HP Directors Lack Skin in Game

By Eric Jackson, Senior Contributor09/29/10 - 05:59 AM EDT

Stock quotes in this article:HPQ, ORCL

By the time this article appears, we will likely know the next CEO of Hewlett-Packard(HPQ_). [Actually, we didn't find out yesterday.]

And leading the committee who selected the new CEO is Silicon Valley wunderkind Marc Andreessen. Andreessen was the public face of HP when it ousted former CEO Mark Hurd in August (after granting Hurd an estimated $35 million severance package to get him through in between jobs).

When HP and Oracle(ORCL_) crossed legal swords after Hurd became Oracle's next co-president 30 days after leaving HP, it was apparently Andreessen who called Larry Ellison to smooth things over.

HP shareholders might be surprised to learn, however, that Marc Andreessen owns exactly zero shares in HP. As an HP shareholder, I'm very disappointed that Andreessen and most of his colleagues on the HP board haven't dug into their own (deep) pockets to buy some HP stock.

I'd prefer feeling that my representatives on the board feel the same pain that I do when the stock tanks. For this reason, I've recently filed a shareholder resolution with HP to adopt high stock ownership requirements for all directors. I hope that HP will allow its shareholders to vote on this matter at the spring annual meeting.

Long-term shareholders have been disappointed in HP's stock returns relative to the S&P 500 index return over the last decade. As of Sept. 22, 2010, HP's 10-year stock return was 25.14% vs. -22.64% for the S&P 500.

Over that time period, HP's board has been criticized for lax governance practices, including (1) the recent decision to oust Mark Hurd for questionable behavior, while still paying him a rich severance package, (2) the decision to use "pretexting" to gather information on a Wall Street Journal reporter and some of HP's own directors in 2006, and (3) the decision to pay Hurd $98 million in total compensation (before severance) for the three years prior his departure even though HP's stock return for the three years prior to Aug. 6, 2010, was -2.33%.

The Corporate Library, a corporate governance ratings firm, has consistently rated HP's board as "high risk" for its inability to manage incentive compensation. Nell Minow, co-founder and executive editor of The Corporate Library, has called HP's board "a serial corporate governance offender."

I believe that HP's outside directors would be more vigilant and effective monitors of management, as well as better judges of effective compensation packages (including executive perks such as personal use of corporate aircraft, personal travel and meals expenses, and gross-ups at the expense of shareholders for these executive taxable benefits), if all of them owned a significant equity stake in HP which they had to dig into their own pockets to buy, rather than being granted stock or stock options.

........

[** This post is an excerpt of the full article, which is available on TheStreet.com by clicking here. Free Site.**]

Sphere: Related Content

IBM Ends Director Stock Options as Payment in favor of Retainers

A few weeks ago, we discussed Yahoo!'s policy of compensating directors and potential problems, as well as our suggestion of the importance of outside directors having "skin in the game." Today, the WSJ reports of IBM's decision to get rid of stock options in favor of paying directors a retainer. We agree with Professor Elson that stock ownership does better align directors with shareholders. The solution, again, is that directors be required to purchase meaningful amounts of stock themselves (not through grants) and then be paid in cash. Read more on our suggestions here. The full story is listed below.

IBM Ends Director Stock Options,Spotlighting Popular Perk's Decline

By JOANN S. LUBLIN and WILLIAM M. BULKELEY

December 21, 2006; Page A1

Stock options, long touted by many companies as a vital tool for rewarding board members and aligning their interests with those of shareholders, are falling out of favor as a perk amid scandal and accounting and legal changes.

Yesterday, International Business Machines Corp. said it no longer will grant outside directors stock options -- which give recipients the right to purchase company shares in the future at a set price. Instead, starting Jan. 1, those directors will be paid an annual $200,000 retainer, which they can take either in IBM shares or partly in cash -- though rules strongly encourage them to take the shares.

IBM is only the latest big company to abandon options -- which are worthless unless a stock price rises -- in favor of compensation involving cash, restricted stock or outright equity stakes that both rise and fall with the share price. The move by the iconic company underscores a broader repudiation of options for board members two decades after many companies began to embrace them -- and could even accelerate the trend because of IBM's reputation as a bellwether of corporate behavior. Among others that have dropped the practice in recent years are retailer Gap Inc., recruiter Heidrick & Struggles International Inc. and food company Tyson Foods Inc.

In 2001, as the stock-market boom of the 1990s crested, nearly eight in 10 big companies were giving their directors options, according to a proxy analysis of 350 major companies conducted for The Wall Street Journal by Mercer Human Resource Consulting in New York. By last year, the figure was down to 53%.

The percentage may drop to as low as 10% by 2010, because boards now consider options "somewhat problematic," said Charles Elson, head of the Weinberg Center for Corporate Governance at the University of Delaware's business school, and a director of two public companies. Abandoning options "reduces the controversy" because "any potential for manipulation just goes away," said Peter Gleason, chief operating officer of the National Association of Corporate Directors in Washington.

Options are suffering a heavy backlash after big corporate scandals such as the accounting frauds at Enron Corp. and WorldCom Inc. and the more recent backdating scandal, corporate-governance experts said. In those and other cases, critics have claimed directors, motivated to boost returns on their stock options, turned a blind eye to problems.

The backdating scandal has revealed that dozens of companies altered their grant dates to days when their stock was trading at a lower price -- thereby boosting profits on options. More than 130 companies currently are under investigation for the practice in the biggest corporate-fraud probe in decades. An academic study released this week suggested that as many as 1,400 outside board members at 160 companies received questionable option grants, though the study didn't address whether they knew about it.

Companies also are responding to new accounting rules requiring options to be counted as an expense after more than a decade in which they weren't. Under proxy-disclosure rules that took effect for fiscal years ending after Dec. 15, moreover, businesses must reveal far more detail about the elements and costs of board compensation packages -- which could make options less attractive.

More broadly, post-Enron changes in laws and corporate practices have imposed greater demands on outside directors -- that is, those who have no other ties to a company. The New York Stock Exchange, for instance, now requires that a majority of board seats, and all compensation- and audit-committee members, be independent.

That has prompted plenty of discussion about how best to compensate outside directors and keep them focused on shareholder interests while protecting their independence. Outside directors are supposed to play a special role safeguarding against cozy board relationships with management.

"The overall governance thrust today is to have board members be [stock] owners rather than optionees," said Pearl Meyer, senior managing director of Steven Hall & Partners, a pay consulting firm in New York. Options focus recipients "too much on short-term movements in the stock price," she said.

Director compensation has been a subject of heated debate and experimentation for more than two decades. In the 1980s, corporate reformers and some large institutional investors argued that options would help motivate directors to focus harder on shareholder returns by giving them ownership incentives. The idea gained fuel thanks to tax and accounting policies that kept options tax- and expense-free, and the large fortunes that began to be made by companies going public in the early days of the 1990s boom.

According to Executive Compensation Reports, a newsletter that covered executive pay, just 1.6% of the nation's 1,000 largest companies gave directors some kind of stock in 1983. By 1994, nearly one in five did.

No one has suggested that IBM's directors received backdated grants. An IBM spokesman said the Armonk, N.Y., computer giant's action was consistent with its practice of "broadly reducing our reliance on stock options" as compensation for employees and officers.

IBM started expensing options in 2005 because of new accounting rules. But even before that, "we'd been saying we were reducing our reliance on equity compensation," he said. People familiar with the matter said IBM also believes options tend to make recipients more oriented toward short-term results than they are with other forms of compensation.

IBM said the additional cash compensation for directors is equal to the value of the stock options outside directors have been receiving; each year they were given 4,000.

Ironically, IBM's elimination of options increases the likelihood that outside directors will acquire sizable share stakes -- thanks to its substantial stock-ownership guidelines. The company pays 60% of these board members' annual retainer in a type of deferred stock known as "Promised Fee Shares," the latest proxy noted. Those shares are based on the market price of IBM stock. They accumulate dividends in the form of more Promised Fee Shares, and they can't be redeemed until retirement or departure from the board, at which time the director can receive either IBM stock or the cash equivalent.

Under IBM's corporate-governance guidelines, such directors are expected "to have stock-based holdings in IBM equal in value to five times the annual retainer," the proxy added. With the retainer doubled to $200,000, each outside IBM board member must now aim to own $1 million worth of shares.

The IBM spokesman said all the company's outside directors this year chose to invest all of their cash compensation in such shares. IBM directors include Lucio Noto, former chief executive of Mobil Corp.; James W. Owens, chief executive of Caterpillar Inc.; Kenneth I. Chennault, chief executive of American Express Co.; and Minoru Makihara, former chairman of Mitsubishi Corp. IBM Chairman and Chief Executive Samuel J. Palmisano is the only IBM employee on the board.

Recent years have seen companies take a wide range of approaches to compensating directors. Coca-Cola Co. earlier this year unveiled a plan to pay directors solely through annually allocated "equity-share units," which can't be cashed until three years have passed -- and then only if Coke posts compounded annual growth of 8% in earnings per share.

Similarly, Campbell Soup Co. board members will no longer get options as of Jan. 1. Instead they will receive an equal mixture of actual shares and cash, the big food maker disclosed in its latest proxy statement. "We have moved away from stock options as a form of compensation in part due to the change in accounting rules," a spokesman said.

When Heidrick & Struggles eliminated options for directors in 2002, it replaced them with restricted stock units, believing that "would better align the interests of the directors with our stockholders," its 2002 proxy said. In light of later controversy over options, "it looks like it was a wise decision," said Gerard Roche, senior chairman. "We're in a position where we don't have any worries" about director compensation.

Some companies eschew any stock-based compensation for directors at all. Those that pay outside directors only in cash include Alcoa Inc., Berkshire Hathaway Inc. and Sears Holdings Corp.

IBM won mixed reviews yesterday. "It's a welcome move" because options create incentives "that aren't in the interest of long-term shareholders," said Dan Pedrotty, head of the AFL-CIO's Office of Investment. But he said he wishes the company would go further and adopt a performance-share plan for directors. Union-sponsored pension funds have assets of about $400 billion.

But Mr. Elson, of the University of Delaware, said he was troubled by the move -- even though outside directors must hold a high multiple of their cash retainer in IBM shares. "To show continued confidence, you have to own stock over the long term" and also be partly paid in stock, he said. "You should increase your [stock] position over time."

Separately, American Tower Corp. said yesterday that directors and officers who received options at prices below the fair-market value on the legal grant date have agreed to "eliminate any benefit" by compensating the company in cash, or by canceling vested but unexercised options. The company will increase the exercise price of any unexercised options to the fair-market value. American Tower, a Boston-based owner of cellphone towers, said that the value of eliminating the benefit is $7.5 million.

American Tower said it plans to eliminate similar options benefits totaling $7.6 billion for three former executives.

American Tower has said that "there were a number of deficiencies in the company's stock option granting practices." Last month it restated results for 2005 to reflect a review of the options. A spokesman didn't immediately return calls seeking comment on the options issue or the names of the executives and directors involved.

--Charles Forelle contributed to this article.

Write to Joann S. Lublin at joann.lublin@wsj.com and William M. Bulkeley at bill.bulkeley@wsj.com

Sphere: Related Content

A Case Study in Ousting A Favorite CEO

From today's WSJ:

How a Giant Insurer Decided To Oust Hugely Successful CEO
By JAMES BANDLER and CHARLES FORELLE
December 7, 2006; Page A1

Over the past 15 years, the board of UnitedHealth Group Inc. couldn't have been more supportive of its chairman and chief executive, William McGuire. Directors lavished close to $2 billion in compensation on him, counting stock options, as he built UnitedHealth into one of the country's largest health insurers.

Some directors moved with him in social and charity circles. "We're so lucky to have Bill," director Mary Mundinger said earlier this year. "He's brilliant."

Last week, Dr. McGuire left his job, following a vote by the same board to dump him. It acted unanimously in October after concluding that his explanations for a pattern of unusually well-timed stock-option grants didn't add up. Dr. McGuire thus became one of the biggest casualties in the options backdating scandal, which so far has swept away more than 60 corporate officials, including 16 CEOs. (See related article on page A3).

How did one of America's most pliant boards turn on its star chief executive? Dr. McGuire's support slowly leached away over the course of a six-month internal investigation.

Documentation that could support his defense was sparse. A board-ordered statistical analysis undercut his arguments. And his closest board ally was sidelined by a conflict of interest that unsettled other directors. In the end, directors felt pressure after their lawyer told them federal regulators appeared likely to charge the UnitedHealth chief.

Now, Dr. McGuire and the board are girding for tense negotiations over how much of his giant cache of stock options, many still unexercised, he'll be able to take with him. He has already agreed to surrender about $200 million of those options' value, and people close to the situation say the company hopes to get back at the very least $250 million more. He is still likely to end up with more than $1 billion, although last week a federal judge hearing a shareholder lawsuit temporarily barred him from exercising any options or receiving any retirement pay.

Dr. McGuire's lawyer, David Brodsky, said, "While neither a lawyer nor accountant, Dr. McGuire believed that the processes by which options were granted were transparent, appropriate and approved. Indeed, experts who reviewed these processes never raised concerns at the time about the stock options program." Dr. McGuire himself declined to be interviewed.

Dr. McGuire's troubles began in March, when The Wall Street Journal published an article raising questions about exceptional patterns of stock-option grants at a number of companies, including UnitedHealth. In three separate instances, the article found, Dr. McGuire had received options at UnitedHealth stock's lowest closing price of the year.

That made them especially valuable, since options typically convey a right to buy the employer's stock in the future at the price on the grant date. The formula means a recipient can profit only if the stock rises. But it turns out many companies cheated by granting options on one date and pretending they had been issued earlier, when the stock was cheaper. Besides Dr. McGuire's grants at yearly lows, a number of his other grants were dated just before price runups.
After the article, Dr. McGuire initiated an internal investigation. In early April, the board formed a special committee. It hired William McLucas, a former Securities and Exchange Commission enforcement director, now at the law firm of Wilmer Cutler Pickering Hale & Dorr.

At the outset, Dr. McGuire could draw on a big reservoir of goodwill from directors. A former pulmonologist, he helped coordinate care when the wife of one director, William Spears, fell ill. Dr. McGuire's family foundation and the company gave generously to charities some directors were involved with. And directors had made millions from their UnitedHealth options as the stock soared more than 50-fold during Dr. McGuire's tenure. That enormous rise accounted for most of the millions Dr. McGuire earned.

Of 10 outside directors, the CEO had strong support from at least four: Mr. Spears, a New York money manager and friend; Ms. Mundinger, dean of Columbia University's nursing school; Thomas H. Kean Sr., a former New Jersey governor and chairman of the 9/11 commission; and Gail Wilensky, a specialist in health-care policy. The first three had served on the compensation committee during much of the period under scrutiny, making their own conduct an issue in the internal probe.

But Dr. McGuire's core allies would have little role in shaping the investigation. That fell to the special committee, led by James Johnson, a former chief of mortgage giant Fannie Mae who recently served as an adviser to Sen. John Kerry's presidential run. Also on the panel was Douglas Leatherdale, a former chief of insurer St. Paul Cos., and Richard Burke, a founder and retired CEO of UnitedHealth, who was friendly with Dr. McGuire. The committee closely supervised the lawyers and accountants doing the actual digging. Other directors were filled in later and less frequently.

Key Question

Complicating matters was that the board had given Dr. McGuire broad latitude to issue options to subordinates as well as to a right to choose when he wanted option grants to himself made.

After picking a date, he had to get approval from the compensation committee. The key question the WilmerHale lawyers faced: Did the board committee really approve Dr. McGuire's grants on the dates reflected in company regulatory filings? Or might they have been backdated to low-price days that would make them more lucrative?

Directors asked for records to show the options were approved on recorded grant dates. Management came up largely empty-handed. Some minutes of compensation-committee meetings were missing. Others didn't mention approval of any grants near a period in question.

In interviews with the WilmerHale lawyers and in phone calls with directors, Dr. McGuire said he hadn't backdated anything but, rather, had chosen to receive grants when the stock was low after a decline, according to people briefed on the conversations. He expressed disappointment that there wasn't more corroboration and that underlings hadn't kept proper paperwork.

Dr. McGuire also stated that as a man of high ethical standards, he wouldn't have fabricated anything. He said that after picking a date for his grants, he would seek approval from Mr. Spears, head of the compensation committee, or occasionally another panel member.

The main person who could verify this account was Mr. Spears. He told the board's lawyers that while he recalled conversations with Dr. McGuire, he couldn't be sure when they actually took place. Phone records showed the two talked frequently, often around the times of some grants, but these records proved little because the two were close friends.

Mr. Spears's value as a witness soon suffered a blow. The money manager told the lawyers he had handled more than $55 million of the McGuire family's fortune and had accepted a $500,000 investment in his own business from Dr. McGuire.

Mr. Spears maintained he had disclosed this conflict of interest to the board before. Two 1999 documents supported that account: an email and an executive's handwritten meeting minutes. But among the directors, only Mr. Kean thought it was possible he could recall having been told of the relationship, say people familiar with the matter; the others said they had no idea.

Many directors were "incredulous" when they learned of the financial tie at a meeting in the spring, according to someone who was there when the board was briefed. While directors felt
Mr. Spears was honest, the entanglements tainted any defense he might have made of Dr. McGuire. Aware of fellow directors' feelings, Mr. Spears stayed on the debate's sidelines in later meetings, says someone familiar with the gatherings.

Dr. McGuire expressed frustration that his reputation was being hurt by a scandal he considered hyped. "He indicated that this was way blown out of proportion and unfair," says Irwin Redlener, a friend and co-founder of the Children's Health Fund, a not-for-profit group

UnitedHealth supported.

On June 25, Mr. McLucas brought some compelling data to the board's special committee. His presentation showed that grants were regularly dated at or near the stock's lowest prices for the quarter, a suspicious pattern. Later, directors learned that after the mid-2002 passage of new federal rules requiring almost immediate disclosure of option grants, there wasn't a single quarter in which the large grants customarily given to top executives were dated at a quarterly low.

The point: After rules had made backdating impossible, Dr. McGuire's purported ability to pick propitious grant dates vanished. That juxtaposition wounded a key line of defense and "made everyone in the room sit up and focus," says one person close to the situation.

Mr. Johnson was becoming convinced the CEO would have to depart. The former Fannie Mae chief was well aware of how negative perceptions can hurt a company. In a 2004 accounting scandal that brushed close to him, Fannie Mae suffered a stock-price decline, congressional grilling and the loss of its chief executive at the time. One person recalls Mr. Johnson saying in June or July that it was unlikely Dr. McGuire would be able to survive.

On July 11, directors convened for a regular meeting in Minneapolis. Dr. McGuire made a pre-emptive move. He sent directors a five-page memo suggesting a series of steps to deal with the options problem, say people familiar with its contents. He said the board could reprice any tainted options, name a chief administrative officer to remedy deficient record-keeping and make other changes to processes. Deep in the memo, Dr. McGuire said he would be ready to leave if the board thought that was in the company's best interest.

The board didn't want to act before the full scope of the problem was known. It took no action.

In late August the lawyers running the probe made another unsettling finding. In late 1999, the board had approved new options for Dr. McGuire and others to replace a batch that were temporarily worthless. That is, their exercise price was higher than the current stock price because of a stock decline after they were issued. In granting the replacements, the company had suspended, rather than canceled, the old ones, largely for accounting reasons.

Mr. McLucas learned that in August 2000, the suspended options had been reactivated, meaning that the recipients, including Dr. McGuire, effectively got a huge second helping. For Dr. McGuire, the profit embedded in the extra options -- the difference between their exercise price and UnitedHealth's market price -- is now around $250 million. The maneuver skirted disclosure requirements and potentially violated accounting rules, WilmerHale lawyers concluded.

Mr. McLucas brought the issue to the special committee and eventually to other directors. Lawyers later said two directors recalled some discussion in 2000 of reactivating suspended options for other employees, but no compensation committee member recalled intending such a lucrative award for Dr. McGuire himself. "Alarm bells were going," says a person close to the board.

Skirmish Over Math

Meanwhile, a side skirmish broke out over math. The Wall Street Journal's analysis had found that the odds of Dr. McGuire's highly favorable pattern of awards occurring by chance were one in 200 million or greater. Some directors, including Ms. Mundinger, who has a doctorate in public health, criticized the Journal's methodology. The result was a lengthy statistical discussion among directors that resolved little.

After word reached directors that Dr. McGuire had hired a statistics firm to help him rebut the Journal's findings, the WilmerHale lawyers decided to bring in their own numbers experts. In a board meeting on Oct. 2, the lawyers presented an analysis from a firm called Lexecon Inc. It said there were many ways to crunch the numbers, each yielding different probabilities. But all the odds were very long. In the end, Dr. McGuire never presented statistical data to directors.

By early October, the investigative work was all but finished. A squadron of lawyers and accountants had plumbed millions of pages of documents and conducted interviews with more than 80 witnesses. After discussing Mr. McLucas's findings, special-committee members agreed that the situation was serious and the CEO's departure was a likely outcome.

It fell to Mr. Burke, the former UnitedHealth CEO, to travel to Minnesota to tell his old comrade the bad news. But to the surprise of some committee members, Mr. Burke proposed a solution short of Dr. McGuire's departure. He suggested the CEO temporarily step aside until the options tempest calmed, according to people familiar with the matter. Dr. McGuire rejected the idea out of hand, two people close to the situation say. If the board wanted him to leave, he said, he'd leave.

Outside directors set Friday, Oct. 13, as the day for a critical meeting at WilmerHale's Washington offices. The agenda: a review of the investigative report and a discussion of Dr. McGuire's fate. At that point, some directors hadn't yet made up their minds.

The meeting began around 10 a.m. in a large room filled with directors and their lawyers. Directors not on the special committee received the 14-page report for the first time that morning, a person close to the board says. The strongly-worded report concluded it was likely that backdating had occurred and that Dr. McGuire played a central role. Citing the CEO's claim that he didn't backdate any stock options, the report dryly said, "Certain facts run contrary to this assertion."

The report didn't suggest any complicity by directors on the compensation committee. It said it "might have been better" if they had paid more attention to the granting process and asked more questions.

Seated around the conference-room table, the directors took about a half hour to read through the report. No one spoke.

Directors asked Mr. McLucas for his assessment. According to several people, he said that he thought it was likely the SEC would bring charges against Dr. McGuire, and that the agency could seek to bar him from serving as an officer or director of a public company.

Mr. McLucas told directors they should make their decisions based on Dr. McGuire's conduct. But he also said they would be in a difficult spot if they voted to keep him and the SEC sought a short time later to remove him. UnitedHealth has since given the results of its probe to federal prosecutors and the SEC, neither of which has taken action.

At about 4 p.m., a subdued Dr. McGuire addressed directors. He spoke somberly, without notes, for about 40 minutes, talking about how much the company meant to him and how proud he was of its success. He said he believed he had acted ethically and appropriately, say people familiar with the meeting. "I apologize to everyone for putting the company through this trauma," one person recalls him saying.

Some directors couldn't meet his gaze. "It was an anguishing event," said another person in the room who had been close to Dr. McGuire.

Dr. McGuire's lawyer, Mr. Brodsky, of Latham & Watkins, made a brief presentation, saying the WilmerHale report had given short shrift to evidence of his client's innocence. Mr. Brodsky, a former federal prosecutor, said the CEO's money-management relationship with Mr. Spears had been properly disclosed, citing a company lawyer's 1999 email saying "the full board" had been apprised of financial conflicts.

Mr. Brodsky also contested the report's treatment of a McGuire memo that counted against him. In it, the CEO wrote to the compensation committee on Oct. 22, 1999, about a grant that "should be awarded." Despite his use of the future tense, this stock-option grant ultimately bore an earlier date: Oct. 13, the day the stock closed at its lowest price that year. Mr. Brodsky called this meaningless. He said the memo was a rewrite of an earlier draft, and Dr. McGuire merely hadn't fixed the verb tenses.

Dr. McGuire and his lawyer left the room, and directors asked Mr. McLucas for his impression of the defense. "I don't think there's anything we've heard that would change our assessment," one person recalls the lawyer saying.

Directors took no action that Friday. On Sunday, the board had scheduled a meeting in Minnesota. Exhausted, they changed plans and convened instead in Washington. Dr. McGuire didn't attend.

Mr. Spears, the compensation-committee member who managed some of Dr. McGuire's money, arrived at the meeting. He then submitted his own resignation from the board and left.

At the meeting, directors took a vote on a 14-step plan to deal with the options issue. It included Dr. McGuire's immediate departure as chairman and his resignation as chief executive by Dec. 1. The vote was unanimous. Mr. Burke traveled to Minnesota to deliver the news.

Later, several directors called Dr. McGuire to express their gratitude for his service and their sadness over the way things had ended. Dr. McGuire was distressed, said a person familiar with one of these conversations. "He continues to believe he did nothing wrong, which makes it all the more painful."

Last Thursday was the last day Dr. McGuire reported to his 10th-floor office. A private man, he left that day without emotional goodbyes. Said one person close to the matter, "He slipped out without anyone noticing."

Write to James Bandler at james.bandler@wsj.com and Charles Forelle at charles.forelle@wsj.com

Sphere: Related Content

Why Yahoo!'s and other Outside Directors Should Have Skin In the Game

In 1999, I got to work with Don Hambrick at Columbia on a major research study funded by McKinsey and Korn/Ferry. Academics from across the country were chosen to study particular domains of management and how they impacted corporate performance over the long-term. For example, one academic studied executive compensation, another studied organizational structure, etc.

Don was asked to study corporate governance and my job, as his research assistant, was to sift through hundreds of corporate proxies in the library (and the SEC’s office at the tip of Manhattan), coding all the possible corporate governance characteristics that might impact an increase in total shareholder returns over time.

This project, called “Project Evergreen,” studied about 200 companies from 50 industries over a 10-year time period, roughly from the mid-80s to mid-90s. For each industry, we looked at 4 companies: 1 “Star” (which outperformed the industry benchmarks over the 10 years), 1 “Found It” (which underperformed but later outperformed the industry benchmarks), 1 “Lost It” (you get the picture), and 1 “Never Had It.”

We coded every corporate governance variable you can imagine that might have had an impact on a company’s stock price: director age, board size, director background, how many committees or other boards they served on, whether the CEO and Chair role was split, how much stock they owned, etc. Of all these various characteristics (and we looked at well over 50), only one predicted an increase in company performance over time (controlling for company age, size, and its previous success): whether the company had a majority of outside directors who had purchased sizable equity stakes in the company (as opposed to being given stock or options).

The complete article was published in California Management Review and is located here. It’s worth a read, if only because it’s remarkable how few companies today (even in our post-Enron world) can claim they have outside directors that do this.

Most companies still dole out big options or grants to their directors, which, according to our research, had zero impact on later company stock performance. Very few require directors to dig into their own pockets. The claim I have often heard made by companies in response to our research finding is that “If I did that, I couldn’t get anyone good to serve on my board.” Our reaction: “If that’s the case, what does that say about your company and what are you doing to fix it?”

Let’s take Yahoo! as an example. They claim 8 out of their 10 directors are “outsiders” or “independent” (although 2 of the 8 have been on the board over a decade making it arguable how much of an outsider’s eye they can really bring to board discussions). The stock has certainly been depressed in the last 2 years (down from $40 to under $26.50 yesterday), while their chief competitor’s stock has vaulted ahead. Their policy is that outside directors should try to hold 12,000 units of stock (or $320,000 at recent prices). However, this stock can be held in the form of grants or options. Yahoo! pays its directors in stock for serving on its board, not cash (each director received 50,000 options in 2005, except 1 who received 100,000). Almost all the outside directors have total options today between 300,000 – 750,000 with strike prices well below the currently depressed level. These options should make them feel like ‘owners.’ Yet, where has been the board vigilance in the past two years? Where has been the ‘tough questions’? Just giving out lots of options has not led to increased performance. Yahoo! has no requirement for directors to buy stock. They should.

In the previously mentioned 2000 CMR article referred to above, we quoted a recently retired CEO about how putting ‘skin in the game’ and buying stock affected his behavior as a director:

I’m convinced that having a significant financial stake in the company affects the alertness and behavior of directors. I’ve seen it in others, and I’ve seen it in myself. You seek more information, you spend more time with the information, you ask more questions, you probe much more. And, best of all, the CEO knows you’re super-interested, and so he does a better job too.

I’ve been on several boards. I’ve always held small, token amounts. But now I’m on a board where the CEO encouraged us to buy and hold significant shares. I’m in for about a half a million dollars, and I can tell you I’m a heck of a lot more attentive to this company than I have been to the others. If this company faces a challenge, I lose sleep at night – which is what you want from your directors.

All outside directors should be investors in the companies they are involved in. If they aren’t willing to drop a quarter or half million of their own money to be involved, should the company’s investors really want them to have a say at board meetings? The evidence overwhelmingly says no.

A couple of closing caveats. We recognize in the paper that some directors can’t easily invest this kind of money due to their jobs, yet they make fabulous directors. You can’t simply set a financial number as a threshold and limit these people from the pool of possible directors. We offer some suggestions for how to handle this tricky issue in the paper.

Finally, when I slogged through the proxies (with the help of several Columbia College students) coding governance characteristics, we necessarily had to look at “governance structure” variables not “process” variables as predictors. After all, we weren’t in the room to observe how these directors asked questions and conducted meetings. How a board operates is even more important that who sits on a board and how much stock they own. We’ve just completed some new research with over 150 organizations that bears this out. More on this in a future posting, but for now, check out more details on our Breakout Performance Index tool and some information on our recent study here.

All directors should have ‘skin in the game’ – this makes them, according to our research, not passive observers, but active and more effective fiduciaries.

Sphere: Related Content