Executive Compensation, Stock Options & Fiduciary Responsibilities

Executive Compensation, Stock Options & Fiduciary Responsibilities In the movie Pirates of Silicon Valley, there is a scene where co-apple founders Steve Wozniak and Steve Jobs have a discussion regarding the $116 million worth of stock options granted to Steve Wozniak. In the film Wozniak complains to Steve Jobs that the amount of stock granted to him was just too much for him to fathom, given his meager upbringing and current simple-lifestyle.

Woz, as he is commonly referred to in the movie even informs Steve Jobs that he is going to give (transfer) some of his stock ownership rights to other early employees like Daniel Kottke, Apple’s first official employee. Although this was generous decision on behalf of Wozniak, according to Prof. Jeanne Calderon, Apple and it founders are not legally required to issue IPO to its original employees (Daniel Kottke) as long as the information expressed in the “IPO prospectus and the SEC registration process precisely corresponds with actual conduct of the company. Since, Steve Jobs and Steve Wozniak were the founding members of the Apple it is reasonable for them to profit substantially from the company’s initial-public-offering (IPO). However, it is still interesting to note that the discussion of excessive stock option grants precisely followed the induction of John Sculley as Apple’s new CEO. The movie is historically inaccurate because it suggests that Apple’s IPO occurred, specifically, in tandem with Steve Jobs relinquishment of power to Sculley, when in actuality the Apple went public in 1980 whereas Sculley officially became Apple’s CEO in 1983.

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What is even more concerning about this scene was Steve Jobs close affiliation and integral influence in recruiting John Sculley as Apple’s CEO. Essentially this scene is a great example of the excessive compensation packages executives at major corporations are commonly granted (IPO, Stock options), while lower ranking employees are granted none or their options become worthless because their executive administration is corrupt.

Following numerous corporate scandals and bankruptcies in the last decade, excessive executive compensation has become a major issue in contemporary law, business, and society. This portion of the paper will attempt to analyze the evolution and current status of executive compensation as to how it is applied and interpreted from legal, social and corporate perspective. In recent decades, stock options plans have become the largest factor in structuring executive compensation packages.

A stock option is a flexible way to share ownership with employees of company. Stock options are also an efficient means to attract, retain, reward and motivate employees because they are form of payment that preserves the company’s cash flow reserves while tightening the alignment of an employee’s economic interests with cumulative shareholder interests. Stock options, essentially, give the person who is granted the option (the optionee) the right to buy a certain number of shares at a fixed price for a specific number of years (the exercise period).

The price at which the optionee can exercise the option by purchasing the stock is called the grant price or strike price. This price is generally defined as the market value of a single share of stock at the precise time the option was approved. Corrupt executives will commonly back-date (re-price) these option contracts, in order to receive a higher-market value spread when they decide to exercise their options. For instance, last year, former United Health Group (UHG) Chair & CEO, William McGuire, had to resign for engaging in this unethical practice.

He recently settled with the SEC and the UHG Special Litigation Committee which required McGuire to return more than $420 million in stock options and other compensation to settle issues related to his involvement in back-dating (re-pricing) his stock options during his tenure as CEO of the company (Dash). The payback is on top of the $198 million that Mr. McGuire, an entrepreneur who built UnitedHealth, had previously agreed to return to his former employer.

Many of these over-paid executives are able to avoid indictment or sentencing by utilizing their wealth and prestigious status to convince the litigators that settling is in everyone’s best interest. Corporations usually establish restrictions on when the options can be exercised; these restrictions are referred to as vesting restrictions. These constraints generally require the optionee to have been employed a specific number of years at the company before the options can be exercised. There are two principal types of stock options, non-qualified stock options (NSOs) and incentive stock options (ISOs).

Private companies typically use ISOs whereas publicly held companies typically use NSOs. A different set of rules, regulations and tax consequences apply to the two types of stock options differently. However, for the purposes of this paper it is only important to know that with NSOs the company gets to deduct the spread (difference between strike price and fair-market-value) from its earnings, but the spread is taxable to the optionee as ordinary income. This process in is important to public companies because they can receive tax break without having to part with any cash in order to claim the deduction.

In contrast, the sale of ISOs are only taxed as a capital gains (cheaper) for the optionee once the sale of the shares is fully realized. However, with ISOs the company is not allowed to deduct the spread (the gain) from its corporate earnings. Traditionally, companies were not required to treat ISOs or NSOs as an expense when they reported their profits to shareholders. However, after the collapse of Enron and Global Crossing various economic scholars criticized the “lack of symmetry between the tax and accounting effects of the stock options” (Savage & Bagley).

In both cases, these corporations had authorized excessive executive compensation packages, and then these executives exercised their options and hastily sold all their shares just before the stock price and corporation collapsed; causing huge economic damages to the company’s employees and main investors. In response, the International Accounting Standards Board (IASB) issued a ruling that companies using the IASB standards need to start recognizing stock options as a corporate expense. Many U. S. companies followed suit by volunteering to begin expensing options too.

These reforms support studies that suggest the existence of an inverse relationship between amount of options granted to key executives and the ultimate success of the corporation they control. All critics of stock options cite the same economic question: How can a company return major profits to its shareholders if the stock value becomes increasingly diluted (value sacrifice) from the excessive compensations packages provided to all administrating executives? In the 1890’s, the New England Norton Company offered the very first stock options to its top employees.

From the 1920’s into the 30’s the use of employee stock options was rampant. Then in the 1950’s stock options became the preferable compensation choice of many corporate executives in response to a law Congress passed that allowed the profits from sale of security options to be taxed at the capital gains rate of 25 percent. This rate was highly attractive to many corporate executives because they would be able to bypass their usual top-bracket income tax rate of 91 percent by issuing and exercising stock options for themselves.

Two years later 1,084 corporations were utilizing executive stock option plans as an alternative form of executive compensation to bypass their usual high-income tax rate. However, by the 1960’s Congress had enacted numerous opposing and restrictive laws that rendered the savvy executive compensation method useless. Later in the 1970’s scholars developed an advanced economic theory (Black-Sholes Method) to value stock options. Next in 1980s Congress enacted new laws that “created incentive stock options and slashed the capital gains tax rate,” (Savage & Bagley).

Abruptly following these economic events a surge of major corporations began offering increasingly large stock option grants to major executives within their company. Then during the economic-bubble boom of the 1990’s, many technology based corporations began offering all their employees IPO and stock options to preserve their cash for future growth. Most contemporary executives and officers are both employees and substantial shareholders of the corporations they work for.

Given the dual-nature of their roles in company, they retain a lot of inside information regarding the company’s health and how it will impact the overall value of the stock price. In the last decade, numerous corporate scandals (Enron, Arthur Anderson, WorldCom, Tyco, & Global Crossing) have arisen and revealed that many officers and executives were engaging in fraudulent activity where they would falsify accounting records and disseminate faulty information to investors (painting a rosy picture of the company’s future), while at the same time exercising and selling off all available stock options they retained.

Two of the most infamous corporate scandals are those of Enron and WorldCom. Both companies filed for bankruptcy and most employees lost everything in their retirement funds, while all the high-ranking executives scampered off with millions of dollars and an irresponsible attitude, claiming that they did not know the company was in such dire health. So who are the authorities in charge of approving these extraordinary stock option plans? And what are their legal responsibilities to the firm and its shareholders for sponsoring inept corporate executives?

Usually, the board of directors of a corporation appoints some of their members to a compensation committee to approve and supervise all the executive compensation packages. In theory these committees are supposed to help the shareholders keep executive compensation in control by approving compensation in precise proportion to the executives overall performance and their credentials. In fact, this is an official fiduciary responsibility, because the board members are acting as financial supervisors (trustees) for the corporations shareholders.

The two basic duties that any corporate fiduciary (trustee) owes to the organization are a duty of care and a duty of loyalty. The duty of care provision requires fiduciaries to make “informed and reasonable decisions and to exercise reasonable supervision of the business” (Savage & Bagley). In the cases challenging board decisions for breach of the duty of care, the courts usually use the business judgment rule to assess whether or not certain good-faith (best interest of the company) behavioral standards were exhibited by the committee members.

If the committee directors can effectively prove that they made an informed decision based on objective information and their personal interests did not interfere with their contractual obligation to the company and its shareholders, then the court will not hold these members accountable for gross negligence. For example in Pirates of Silicon Valley movie there is a scene where Steve Jobs is watching his employees battle each other in food fight at a local bar. Moments later, Steve Wozniak walks into the bar to see Steve Jobs sitting in the corner laughing while his employees continue to combat each other.

Wozniak immediately comments to the audience that Steve Jobs was “destroying the company,” by pinning each Apple-employee division all against one another. Wozniak’s eye witness account regarding the irresponsible management style of Steve jobs is credible common law proof that Steve Jobs was not living up to his fiduciary responsibilities as major executive of Apple Inc. Later in the movie, the audience witnesses Steve Jobs gleefully gazing at a physical fist fight between two of his best Macintosh programmers.

This irresponsible behavior is a clear breach of the duty of care responsibility that Steve Jobs owed to Apple as a corporate fiduciary, because any reasonable person would recognize this lack of concern as an obvious potential threat to the company’s operations and reputation. The duty of loyalty provision requires fiduciaries to “act in good faith and in what they believe to be the best interests of the corporation, thereby subordinating their personal interests to the welfare of the corporation” (Savage & Bagley).

Historically, when it comes to executive compensation and executive approval, the boards of directors for many major corporations have been most unremarkable at living up to this chief fiduciary responsibility owed to their shareholders. For example, in 2001 a New York Times study revealed that more than 20 percent of the country’s 2,000 largest corporations “had compensation committees with members who had business ties or personal relationships with the CEO of the company that could compromise their independence.

Even the chair of the compensation committee had such ties at more than seventy of these companies,” (Henriques & Fabrikant). This issue is further illuminated in the case titled: In re The Walt Disney Company Derivative Litigation. In 1994 Michael Eisner hired his personal friend to be the new president of the Walt Disney’s Corporation. Although, Ovitz was clearly unqualified to be appointed president of a publicly owned entertainment company, Eisner still persuaded the board of directors and compensation committee to approve of Ovitz as president and fork over an extraordinary compensation package for him.

According to the case report, the board basically authorized full power to Michael Eisner to decided and structure Ovitz’s employment contract and benefits package as he saw fit. No documents or spreadsheet were reviewed by the board, the entire approval meeting lasted less than an hour, and the compensation committee immediately named Eisner chief negotiator, without any discussion about the details of Ovitz’s salary, stock options or possible termination.

After two years of an unsuccessful tenure at Disney, Ovitz decided to seek other employment opportunities. His boss and best friend, Michael Eisner, quickly helped him file a non-fault termination agreement with Disney to allow Ovitz to leave early without losing any of his compensation benefits. After Eisner finalized Ovitz’s non-termination without consulting compensation committee or obtaining its approval, a group of shareholders filed a derivate action suit.

The plaintiffs (shareholders) claimed that Disney’s board of directors breached their fiduciary duties when they approved the employment agreement and again when they failed to participate in Eisner’s dealings with Ovitz concerning his non-fault termination plea. The court affirmed the shareholder claims that they were entitled to monetary compensatory relief because Disney’s directors failed to meet the regulatory standards of their fiduciary responsibilities.

This is a landmark case involving the controversial issue of excessive executive compensation, where Ovitz’s non-fault termination severance package was estimated to be worth $140 million. It is clear that, in this case, Disney’s directors broke their fiduciary duty of loyalty to their shareholders and to the corporation because they based their supervision decisions on their relationship with Michael Eisner’s rather than objective circumstantial information.

Since stock options makeup an ample percentage of most executive compensation packages it is important to know what regulatory laws govern this practice, and stock options litigation, in general. Since stock options plans are essentially security (investment) contracts, these plans are always subject to state “blue-sky” laws, traditional security exchange laws (1933 and 1934 Acts) and new federal regulation under the 2002 Sarbanes-Oxley Act. The evolution of these laws has continuously added reinforcement provisions with same basic intentions of: 1. Providing investors with all essential information in timely and meaningful manner 2.

Delineating the liable parties in relation to specific illegal conduct 3. Preventing corporate insiders (executives, chief officers) from abusing their unique insider position to create a financial advantage over other investors 4. Allowing, investors who are victims of fraud or were provided inaccurate information to be compensated with adequate relief After the major collapse of Enron and Arthur Anderson, Congress raced to ratify the Sarbanes-Oxley Act as a reactionary response to the financial and social devastation is caused for the firms many investors and subordinate employees.

Essentially, this federal act provided eleven new provisional titles which defined many new requirement standards to increase the amount of disclosure corporations need to expose to its investors and employees. By increasing the amount of disclosure corporations are legally required provide, Congress has effectively eradicated the specific problems they believed had caused “the numerous corporate debacles around the turn of the millennium” (Savage & Bagley). One mandate specifically addressed the issue of excessive executive compensation.

This mandate requires that all additional transactions involving directors, officers, and principal stakeholders to be publicly disclosed. For instance, on top of the excessive stock option plans these corrupt CEOs were obtaining, many of these executives were exposed as having embezzled millions of dollars worth of loans from the company to use as personal funds that they never intended to pay back. For example, former Tyco International CEO, Dennis Kozlowski received $350 million worth of interest free loans from Tyco’s employee loan program and then used the money to build a lavish lifestyle on his company’s meal ticket.

With the funds he received from these loans, he purchased houses and boats all around the word, invested in a Hollywood movie, and even treated his wife to a birthday party estimated to cost over $1 million. However, according to Professor Jeanne Calderon the 2002 Sarbanes-Oxley Act and stricter SEC enforcement have “done the trick,” meaning that blatant misuse of corporate funds is no longer probable given the amount of disclosure companies are required to share with their investors. The SEC (Securities Exchange Commission) has taken a similar approach to regulate executive compensation.

The commission realized that although they do not have the authority to directly regulate executive compensation, they can still regulate it indirectly by requiring corporations to provide all its shareholders with precisely delineated information regarding the company’s executive compensation packages. As SEC Chairman, Richard C. Breeden, explained “the best protection against abuses in executive compensation is a simple weapon-the cleansing power of sunlight and the power of the informed shareholder based. Now that the regulatory framework and evolution behind executive compensation has been presented, the rest of this paper will provide a contemporary corporate outlook on the issues of stock options and executive compensation. The broad based corporate use of employee stock options during the 1990’s technology driven economic bubble-boom has resulted in a subsequent wave of employee litigation during this decade. Specifically, stock options have become a chief component of alleged damages in wrongful termination suits. According to, John C.

Fox, Chairman of Fenwick & West Labor Law Group, in recent years “wrongful termination suits…have been all about stock options. ” For example in the case Fleming v. Parametric Technology Group, the U. S. Court of Appeals found that Parametric had clearly breached their fiduciary duties of good faith and fair dealing when it fired former employee, Forrest Fleming, to prevent him from exercising his options. In addition, these stock option suits generally involve allegations of employee discrimination which can result in larger damage awards for the plaintiff.

In the case of Greene v. Safeway Stores Incorporated, the court awarded the plaintiff Robert Greene $4. 4 million dollars because he was wrongfully terminated in violation the Age Discrimination Employment Act which prevented him from exercising his options at the appropriate time. While in theory stock options are supposed to be an effective means for aligning the interests of employees and executives with those of the shareholders, most economic experts claim that the stock options corporate phenomenon has completely backfired.

These critics argue that “at best, stock options promote a short-term focus and at worst they have created an incentive for executives to inflate company earnings and make irresponsible forecasts” (Savage & Bagley). This practice entitled the pump and dump strategy was made famous by corrupt corporate executives like Gary Winnick of Global Crossing and Dennis Kozlowski of Tyco International who fraudulently manipulated their company’s earnings to keep its stock price high long enough for them to exercise all their options and sell all their stock at these extremely inflated prices.

In response to these crimes corporations have decided to shift away from stock options and instead offer their executives and employees replacement alternatives including: restricted stock, employee stock purchase plans, stock appreciation rights, and phantom stock. The technical details of these specific alternatives are not important to know for the purposes of this paper. Other drivers influencing the compensation reform initiatives include: investor activism, accounting treatment reforms, and stock value dilution.

Similar organizational reforms are affecting corporate policy attitudes and approaches concerning the justification process of contemporary executive compensation packages. Three large corporate activist organizations including the Conference Board Commission on Public Trust & Private Enterprise, the Business Roundtable, and the National Association of Corporate Directors on Executive Compensation have prepared reports that share consensus on the six key principles regarding the role of the compensation committee in creating executive compensation packages.

First, these activist organizations emphasized the need for compensation committees to think and behave with a strong and independent attitude and make every necessary effort (consultants, reports) to understand the details of entire compensation package (do their homework). Second, the committee should base all or most (at least 50%) of their executive compensation decisions on a strict performance basis, in order to create a stronger link between pay and performance in order to ease investor qualms.

Third, benchmarking needs to be eliminated from the committee’s major decision process because it creates a hyper-competitive recruiting environment; where every board considers their executives as distinctively above-average and thus provide an escalating compensation plan to stay ahead of other corporations. Fourth, options need to be expensed to keep the accounting effect neutral so as not to taint the official investor reports.

Fifth, executives should be forced to hold significant equity stakes in their employers to prevent a short-term inflationary focus, and instead align the long-term interests of executives with those of the shareholders. Finally, all details of the compensation packages need to be fully disclosed and transparent, which is a vital need and right for the all of company’s shareholders and employees. Works Cited Calderon, Jeanne. “Public and Private Offerings of Securities. ” NYU KMC Building, New York. 06 Dec. 007. Dash, Eric. “Former Chief Will Forfeit $418 Million. ” The New York Times 07 Dec. 2007. 07 Dec. 2007 <http://www. nytimes. com/2007/12/07/business/07options. html? em&ex=1197176400&en=b88e75e30fadc53d&ei=5087%0A>. Fleming V. Parametric Technology Corp. No. 97-56262, 97-56350. United States Court of Appeals for the Ninth Circuit. 29 June 1999. 08 Dec. 2007 <http://www. lexisnexis. com/us/lnacademic/results/docview/docview. do? risb=21_T2674557366&format=GNBFI&sort=RELEVANCE&startDocNo=1&results

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