Chapter 8 - Executive Compensation

Question 1

What is the role of compensation as a governance mechanism?

Answer 1

Aligns the interest of managers and owners through salaries, bonuses, and long term incentive compensation, such as stock options.

Question 2

What are the 3 roles of executive compensation?

Answer 2

1. Attract talent
2. Motivate
3. Retain Talent

Question 3

What is a potential disadvantage of shareholder pay?
What are the 2 disadvantages outcomes of poor pay arrangements?

Answer 3

Excess pay costs the shareholders.

If there is a poorly structured pay arrangement than it can:
1. Dilute incentives to serve shareholders
2. Distort incentives.

Question 4

What are the 4 considerations when forming compensation strategies?

Answer 4

1. Does management make a difference in performance
2. Does compensation make a difference in getting good management
3. What constitutes good performance
4. How much, if any, of management compensation should be at risk

Question 5

What are 2 different performance measurements to use to set the CEO pay?

Answer 5

Idea 1 - Company targets that trigger bonuses or stock rewards should be linked to shareholder return rather than accounting metrics like EPS because accounting metrics provide the wrong incentive for management to manage earnings. If they are beating their peer groups on total return, it is not something they can manipulate.

Idea 2 - Based on the success metrics of the company. Less concern with stock prices since that is to easy to play around with through buybacks as opposed to metrics like cash flow or profitability. The success of the company should be the hallmark of the CEO compensation

Question 6

What actually drives the compensation of a CEO/ What is the largest determinant?
- What are the statistics regarding this?

Answer 6

The compensation of the CEO is actually driven by the company size, since there is a 6 fold increase in company size led to 6 fold increase in pay between, thus company size is the largest determinant of the CEO pay level.

Question 7

What are the 2 competing theories of CEO pay? Describe

Answer 7

1. Optimal Contracting - Contends that CEO pay is awarded through an efficient process, driven by competitive market forces.
2. Rent Extraction - Belief that pay levels are the result of market failure, which has enabled CEO’s to exert influence over boards to extract compensation over and above what would be rewarded in the competitive process.

Question 8

What are the 4 central ideas of management compensation?
- Based on
-Avoids
- Underlying challenge

Answer 8

1. Management compensation must reward the current strong performance and simultaneously provide incentives for similar future results.
2. Structured in a manner such as to avoid premiums for average or poor performance
3. The justification of an expensive CEO package to the general public vis-a-vis the threat of losing an impressive CEO to another competing firm.
4. Challenge for the shareholders is finding the best deal for the shareholders

Question 9

Who sets the executive compensation?

Answer 9

Different per the company but there are three key players - Compensation consultants/committees, board of directors, and shareholders.

Question 10

What rights were granted to the shareholders under the 2010 DODD Frank Act

Answer 10

It is the say on pay, non binding idea that is a practice whereby shareholders are granted the right to vote on a company’s executive or director compensation program at the annual meeting.

Question 11

What is the role of the compensation committee and the board of directors in setting the executive compensation?

Is this process straight forward? What is the right amount to pay?

Answer 11

They approve the compensation program, which is assisted by the HR and third party compensation consultants, which should be a straight forward process, which should be the minimum amount it takes to attract and retain a qualified individual.

Question 12

What are 3 reasons to use the compensation consultants?

Answer 12

1. Establish external parity in CEO compensation
2. Provide both expertise and objectivity that might enhance the boards credibility with shareholders and other constituencies.
3. Might be subject to conflicts of interest if they provide other services to the company.

Question 13

Describe the compensation consultants and conflicts of interest. Is there a basis on their claims?

Answer 13

CEO pay is higher among companies that use a consultant, but evidence suggests that it is due to quality of the governance and not the consultant themselves. There is no evidence that conflicts influence pay levels, they do not very between companies that use dedicated compensation consultants and those in general HR consultants.

Question 14

How do boards determine the compensation?

What is the common practice?

Answer 14

Most boards will benchmark the CEO pay against a peer group of companies comparable in size, industry, and / or geography.

Cash compensation (Salaries + bonus) at the 50th percentile and long term pay at the 75th percentile

Question 15

What are the main potential drawbacks to benchmarking? Explain

Answer 15

Ratcheting effect - The median compensation tends to increase if all organizations seek to pay media or above, median will inevitably rise.

Question 16

What are 3 smaller potential drawbacks to benchmarking?

Answer 16

1. Based on size of the industry rather than value creation
2. Can lead to different pay packages, depending on the specific companies included in the peer group
3. Companies include unrelated firms in the peer groups, to increase the firms pay.

Question 17

What was Bizjak, Lemmon, and Naveen (2008) study?

What were the results in the study?
- Median and increases
- Short tenures
-Turnover Rates
- Poor governance

Answer 17

Studied whether firms selectively include companies in their peer group to inflate the CEO pay.

1. CEO’s paid below median receive larger increases than CEO’s above median
2. CEO’s with short tenure and better performance receive larger pay increases
3. CEO’s with larger pay increases face higher turnover rates
4. No evidence that large pay increase are associated with poor governance quality.

Peer groups are used to set competitive pays

Question 18

What was the Faulkenderand Yang (2010) study?

What was the result in the study?

Answer 18

Studied the impact of peer group selection on CEO compensation

Companies choose peers with above average CEO pay (controlling for all else). This effect is stronger in firms where CEO has more power (CEO is chairman or is long tenured) and where directors are busy serving on multiple boards.

Peer groups are selected to inflate pay

Question 19

What are the 6 components of the CEO pay structure?
What percentage of their salary is not their base salary?

Answer 19

1. Cash bonus
2. Stock options
3. Stocks
4. Base salary
5. Pension
6. Other perks

• 90% of a CEO’s compensation comes from things that are not their salary.

Question 20

What are the 4 components of the Executive Compensation?

Answer 20

1. Current or annual core compensation
2. Deferred Compensation: Equity Agreements
3. Perquisites (Perks)
   4, Clawback provisions

Question 21

What are the 5 types of deferred compensation: Equity Agreements

Answer 21

1. Non statutory stock options / stock options
2. Phantom Stock
3. Employee stock purchase gain
4. Stock appreciation
5. restricted stock plan

Question 22

What are the 2 components of the current or annual core compensation.

• Up to what percentage is exempt?

Answer 22

1. Annual base pay - Fixed element of annual cash compensation, only up to $1 million in fixed annual salary is exempt from a company’s tax liability.
2. Bonus

Question 23

What is a discretionary bonus?
What is a performance contingent bonus?
What its the predetermined allocation
What is the target plan

Answer 23

Awarded on an objective basis
Based on the attainment of specific performance criteria
Based on a fixed formula
Ties bonuses to executives performance

Question 24

What is the incentive plan success based on? Describe the three performance and their relative awards

Answer 24

• Proper alignment of the target performance with the payout
• Threshold (85-90% chance of achievement) award of 50%
• Target (60% chance of achievement) award of 100%
• Maximum (10% chance of achievement) award of 200%

Question 25

What is the role of long term compensation? - Mitigates - Is it substantial?

Answer 25

Long term incentives are added to the compensation mix to encourage executives to select long term investments that increase shareholder value It mitigates the tendency of a risk averse executive to reject risky investments, thus the long term compensation is substantial.

Question 26

What are stock options? What are restricted stock grants? What is exercise of stock grants? What is disposition? What is fair market value?

Answer 26

1. Stocks purchased at a designated price for a specific time 2. A company offers stock to employees with vesting and restrictions 3. Purchase of stock 4. Sale of stock 5. Average stock price on the exchange (maybe TSX)

Question 27

What are stock options?

Answer 27

Rights to buy shares in the future at a fixed exercise price, generally equal to stock price on the grant date. Typically vest evenly (annually over four years) and expire at the end of the term (generally 10 years)

Question 28

How do stock options work? What is vesting? What is maturity?

Answer 28

Right to purchase stock at a later date, and the strike price is set at the date of issuance How long until the option is yours How long do I have till I exercise my right to purchase.

Question 29

What are the two situations where the stock option increase in value? What does vesting requirements do?

Answer 29

Stock options increase in value as the stock price increases - long term investment Stock options increase in value with stock price volatility - taking risk Vesting requirements and options have deferred payoffs that encourage a focus on long term result

Question 30

What are the 4 variations in the stock option?

Answer 30

1. Premium option - Exercise price higher than current price. 2. Performance vested (Accounting based) - Accelerated vesting based on achieving accounting based targets 3. Performance vested (stock price based) - Accelerated vesting based on total stock price returns 4. Performance vested (non financial based) - Accelerated vesting based on strategic milestone (FDA Approval)

Question 31

What is the non statutory stock options? How are the taxes treated?

Answer 31

Company awards stock at a discounted price. Taxes paid on the difference between the discounted price and the fair market value at the time stock was granted

Question 32

What is restricted stock? - Outright -Awarded -Ownership - What happens if the executive leaves?

Answer 32

1. It is the outright grant of shares or stock units (RSU) that are restricted in transferability and are subject to vesting 2. At the market or discounted price 3. Ownership of stock is granted at a specified future date, often multiple years (vesting period) 4. Executives must sell the stock back to the company at the same price if they leave before vested

Question 33

What are stock appreciation rights? How is the bonus payment calculated? Are the executives permitted to keep the stock?

Answer 33

Similar to restricted stock, but the executive never has to exercise stock rights to receive income. Instead the company awards a bonus payment. Bonus payment is the difference in the stock price between the time the company granted the stock rights at fair market value to the end of the designation period. This arrangement permits the executive to keep the stock.

Question 34

What are phantom stock appreciation? What are the two conditions that will increase the value of the shares?

Answer 34

Bonus in the form of the equivalent of either the value of company shares or the increase in value over a period of time based on meeting two conditions. Conditions: 1. Executives must be employed for many years 2. Executives must retire from the company

Question 35

What are the employee stock purchase plans? - Set Aside - Companies establish

Answer 35

Executives may purchase stock after a specified time period. Executives set aside money through payroll deductions throughout this time, which is the offering period. May establish stock purchase plans on a tax qualified or non qualified basis.

Question 36

What are the restrictions on compensation? What does the stock ownership guidelines state?

Answer 36

Compensation programs might also be subjected to restrictions, like the stock ownership guidelines. Executive is required to own a minimum amount of company stock, generally expressed as a multiple of a base salary (five times)

Question 37

What do most CEO contracts have? What do the terms relate too? What is the downside of this?

Answer 37

A clause that stipulates the situations under which the CEO is considered to be in breach of contract Terms relate to a character of dishonourable acts, evidence of dishonesty, and other acts that are detrimental to the reputation of the company. The CEO can be removed for the violation of these terms, however the board and the company are required to fulfill the terms of the agreement often including a handsome severance payment if they decide to remove the CEO for reasons other than for cause

Question 38

What is the golden parachute concept?

Answer 38

It is the severance agreement that the CEO is entitled to additional compensation upon termination.

Question 39

What is the definition of a golden parachute?

Answer 39

Provide executives pay and benefits following termination due to ownership change or corporate takeover (merger or combining of two separate companies)

Question 40

What are the four advantages to executives and the company for having a golden parachute?

Answer 40

1. It makes it easier to hire a new CEO in a climate of corporate takeover, where one may lose ones job through no fault of their own. 2. Virtually eliminate an executive from making decisions to save his/her job at the expense of company welfare. 3.It gives chief executives an incentive to work toward the interest of the shareholder in case of a takeover threat 4. It increases the cost to the predator company

Question 41

What are the 5 disadvantages/critics of the golden parachute state?

Answer 41

1. The golden parachute is an inappropriate use of a company's money 2. The idea that many doubt that well paid CEO positions would go begging without the golden parachute. 3. Given the scale of a large takeover the cost of golden parachutes is unlikely to prevent a takeover. 4. It is not tied to the performance or takeover premium. 5. CEO's are already well compensated, and they are paid precisely to manage the company as best as they can for the benefit of, among others, the shareholders, even at some possible detriment to themselves.

Question 42

According to the research, what does the golden parachute increase, not influence, and motivate managers to do?

Answer 42

1. Golden parachutes increase the likelihood of an acquisition 2. Do not influence CEO incentives to negotiate better deal terms 3. Motivate managers to close deals but not necessarily negotiate the highest premium.

Question 43

What are platinum parachutes? Why are they awarded?

Answer 43

Lucrative awards that compensate departing executives with severance pay, continuation of company benefits, and stock options. They are awarded to avoid legal battle or critical press report.

Question 44

What is a claw back provision? What are they required under? Are claw back provisions becoming more or less common and explain.

Answer 44

Allow the board of directors to take back performance based compensation when performance goals were not achieved. Dodd-Frank act. They are becoming more common due to the increasing public scrutiny of executive compensation packages,

Question 45

What are the 6 common perquisites for CEO's?

Answer 45

1. Company car - Reserved parking, chauffeur service, car phone 2. Security Services - Home security 3. Loans at low or no interest rates - To keep interest aligned 4. Legal Service - Legal and financing counselling, estate planning, income tax preparation, financial seminars, personal liability insurance 5. Recreational facilities - Country club memberships, luncheon club membership, executive dining room 6. Travel Perks - Company plan, first class air travel, spouse travel.

Question 46

What is the relative trend regarding the perks?

Answer 46

Among the Fortune 500 about 85% offer perks to their CEO's. but they offer fewer perks than in the past. The percentage of companies offering 3 or more perks dropped from 60 to 30% in 2008, The percentage of companies dropping perks altogether increased 15% from 6% in 2008

Question 47

What is the compensation mix consideration?

Answer 47

Compensation risk affects how managers operate the firm. If there is not enough risk the manager will not put in effort, and if there is too much risk they will always avoid risky projects, we need to control the compensation risk, not eliminate it.

Question 48

What is the human nature regarding risk and how does this relate to the CEO?

Answer 48

We are risk averse individuals, and we trade risk and return. Thus to motivate managers at the lowest cost, designers of efficiency incentive compensation plans try to get the most motivation for a given amount of risk imposed. or equivalently the least risk for a given level of motivation.