Transcript Executive Incentives

By: 1. Kenneth A. Kim
John R. Nofsinger
And
2. A. C. Fernando
Lecture 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
Potential “Incentive” Problems with Incentive
based Compensation
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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.
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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.

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.

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.
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Cont:◦ The stock price fell to less than $10 per share.
◦ So, who are the ultimate loser?
◦ The stockholders……
70
Xerox executives sell $48 million worth of
options and $31 million in other stock.
50
40
30
20
10
period of phony profits
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
0
Jan-90
Xerox Stock Price ($)
60
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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.

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.

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.

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.
Expensive Executive Options: An Easy Solution
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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.
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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.
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.
◦ CEO Club Membership Qualifications
 The membership is limited to senior executives
including the following level of managers:
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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
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Retirement (or resignation) compensation
◦ E.g. Chairman of FleetBoston, Terrence Murray,
receives a pension of $5.8 million per year.
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Executives receive millions of dollars as
company loans at extremely low interest
rates, sometimes even interest free.
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.

International Perspective- CEO Compensation
around the world:
◦ Paying the top officer in the company with longterm 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)
◦ 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.
Perquisites
Variable Pay
Canada
Brazil
Belgium
Australia
Venezuela
United States
United Kingdom
Taiwan
Switzerland
Sweden
Spain
South Korea
Singapore
Netherlands
Mexico
Japan
Italy
India
Germany
France
China-Shanghai
China-Hong Kong
Fixed Pay
Argentina
Percent of Total Pay
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Summary
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Main problem in the corporations are separation of
ownership and control.
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Managers are supposed to work for the best interest
of the shareholders.
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Managers try to take the advantage of their control
power.
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Stocks and options benefits can’t guaranteed to
reduce the conflict.