensation of CEOs around the world split into three categories  Fixed pay (base salary and benefits)  Variable pay (incentive-type instruments like stock options)  Perquisites (addition to salary etc)

22. ◦ 63%, on average, of a US CEO’s pay is variable in nature. ◦ Singapore and Canada CEOs have 59% and 52%, on average, the variable pay respectively. ◦ In China (except Singapore), 79% of the CEOs compensation is fixed. ◦ India, one of the five countries with less than 50% composition is fixed pay, pays an extraordinary 38% of total compensation in perquisites.

24. Summary  Main problem in the corporations are separation of ownership and control.  Managers are supposed to work for the best interest of the shareholders.  Managers try to take the advantage of their control power.  Stocks and options benefits can’t guaranteed to reduce the conflict.