Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

If the facts don’t fit, you must remit. That seems to be the view of an increasing number of companies, as they have adopted provisions requiring repayment of executive compensation found to have been based on incorrect financial statements.

The concept of compensation clawbacks was actually built into the Sarbanes Oxley Act. Section 304 requires CFOs and CEOs to reimburse their companies for incentive compensation and stock sales profits if the financial statements for that year are restated and the restatement is due to “misconduct.”

According to a June 2008 report (here) from the Corporate Library, an increasing number of companies have adopted their own clawback provisions, “either as part of the rules of an incentive plan, as governance policy, or simply as a board statement of intent.”

In its prior 2003 review, the Corporate Library had found that just 14 companies had adopted clawback provisions. But in its June 2008 survey, the report found that 295 of the 2,121 companies examined had “disclosed the adoption and implementation of a clawback provision of one kind or another.”

The survey found that the provisions vary from company to company, but could generally be classified as either “performance based” (if the provision applies to all executives who received an incentive payment of some kind based on incorrect financial) and “fraud based” (if it applies only to those executives who have engaged in fraudulent activity or misconduct that has caused a restatement). The survey found that 44.4% of the clawback provisions were “fraud-based” and 39% were “performance based.” An additional 16.6% of the provisions could not be classified.

The report cites several examples of the clawback provisions and even notes one example, involving Warnaco, in which a clawback has already occurred. The company reported in this year’s proxy statement (here, see page 21) that its compensation committee had cut the incentive pay for three executives in 2006 by a total of $120,000. The reduction occurred after the company restated its 2005 financial results due to certain accounting errors and irregularities.

These kinds of provisions have the support of various governance groups. As the June 8, 2008 New York Times stated in an article discussing the Corporate Library report (here), “why should executives keep compensation if it is discovered later that benchmarks were unmet?”

Not only do these kinds of provisions address basic principles of pay equity; they may also have a deterrent effect as well. Indeed, a June 4, 2008 CFO.com article entitled “Clawbacks Claw Their Way Into Corporate Strategy” (here), comments that “the emergence of clawbacks could be one factor in the recent decline in the number of financial restatements.” (For further background regarding the declining number of restatements, refer here.)

The possibility of a compensation clawback is not the only consequences that could affect executives at restating companies. A March 2008 study by Juan Manual Sanchez and Adi Masli of the University of Arkansas Sam M. Walton School of Business, Denton Collins of Texas Tech University, and Austin Reitenga of the University of Alabama entitled “Earnings Restatements, the Sarbanes-Oxley Act and the Disciplining of Chief Financial Officers” (here) found not only that companies restating earnings “have higher rates of involuntary CFO turnover,” but that CFOs of restating companies “face stiff labor market penalties.”

The authors looked at 167 restating companies and then matched them with a control company of comparable industry, size and age. The authors looked for instances where CFOs left the restating company within two years of the restatement. They then tracked the CFOs for four years to determine their subsequent employment.

The authors found “higher CFO turnover rates following restatements in both the pre- and post-SOX periods, which implies that governance mechanisms served to identify and discipline CFOs implicated in the restatements in both periods.”

The authors also found that “former CFOs of restatement firms are less likely to find a position with a job title that is comparable to their prior CFO position, less likely to find employment in a publicly traded company, or less likely to find a comparable position in a public firm.”

Finally, the authors found that “executives terminated in the post-SOX period appear to suffer greater reputational/labor-market penalties compared to the pre-SOX period, suggesting that firms are less willing in the post-SOX period to hire a former CFO with a tarnished reputation. This appears to be consistent with the intent of the legislation to increase executive accountability.”

With all the disincentives for bad behavior, one might optimistically hope that the sins of the past will not recur. Unfortunately, certain aspects of the current credit crisis arguably belie that hope. Nevertheless, one useful takeaway from this analysis is that the presence of corporate clawbacks could provide a deterrent for bad behavior, and could be a positive risk assessment factor.

Hat tip to the CFO.com for the reference to the academics research paper about career consequences for CFOs of restating companies.

Update on a Backdating Settlement That Went Awry: In a prior post (here), I discussed the recent opinion in which Judge Alsup used harsh language in rejecting the Zoran options backdating-related derivative lawsuit settlement. Among other things, Judge Zoran questioned the parties’ representations of the settlement’s value, and questioned the absence of any cash payment to the corporation.

According to a June 9, 2008 Forbes article entitled “Fee Fixers” (here), “it turns out that Alsup was on to something.” According to the article, on May 29, the lawyers resubmitted the settlement, but this time, the settlement included $3.4 million in cash, $3 million from Zoran’s insurance company and $395,000 from Zoran’s CEO and another executive. The article noted that “for having done such a good job,” the plaintiffs’ lawyers “have requested $1.5 million in fees and expenses, $300,000 more that the first time around.”

According to the company’s June 12, 2008 press release (here), Judge Alsup has granted preliminary approval to the settlement. The rejiggered settlement may have passed judicial muster. But let’s be explicit about what the sequence of events really consists of.  Basically, and other than with respect to the $395,000 payment, the insurance company is being asked to pony up the additional $3 million, and undoubtedly will also be called upon to pay the additional increment in the plaintiffs’ fees, as well as all of the additional defense expense incurred after the first settlement cratered. Perhaps there is nothing remarkable in all of this. But at some point, you really do start to wonder about the social utility of all of this activity. It is enough to make anybody cynical.

Hat tip to the 10b5-Daily (here) for the link to the Forbes article. Special thanks to Zusha Ellinson of The Recorder for the link to the Zoran press release.

• Print
• Comments
• Trackbacks

One of the legacies from the era of the corporate scandals is the lasting image of certain corporate leaders as “imperial CEOs” (refer here) – that is, as greedy, power hungry overlords who exploited their companies to their own enrichment and to the shareholders’ detriment. Excessive CEO pay remains a widely perceived marker for poor corporate governance and even for securities litigation risk. But recent scholarly analysis of senior corporate executive compensation suggests that outsized CEO pay may not only indicated weak governance, but may also be associated with company underperformance.

In a paper most recently revised in May 2008 entitled “CEO Centrality” (here), Lucian Bebchuk of Harvard, Martijn Creamers of Yale and Urs Peyer of INSEAD “examine the relationship between CEO centrality – the relative performance of the CEO within the top executive team in terms of ability, contribution and power – and the value, performance and behavior of public firms.”

In order to measure so-called CEO centrality, the authors used as a measure “the CEOs pay slice” (CPS) – that is, the “percentage of the aggregate compensation awareded to the firm’s top five executives captured by the CEO.” The authors hypothesized that higher CPS “will tend to reflect a greater relative performance of the CEO within the top executive team.”

In order to compute each CEO’s pay slice, the authors used data from Compustat’s ExecuComp databse from 1993-2004. The authors attempted to control for some factors that could influence the CPS, including the CEO’s tenure, the CEO's status as a large owner or founder, and the size of the company’s aggregate top-five compensation relative to peers.

The authors concluded that CEO centrality has a “rich set of relations with firms’ behavior and performance.” Specifically, the authors concluded that CEO centrality is correlated with

(i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO’s receiving a “lucky” option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, and (vi) lower firm-specific variability of stock returns over time.

The apparent correlation of outsized CEO compensation and “firms’ behavior and performance” tends to corroborate the view expressed, for example, by the Corporate Library (here), that “CEO compensation practices that are poorly aligned with shareholder interests remain a powerful indicator of potential securities litigation.”

While the authors’ conclusions seem intuitively correct to me, I do wonder whether certain aspects of the analysis are a refection of the time spread of the data used. The database is heavily weighted to the 90s and to the era before the corporate scandals and before the recent increased focus on corporate governance and on executive compensation. It might be interesting for the authors to perform the same analysis but to use only data from the five years after the enactment of the Sarbanes-Oxley Act. Perhaps the conclusions would be the same, but I do wonder whether or not the correlations would be as strong for the more recent years.

CEO compensation practices obviously are critical, but CFO compensation practices may also be significant, as I discussed on a recent post (here).

Countrwide Derivative Lawsuit to Proceed: According to a May 15, 2008 New York Times article (here), Judge Mariana Pfaelzer of the Federal District Court in Los Angeles has denied the defendants' motion to dismiss the shareholders' derivative lawsuit that has been filed against Countrywide Financial, as nominal defendant, and certain of its directors and officers. (A description of the lawsuit can be found here.)

The opinion is not yet posted on PACER so I have not had a chance to review it yet, but from the description in the times it sounds like it could be worth reading. Among other things, Judge Pfaelzer said, with respect to Angelo Mozillo's frequently revised 10b5-1 plan, "Mozillo's actions appear to defeat the very purpose of the 10b5-1 plans."  I will try to add a link to the opinion here when I can get my hands on a copy. (I would be grateful if any reader with access to the opinion could forward me a copy.)

UPDATE: A copy of the court's May 14, 2008 order in the Countrywide Derivative case can be found here.

• Print
• Comments
• Trackbacks (1)

Commentators have long focused on CEO compensation as a leading corporate governance concern. Indeed, the Corporate Library has even suggested (here) that CEO compensation practices that “are poorly-aligned with shareholder interests” are “a powerful indicator of potential securities litigation.” While CEO compensation unquestionably is an important issue, academic research recently published by three Michigan State professors suggests that the CFO’s compensation may be even more important than that of the CEO.

In an April 15, 2008 paper entitled “CFOs and CEOs: Who Has the Most Influence on Earnings Management”(here),  John Jiang, Kathy Petroni and Isabel Yanan Wang report on their investigation “whether CFOs’ equity incentives are associated with earnings management, and whether earnings management is more sensitive to CFOs’ equity incentives than to those of the CEOs.” Prior research has focused primarily on CEOs’ compensation, based on conventional wisdom that because CEOs’ equity compensation was greater than that of CFOs, it should be more influential. In addition, it was generally presumed that because the CFO is the CEO’s agent and the CEO has the power to replace the CFO, “CFOs do not respond directly to their own equity incentives but only to the wishes of their CEO.”

Contrary to these prior assumptions, the authors posited that CFOs equity incentives “may have a stronger impact on earnings management than those of the CEOs, because CFOs have the ultimate responsibility for the management of the financial system, including the preparation of the financial report.”

The authors used a database for the S&P 1500 for the period 1993 through 2006, representing 17,542 firm years of compensation data. The authors examined the CFOs’ equity incentives in three settings where prior research had demonstrated an association between CEOs’ equity incentives and earnings management, namely (1) accruals; (2) the likelihood of beating earnings benchmarks; and (3) the likelihood of restatements.

Based on their analysis, the authors conclude that “because CFOs are primarily responsible for preparing the financial statements, the impact of their equity incentives on financial reporting dominates the impact of the CEOs’ equity incentives.” Indeed, the authors conclude that “earnings management is a key tool that the CFO can expertly use to respond to equity incentives.”

Although the paper has a number of interesting insights, perhaps the most interesting is the authors’ analysis of the way that CFOs respond to the prospect of option grants. The authors found that the occurrence of the grant of options to the CFO was positively correlated to the occurrence of an earnings miss (which would lower the option strike price and thus make the grant potentially more valuable). The authors further concluded that “the likelihood of missing earnings benchmarks is higher for stock options granted to the CFO relative to those granted to the CEO and in some cases significantly so.”

One of the fundamental tenets for the compensation of corporate executives is that the executives’ interests should be aligned with those of the shareholders, and that the best way to achieve alignment is through equity-based compensation. The authors’ research suggests, however, that equity-based compensation may not create alignment, but rather motivates earnings management. Indeed, the authors’ research could be read to suggest that the equity-based compensation could create incentives that are contrary to shareholders’ interests, because shareholders obviously have no interest, for example, in engineered misses of earnings estimates.

The authors do conclude that their research underscores the importance of the SEC’s recently adopted provisions requiring disclosure of CFO compensation. This disclosure, the authors state, “should be relevant to users of financial statements in evaluating the quality of firms’ financial reporting.”

Among those to whom the CFO compensation information could be of interest are D&O underwriters. While the authors’ research does not directly make the connection between CFO equity compensation and the incidence of securities lawsuits, the link the authors do establish between CFO equity incentive compensation and earnings management should be sufficient to suggest the relevance of CFO equity compensation for D&O underwriting purposes. If, as the Corporate Library proposes, CEO compensation is an important indicator of securities litigation susceptibility, then the research of these three Michigan State professors could be interpreted to suggest that CFO compensation is also an important indicator, perhaps even more so.

Hat tip to the CFO Blog (here) for the link to the academic research paper.

For Better or Worse – Unless You Wind Up in Jail: This blog does not ordinarily comment on domestic relations issues, but we did fund it noteworthy that, according to news reports (here), former Tyco CEO Dennis Kozlowski was about to reach terms for his divorce from his wife, the former Karen Mayo. Mayo is the former waitress whom Kozlowski married in 2001, and whose $2 million Roman-themed 40^th birthday party on Sardinia that same year ultimately proved to be a key component of Kozlowski’s later criminal trial.

According to news reports, Mayo had request that the couple’s assets be split equally and she also sought alimony. The news reports do not disclose whether Mayo will receive a portion of the $1/day Kozlowski now reportedly receives “mopping floors or slinging hash” to fellow inmates at the New York correctional facility where he is serving a term of between eight years, four months and twenty-five years.

• Print
• Comments
• Trackbacks

In a partial but significant victory in the New York Supreme Court Appellate Division, former NYSE Chairman Richard Grasso may have accomplished just enough to be able to keep his infamous NYSE pay package. In April 2004, Eliot Spitzer, then New York's Attorney General, sued Grasso to compel him to return the bulk of his nearly $190 million deferred compensation and pension package. Spitzer alleged in the Complaint (here) that the pay package was "objectively unreasonable" under New York law governing nonprofit institutions - the NYSE was a nonprofit institution while Grasso was its Chair - and that Grasso had improperly influenced or misled the NYSE's board of directors to obtain their approval.

In an October 2006 ruling, New York Supreme Court Judge Charles Ramos entered partial summary judgment against Grasso, holding that Grasso had breached his fiduciary duty and that Grasso must return almost $100 million. A copy of Judge Ramos's opinion can be found here. Grasso appealed from this ruling as well as prior rulings in which Judge Ramos had permitted the claims to proceed.

A May 8, 2007 opinion of the New York Supreme Court Appellate Division (here) reversed an earlier ruling of Judge Ramos (here), and granted Grasso's motion to dismiss the first, fourth, fifth and sixth causes of action against him. Each of the dismissed counts were ones that Spitzer had alleged that New York's Attorney General had an implied right of action to pursue under the states Not-for Profit Corporation law. The appellate court held, however, that "these four causes of action are not within the scope of the Attorney General's authority." The appellate court contrasted these four claims with the two claims against Grasso that were not dismissed; the other two claims were based upon specific statutory provisions granting the Attorney General the right to pursue a cause of action. In essence, the appellate court held that the Attorney General is not "authorized to bring causes of action against directors and officers of not-for-profit corporations other than the causes of action the Legislature expressly authorized the Attorney General to bring."

Even though two of the Attorney General's six causes of action against Grasso remain pending, this appellate decision represents a significant victory for Grasso and may ultimately allow him to prevail. Under the two remaining causes of action, unlike the four that were dismissed, the Attorney General must prove both that the payments were "unlawful" and that Grasso knew of the "unlawfulness." Whether or not the Attorney General can prove the unlawfulness of Grasso's pay package, proving that Grasso knew of the "unlawfulness" will be a difficult and perhaps impossible task.

With Eliot Spitzer now occupying the New York Governor's Mansion, the decision whether or not to proceed will now fall to New York's new Attorney General, Andrew Cuomo. Cuomo of course has nothing vested in the case, and he must now decide whether it is in New York's interest to try to overcome the obstacles and to try to compel Grasso to repay his compensation. According to AP (here), a spokeperson for Spitzer said the "state was expected to appeal." The same article quotes Spitzer as saying "This was just a technical issue related to some of the counts and was not the subject of the summary judgment we won." Well, maybe...

Grasso has made it clear that he intends to fight, and he has already expended a significant amount of his fortune fighting the case, as noted in a prior D & O Diary post (here, replete with quotations from Bleak House).

Because the appellate decision deals only with the Attorney General's authority to pursue supposedly implied causes of action under New York's Not-for-Profit Corporation law, it is unlikely to have any significant impact on other efforts to recoup allegedly excessive executive compensation.

Hat tip to the WSJ.com Law Blog (here) for the link the the appellate decision. A May 9, 2007 Wall Street Journal article discussing the decision can be found here (subscription required). A very detailed May 9, 2007 New York Law Journal article discussing the decision can be found here.

ISS Webcast: Adam Savett of ISS (and of the Securities Litigation Watch blog) will be hosting a webcast at 9:30 am on Wednesday May 9, 2007 on the topic Accountability Goes Global: International Investors and U.S. Securities Class Actions. Details about the webcast can be found here. Some of the preliminary findings to be discused are reviewed here.

• Print
• Comments (1)
• Trackbacks

It is now a well-established part of the mythology of American capitalism that Warren Buffett still lives in the same modest brick colonial in Omaha, pictured above, that he bought in 1958 for $31,000. (According to Forbes magazine's annual survey of billionaires' houses, here, Buffett's home had a 2003 tax valuation of $700,000.) Intuitively, we believe that the relative modesty of Buffett's home tells us something about his values and priorities, just as we all probably make certain assumptions about the values and priorities of the occupants of the truly execrable miniature Versailles mansions that have sprouted in recent years on the far-flung fringes of most American cities --even Cleveland, for God's sake!

In one of the more interesting and entertaining articles I have read in a long time, Crocker Liu of the Arizona State University Business School and David Yermack of N.Y.U. Business School take a look at what else the size and valuation of CEOs' homes might tell us. In their March 2007 article entitled "Where Are The Shareholders' Mansions? CEOs' Home Purchases, Stock Sales, and Company Performance" (here), the authors' "central research question concerns the association between CEO real estate purchases and subsequent performance of their company."

The authors developed their hypotheses by questioning whether a CEO's home purchase more nearly indicates the CEO's commitment to their company and its community, or rather represents the CEO's "entrenchment," particularly if the CEO is unconcerned about liquidating their assets (especially their holdings in company shares) and investing in an expensive home so as to provide "a public signal about the executive's status and security."

In order to determine which hypothesis is accurate, the authors undertook some rather creative detective work to identify the homes of the CEOs of the S & P 500 companies (including, among other things, each home's location, size, valuation, date of acquisition, and method of financing). The authors ultimately were able to identify the homes of 488 of the CEOs, 164 of which the CEOs had acquired after taking office.

What the authors found out about the CEOs' homes is fascinating. The median CEOs' home is more than 5,600 square feet, and sits on over one and a quarter acres. The median 2006 market valuation of the CEOs' homes is $2.7 million (although this may be understated because some of the homes are sufficiently unique that there are no ready market valuations). 12% of CEOs' homes are on the waterfront, and 8.5% are on golf courses. The median distance from the office for CEOs' homes is 12.5 miles, but 16 of the CEOs live more than 1,000 miles from their company headquarters and another 16 live between 250 and 1,000 miles from their office.

With respect to the question about the correlation between the CEO's home purchase and company performance, the authors found that when a CEO buys a home, "future company performance is inversely related to the CEO's liquidation of company shares and options" to finance the transaction, even if the stock sales are small relative to the CEO's holdings. The authors also found that "future performance deteriorates when CEOs acquire extremely large or costly mansions or estates," regardless of the method of financing. The authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

The authors' assessment of this finding is that the CEO who purchases his or her home without selling shares is perhaps signaling their commitment to the company and expectation of future stock returns. The CEO who liquidates his or her shares to finance their home purchase , or buys a very expensive home, is signaling his or her perception of his or her status and security, and therefore the purchase represents a proxy for CEO "entrenchment."

The authors contend that these facts suggest an investment strategy, essentially shorting the shares of companies whose CEOs who acquire very large and expensive homes, but maintaining long positions on the companies whose CEOs acquired their homes without selling company shares. According to the authors, both ends of this strategy would substantially outperform the companies taken as a whole.

I find the authors' work intriguing, but I wonder whether the apparent link between the CEO's home valuation and corporate performance might not be a manifestation of what a former colleague of mine poetically calls "multicollinearity." That is, is the inverse correlation between CEO home valuation and corporate performance simply the quantification of another phenomenon - for example, the level of CEO compensation?

For the record, Buffett's home was not among the houses the authors studied, since Berkshire Hathaway inexplicably is not a part of the S & P 500. The authors' data set also does not include Bill Gates' $140 million, 66,000 square foot home, since he is no longer the CEO of Microsoft. Steve Ballmer's $8 million, 4,100 square foot home was included, however.

I am hoping that the authors' next article will compare the valuations of CEOs homes to those of the leading securities class action plaintiffs' lawyers. I suspect it would provide even more interesting analysis.

One of the Internet tools the authors used is the website, Zillow.com (here). If you have never visited the site, drop what you are doing immediately and go there. Just be prepared to spend the next few hours figuring out how much you neighbors', friends', and acquaintances' houses are valued for. Unless you really don't find things like that interesting at all. (Right...) Coincidentally, the April 4, 2007 Wall Street Journal reports (here, subscription required) that Zillow.com CEO Richard Barton is currently attempting to sell his Seattle home for $2.6 million (marked down from the intial asking price of of $3.475 million).

Special thanks to an alert reader (who prefers anonymity) for the link to the article.

Adults Only: When my oldest daughter was eight years old, she expressed an interest in reading The Hunchback of Notre Dame. (For reasons that no one who has actually read the book could possibly explain or understand, Disney had just released a childrens' cartoon movie based on the book.) I told her that I did not believe the book was appropriate for children. She of course asked why, and I told her that the book deals with "adult themes." She cocked her head at me and squinted her eyes and said, "You mean like real estate?"

Yes, like real estate. Exactly.

• Print
• Comments
• Trackbacks

Eliot Spitzer sued former NYSE Chairman and CEO Richard Grasso to compel him to return the bulk of his nearly $190 deferred compensation and pension package, alleging that the pay package was "objectively unreasonable" under New York law governing nonprofit institutions and that Grasso had improperly influenced or misled the NYSE's board directors to obtain their approval of the package. (The NYSE was a nonprofit institution while Grasso served as its Chair.) A copy of the complaint against Grasso can be found here.

Spitzer may have moved on the New York governor's mansion (refer here), but the case lives on, as highly contested cases will do. The case is currently on appeal, as Grasso challenges the entry of partial summary judgment against him by New York Supreme Court Justice Charles Ramos. Justice Ramos ruled in October 2006 that Grasso had breached his fiduciary duty and that Grasso must return almost $100 million. A copy of Justice Ramos's opinion can be found here.

Litigation at this level is expensive, but the magnitude of the expense involved may exceed even the inflated standards of our age. In a January 17, 2007 interview reported on Bloomberg.com (here), Grasso said that the "costs of all sides involved...may have exceeded $100 million," which the article notes is an amount almost equal to the amount the New York Attorney General is seeking. Grasso is quoted as saying, "I would not be surprised if the legal bill were in excess of $100 million." Grasso added that "This lawsuit is about honor. It is not about money any more."

Indeed. It is always about honor. But the money does play a role, however slight it may concern Grasso, and unless the goal of the lawsuit is a massive wealth transfer to the legal community, the expense apparently involved does raise certain questions.

Of course, Grasso's legal fee estimate may or not bear any relation to reality. Perhaps to a man accustomed to astronomical dollar figures, a number like $100 million is simply a proxy for a number of a very large size, sort of like the biblical author used the phrase 40 days and 40 nights. Grasso is also obviously motivated to characterize the lawsuit in a particular way, and so has every incentive to portray the lawsuit as excessive or even counterproductive.

But there unquestionably is something arresting about Grasso's estimate. The prospect that the lawsuit might consume in fees as much as the case ultimately is worth brings to mind the litigation travails of another Richard, Richard Carstone, who exhausted himself pursuing his interests in the matter of Jarndyce and Jarndyce in Dickens' novel, Bleak House. Perhaps the comparison between the two cases is not entirely apt, but there is a familiar resonance surrounding the magnitude of the fees and their relation to the matters in dispute.

The following excerpt from the novel (drawn from this source) captures the moment when the parties found the case to be "over" - not due to resolution on the merits, but because of the cumulative effect of the lawyers' fees (the excerpt begins with the words of Mr. Kenge, an attorney):

"For many years, the--a--I would say the flower of the bar, and the--a--I would presume to add, the matured autumnal fruits of the woolsack--have been lavished upon Jarndyce and Jarndyce. If the public have the benefit, and if the country have the adornment, of this great grasp, it must be paid for in money or money's worth, sir."

"Mr. Kenge," said Allan, appearing enlightened all in a moment. "Excuse me, our time presses. Do I understand that the whole estate is found to have been absorbed in costs?"

"Hem! I believe so," returned Mr. Kenge. "Mr. Vholes, what do YOU say?"

"I believe so," said Mr. Vholes.

"And that thus the suit lapses and melts away?"

"Probably," returned Mr. Kenge.

"Mr. Vholes?"

"Probably," said Mr. Vholes.

"My dearest life," whispered Allan, "this will break Richard's heart!"

• Print
• Comments
• Trackbacks

There is no particular reason why I should bestir myself to defend ousted Home Depot CEO Robert Nardelli: He certainly bagged sufficient swag to soften the blows of even his most outraged attacker. Yet I think it is important to incorporate into the modern morality play that his departure has become a fair recognition that by some measures his tenure as Home Depot's CEO was successful. From 2000 (when Nardelli joined the company) to 2005, Home Depot's revenue nearly doubled, from $45.7 billion to $81.5 billion, and during that same period Home Depot's profit increased, from $2.6 billion to $5.8 billion. Dividends quintupled. The company's return on capital increased almost 20 percent, a full 10 percentage points above its cost of capital.

Nevertheless, the consensus view seems to be that his ouster is a victory for shareholders, and that they have shareholder activists to thank. A typical example is the January 5, 2007 New York Times article entitled "Gadflies Get Respect and Not Just at Home Depot" (here), which states that "shareholder activists could claim one of their biggest prizes yet when Home Depot announced the resignation of its chairman and chief executive." The article also notes that since July, activists have also successfully pushed out the CEO's at Pfizer and Sovereign Bank.

In touting Nardelli's ouster as a shareholder activist success story, the Times article note that he had long been "a target of shareholder ire for his large compensation and the company's flagging share price." It is this latter point - Home Depot's flagging share price - that really seems to be at the heart of Nardelli's problems. A January 3, 2007 Fortune.com article entitled "Nardelli's Downfall: It's All About the Stock" (here) makes the connection explicit. Gretchen Morgenstern made the same point in her January 4, 2007 New York Times article entitled "A Warning Shot By Investors to Board and Chiefs" (here, subscription required), in which she says that Nardelli's compensation was "completely at odds with the dismal performance of Home Depot stock on his watch."

One question that needs to be asked is how much of what happened to Home Depot's share price had to do with Nardelli and how much it had to do with where the share price was when Nardelli took over. As PointofLaw.com points out (here), Home Depot's share price was already at stratospheric levels when Nardelli arrived.

But the more troublesome aspect of the criticisms about Home Depot's share price is the clear implication that Nardelli would still have a job (although he would be $210 million poorer) if he had managed to get the share price to go up. It used to be the conventional wisdom that the market determined a company's share price, not the CEO. Moreover, it has not been that long since corporate America faced a series of crises and scandals because too many CEOs seemed to think it was their job to engineer their company's share price rather than to run their company. Corporate activists may be congratulating themselves for their "victory" at Home Depot, but they should be very careful about the lesson here. The danger, as pointed out on the ContrarianEdge blog (here) is that "the ousting of Bob Nardelli sent a wrong message to America's CEOs : it taught them an incorrect lesson - manage the stock, not the company."

No one (at least not me) is going to defend the size of Nardelli's pay package. But as Alan Sloan points out in his January 4, 2007 Washington Post column "Don't Blame Nardelli" (here), the problem isn't Nardelli, it is "the contract that Home Depot's Board gave him." Home Depot's board comes in lot of criticism over Nardelli's compensation. A lot of other people also seem to want to blame the Home Depot board for the whole mess (see here).

Blaming directors for excessive CEO compensation has been a fruitful source of shareholder litigation in recent years. For example, shareholders sued the Disney Board for the $140 million severance paid to departing President Michael Ovitz. And the NYSE's Board faces litigation for the $190 million pay package paid to departed CEO Richard Grasso. The names Disney and NYSE resonate here because of their mystic chords of connection with Home Depot. One of the defendant board members in the NYSE case is Kenneth Langone, who also happens to be a Home Depot board member. Langone also was a director of General Electric, and helped to recruit Nardelli to Home Depot from GE. According to a Janaury 5, 2007 New York Times article (here), shareholder activists blame Langone for both Grasso's and Nardelli's pay packages. The Disney connection to Home Depot is through Martin Lipton, of the Wachtell Lipton firm. According to a January 4, 2007 New York Times article (here), Lipton was not only hired to defend Nardelli and the Home Depot board against shareholder activist Relational Investors, Lipton did the same thing for Disney (and the NYSE, for that matter).

But the outcome of the Disney case should provide some some deterrence for shareholders itching to sue Home Depot's board over Nardelli's pay package and severance. Even though the shareholders took their case over Ovitz's severance all the way to the Delaware Supreme Court, the Disney board ultimately prevailed. (See my article commenting on the Disney case here.)

While Nardelli's pay package undeniably is eye-popping, there are some good reasons why CEOs deserve to be well paid. The first is that it is a tough job. According to one news report (here ), "Mr. Nardelli was an obsessive workaholic who rose at 4 a.m., logged 14-hour days and routinely worked through the weekend." The second reason is that it is a tough job to keep. According to a January 4, 2007 Chicago Tribune article entitled "Pressure's on for CEO's to Deliver--Now" (here), the average tenure of a CEO is 48 months. Shareholder activists may decry CEO's lavish severance benefits, but at one level high severance pay make perfect sense; CEO's obviously want to provide as much deterrence as possible against a board's quick hook, and also want protections against sudden unemployment. These comments should not be interpreted as a defense of excessive CEO compensation, but are merely intended to suggest that there may be more to CEO's severance arrangements than mere greed alone.

All of that said, there is one aspect of Nardelli's compensation history that I find undeniably troublesome. As noted in Gretchen Morgenstorn's article (here), during the middle of 2004, Home Depot "quietly changed the measurement it used to calculate long-term incentive pay for executives." Whereas the prior measure had used peer group comparisons of Home Depot's earning per share, the new measure was based solely on Home Depot's earning per share. Morgenstern's article doesn't mention it, but at the same time as this change was put in place, Home Depot was engaged in a massive share repurchase program. This obviously had the impact of driving up the company's reported earning per share - and management's bonus compensation. As I have previously noted (here), this practice of using share buybacks to boost EPS based executive compensation is the target of increasing criticism.

It is probably also worth noting that Home Depot and its board already face a number of lawsuits over other corporate governance and business practices. Shareholders have sued over the company's options grant practices, which reportedly involve options backdating during a nearly 20 year period from 1981 to 2000 (see news reports here). And Home Depot and its board also faces a 2006 securities class action lawsuit (here), based on whistleblower allegations, that the Company misrepresented its financial condition by fraudulently inflating charges to vendors for defective and/or damaged merchandise; and pressured suppliers who complained about excessive chargebacks by threatening to reduce orders of their products.

A Word to the Wise: Gretchen Morgenstern's description of Nardelli's ouster as a "surprising defenestration" has drawn a certain amount of humorous criticism (here), but The D & O Diary takes it as a point of pride that we previously described the ouster of corporate executives over options backdating as "defenestration" - and our prior post (here) helpfully included the word's etymology (with pictures!).

Latest Proof of How Cool the Internet Is: Want to see Nardelli's contract with Home Depot? Here it is.

• Print
• Comments
• Trackbacks