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Subject 10. Executive Compensation

Investors should analyze both the amounts paid to key executives for managing the Company's affairs and the manner in which compensation is provided to determine whether compensation paid to executives is commensurate with the executives' levels of responsibilities and performance and provides appropriate incentives.

Every year, shareowners learn of new jaw-dropping executive compensation packages that seemingly defy rational explanation. In 2004, the average CEO of a major company received $9.84 million in total compensation, according to The New York Times.

As described earlier, the Board is responsible for ensuring that an executive compensation program is in place that will attract, retain, and motivate strong management performance. Compensation plans should encourage executives to achieve performance objectives and, in so doing, create long-term shareowner value.

Executive compensation has four basic components: base salary, bonuses, stock options, and various perquisites. The amounts paid and the manner in which executive management is compensated can affect Shareowner value in various ways. Investors should examine the reported:

  • Remuneration/compensation strategy. Does the program reward long-term or short-term growth? How does the remuneration/compensation committee set pay for executives? Does it use outside consultants or rely on internal resources? Is the program based on the performance of the Company relative to its competitors or other peers?

  • Executive compensation. This requires the analysis of actual compensation paid to the top executives during recent years and the elements of the compensation packages offered to them. The analysis can help investors determine whether the investment made in executive management is producing adequate returns for the Company.

  • Equity-based compensation. Equity-based compensation can be a critical element of compensation and can provide the greatest opportunity for the creation of wealth for managers whose efforts contribute to the creation of value for shareholders. Thus, equity-based compensation plans can offer the greatest incentives. Shareowner interests are also greatly affected by equity-based compensation plans: the ownership positions of existing Shareowners could be diluted, and executives could assume additional risks because of stock options granted to them, etc.

    • Investors should examine the size of grants, potential value to recipients, cost to the company, and plan provisions that could have a material impact on the number and value of shares distributed.
    • Should all plans that provide for the distribution of stock or stock options to executives be submitted to shareowners for approval?
    • What's the impact on the income statement? IFRS and U.S. GAAP both require Companies to expense stock options grants.
    • Are equity-based compensation plans linked to the long-term performance of the Company?
    • Option repricing: Companies might want to re-price downward the strike prices of stock options previously granted. This would remove the incentives the original options created for management.
    • Investors should examine the information about the extent to which individual managers have hedged or otherwise reduced their exposure to changes in the company's stock price. They should also determine if managers have share holdings other than those related to stock option grants.

Practice Question 1

A company prohibits itself from offering shares at discounted prices to management, board members and other insiders prior to a public offering of its securities. This practice is ______

A. preferred by investors because it demonstrates that the company aligns itself with the investors' interests.
B. not preferred by the capital markets regulatory body because it might encourage an opportunity for insider trading.
C. not preferred from a corporate governance point of view because it might encourage executives to compensate themselves from short-term share transactions.

Correct Answer: A

This practice is preferred because it is beneficial for the long-term interests of investors.

Study notes from a previous year's CFA exam:

a. define corporate governance;

b. describe practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection;