Other Proposals for Change

The government is not the only organization that proposes changes in the corporate governance system. Indeed, groups like the Business Roundtable (made up of corporate executives), the U.S. Chamber of Commerce, and the Securities Industry Association made their own proposals for change. One particularly influential group is the NYSE. The NYSE can enact standards for firms that choose to list on the exchange. As the NYSE is generally considered the most prestigious exchange in the world in which to be listed, it has the power to influence the corporate system.

New York Stock Exchange

Former SEC Chairman Pitt asked the NYSE to review its corporate governance standards for listing on February 13, 2002. The exchange responded four months later with detailed recommendations of changes to the standards. On August 16, 2002, the NYSE approved changes to listing standards. Companies listed on the NYSE were given two years to make some of the changes to their governance system (like altering board composition) and six months for others (like adopting a code of ethics).

While there are many monitors of a firm, the NYSE can really only influence the part of the corporate system that is inside the corporation. In other words, it can influence the function and the structure of the board. It can influence compensation systems and how auditing firms are selected and monitored . It does not, however, have much influence over the actions of outside monitors such as credit rating agencies, investment bankers, financial analysts, and auditing firms. Therefore, its listing standard changes deal with the areas with which it has the most influence. Some of its proposals were also adopted in the Sarbanes-Oxley Act. We focus here on those changes that were not adopted by the Act but were adopted by the NYSE.

Most of the new changes have to do with the structure, function, and incentives of the board of directors. Specifically, the NYSE mandates that companies have a majority of independent directors. Of course, the definition of "independent" is very important and the NYSE tightens the previous definition. A director is not independent if he or she (or his or her immediate family) has worked for the company or its auditor within the past five years. The board members who are not also executives of the company must meet regularly without the presence of management. This move to increase the independence of boards is long overdue and we certainly endorse it. However, we feel that company executives serving as board members present a problem ” especially when a CEO holds the leadership position of chairman of the board. Indeed, of the 30 companies in the Dow Jones Industrial Average, only 8 have a separate chairman and CEO. The NYSE has not made any recommendations about this.

The NYSE also requires some functions of the board. For example, the nominating committee of the board must be composed entirely of independent directors and perform certain duties . This is also true of the compensation committee. Otherwise, the executives would have undue influence on their own compensation. The audit committee must also be independent. However, the members of this committee will have an increased authority and responsibility to hire and fire the auditing firm. To handle this expanded responsibility, the audit committee members are to have necessary experience and expertise in finance and accounting. To help maintain the independence of audit committee board members, members are not to receive pay (especially consulting fees) from the company outside of their regular director fees. Again, we endorse making boards more independent ”particularly the audit and compensation committees . However, we question why only audit committee members must refrain from earning consulting fees. When the CEO of a company hires a board member as a consultant, they develop a special relationship that inhibits the board member from being independent. That is, the board member will be less likely to make decisions against the CEO's desires if that CEO is paying him or her a consulting fee. Why aren't all board members prevented from this type of relationship with the company's executives?

Lastly, the NYSE will require that shareholders approve all executive equity-based compensation plans. That is, there will be a shareholder vote on whether a CEO gets a certain number of stock options or restricted stock shares. This rule creates more transparency because each shareholder will receive a proxy statement detailing the compensation proposal. In general, we support increased shareholder control and higher transparency. However, we have some concerns. First, the rule does not seem to recognize that management-approved proposals nearly always pass. While shareholders will be more aware of a CEO's compensation, that compensation may not be altered much by this process. Second, the rule may inhibit a board from hiring a good CEO to run a company. When hiring a new executive, a board cannot guarantee a compensation package in an offer to a qualified candidate. The package must be voted on by shareholders first. They must either hold a special meeting for the vote (which is costly) or wait until the regularly scheduled annual meeting. If the shareholders reject the compensation package, the newly hired CEO will leave and another search will have to be made. This rule seems to handicap a board in hiring good executives. We would prefer to let the equity-based compensation be more transparent in the financial statement of the firm and strengthen the independence of a board so that it can do its job.

Overall, the NYSE changes to its listing standards do a good job of strengthening a board's ability to monitor executives. However, more can be done.

Expensing Stock Options

Several organizations and people have promoted the idea that the cost of stock options issued to employees and executives should be treated as an expense on the financial statements. Some people, like legendary investor Warren Buffett, have been promoting this idea for quite a while. It appears that there are three reasons that expensing stock options are being promoted.

The first purpose is to have better disclosure and account for the real cost of using options as compensation. The expensing would cause the compensation to be more directly observable to shareholders because it would be reported in the income statements. Also, the expensing would identify that there is a cost to a firm for issuing options. Expensing options will lower the earnings of a firm. As we discussed in Chapter 3, there is a real economic cost to shareholders when executives convert tens (or hundreds) of millions of dollars in options into common stock and then sell it in the stock market. Prior to the push for expensing, this economic cost was not well accounted for on the financial statements of a given firm. In other words, this reason for expensing options argues that the economic cost of options should be more transparent.

The second reason for some groups and people to be proposing option expensing is that it may reduce the amount of options that executives receive and thereby reduce their total compensation. The media attention on the tens (or hundreds) of millions of dollars that executives received in the late 1990s brought this topic to more of the public's attention. Let's face it: Getting paid $200 million (or even $20 million) for working a few years seems obscene. Without recording the cost of stock options in some way, a board has an incentive to use options in a very generous way to reward its CEO. If the cost of the options is expensed and thereby reduces a firm's earnings, its board may not be quite so generous.

The third reason for expensing stock options is the impression of the public and politicians that options owned by CEOs and other executives contributed to corporate scandals. That is, the public's perception seems to be that options gave executives a mechanism for benefiting from using accounting chicanery to artificially pump up the price of the company stock. If options are not as attractive for firms to issue, maybe there will be less of an incentive for executives to misbehave.

We agree that options have an economic cost to a firm and that this cost should be identified more clearly in the financial statements. This added disclosure would move the option issues from the footnotes to the main statements and make the process more transparent for shareholders. This is good. However, we also have some major concerns about expensing stock options.

Our first concern has to do with how companies will respond to having to expense options. Some industries, like technology, use options as compensation for many employees, not just executives. For example, Microsoft issues options to most of its employees. Indeed, more than 2,000 Microsoft employees have become millionaires because of the option programs. [4] Even some non-tech companies, such as department store chain Kohls Corp., use options to pay middle and lower managers. Also, it is common for start-up companies to partially pay employees in stock options to help compensate for low salaries. Using this type of pay system, a young company can conserve one of its most precious resources ”cash ”and motivate employees to work hard. What happens to these compensation systems if options are expensed? The cost to earnings will cause the companies to curtail option programs. This could inhibit the growth of new companies. It could even have an impact on the economy since new companies are an important source of new jobs.

It seems likely that expensing options will have a greater impact on middle and lower management than it will on the top executives. We foresee that a few years from now the top executives will cash in options for millions and the other managers will get nothing. Will we feel better that a CEO only received $100 million instead of $200 million? Not likely! Indeed, the gap between top executive pay and lower management pay may increase because lower levels of management may no longer get options.

Lastly, we do not believe that expensing options solves any of the problems identified in Table 12-1. Expensing options does not alter the incentives of the executives who own them. That is, executives will still have stock options ”although possibly not as many. Therefore, they still have the incentive to manage earnings to maximize the stock price over the short term (a few years) instead of the long term .

Currently, dozens of firms have decided to expense stock options. Other firms announced that they would not. At the time of publication, whether a firm expenses its options is purely voluntary. This is just one more illustration of how the accounting standards do not really seem to be standard.

In general, we are a bit puzzled why expensing options have been pushed so hard and have attained such exposure in the media. We feel that the ramifications of expensing options will be to increase the difference in pay between CEOs and other employees in some firms. In addition, the expensing does nothing to change how stock options are used to reward top executives or how those executives will behave. Expensing stock options is not a solution to the corporate governance problems. So, again, why all the hubbub?

Infectious Greed. Restoring Confidence in Americas Companies
Infectious Greed: Restoring Confidence in Americas Companies
ISBN: 0131406442
EAN: 2147483647
Year: 2003
Pages: 118

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