Corporate Governance and

Performance Analysis

Lecture 5

Executive CompensationPrelude to Change

• Tech boom heightened competition for talent among cash-strapped start-ups

• Irrational exuberance

• Employee focus on ownership percentage

Business Practices Shaped by Boom Period

• Increased use of equity-based compensation, especially stock options

• Increase in overall pay packages

• Company funded (and forgiven) stock purchase loans

• Mega-grants and retention awards

• Stock option repricing

Abuses in Scandal Companies

• Exercise of options and sale of stock prior to stock decline

• Use of overvalued stock to repay personal loans

• Executive bonuses justified by improperly reported financials

• Use of “haircut” provisions to distribute deferred compensation prior to bankruptcy

SOX Act

• Prohibition on personal loans to executives and directors

• Accelerated public reporting of purchase or sale of stock

• Prohibition of trading during pension fund blackout period

Changes in Business Practice

• Equity compensation reduced• Shift away from stock option in favor of “full

value” awards-restricted stock• Movement to performance-based

compensation, especially with respect to annual bonuses and full-value awards

• Impose holding periods and share ownership guidelines

Old Accounting Treatment

• Time-vested options accounted for at “intrinsic value” (typically $0)

• Time-vested full value awards, accounted for at value of stock at date of grant, amortized over vesting period

• Variable accounting– Awards with performance base vesting

New Accounting Treatment

• Options and other appreciation awards accounted for at “fair value” using option pricing model

• Full value awards accounted for at value of stock at date of grant, amortized over vesting period

• No variable accounting

Emerging Grant practice

• Link compensation to performance measures proper for company and industry

• Avoid complete reliance on peer studies• Focus on overall compensation• More disclosure on payouts under all

scenarios

SOX Act

Disgorgement by CEO and CFO of bonus and incentive compensation received during 12 months prior to filing of a financial document that is later required to be restated due to noncompliance with financial reporting requirements due to misconduct