Board independence and executive compensation are issues experiencing more and more media attention lately, but what is being done to correct the problems? While regulators are working to enact new laws, these take a long time to enact and enforce. As a result, many activist and passivist investors have voiced their concerns recently (which led to the current media blitz). One of the most important instances occured on October 23rd when a coalition of pension funds with over $850 billion under management sent out letters to the top 25 U.S. companies by market capitalization expressing concern over executive compensation. In particular, the funds voiced their concern over the independence of the board committees that determine executive pay within a company. Often times these compensation committees also work closely with management in other areas; such relationships could lead to the inflation of executive pay at the expense of shareholders. How does this occur? In the end, these committees are often failing to prevent abuse of Regulation 162(m). This abuse is characterized by performance goals (developed by these compensation committees) containing vague vocabulary designed to maximize the liklihood of meeting goals. When these goals are achieved, bonuses are granted to executives (and they're even deductible!). The pension fund coalition hopes that these letters will remind investors to be mindful of executive pay levels as well as encourage companies and regulators to work to remove any conflicts of interest that may exist between management and shareholders. In the end, it may be shareholders that may have to take action through the use of publicity and proxy threats. After all, it was regulators that passed Reg 162(m) in an attempt to combat excessive compensation in the first place!

Public companies are structured in such a way that shareholder interests and management interests are seperated - at least that's the theory. Problems arise when management holds the position of Chairman, which often leads to their "friends" being appointed to fill the other seats. Shareholder interests are in great jeopardy when this happens because management has complete control and very little oversight. This type of situation can be particularly costly during mergers or acquisitions, when management interests can differ greatly from shareholder interests. Often times, management receives cash bonuses, severence packages, and other benefits that are not realized by shareholders. Occasionally, these benefits are offered by bidders who want to restrict the marketing done to sell the company in order to assure a lower cost of acquisition.

One such instance of this taking place is the Lone Star buyout by private equity firm Lone Star Funds. While the value of such a transaction should be over $40 (based on the analysis of a hedge fund), the company agreed to a buyout priced at only $27.10. Moreover, the company did not solicit any bids until after the company agreed to the $27.10 buyout with a contigency stating that Lone Star Funds would have the right to match any future bids! Combined with an $18 million breakup fee, the company is giving little chance for other bidders to make a higher offer. Why would a company do this? Well, management has a lot of money vested in stock options that will expire soon. If the buyout goes though, the CEO alone stands to make $80 million through the exercise of risk-free options. However, if the buyout fails (or if they would have had to consider other bids) he would have had to spend $14 million to exercise those options with no guarantee that a buyout would take place anytime soon.

Instances like this can cost shareholders a lot of money while management benefits. The problem can be traced back to the fact that management and the board are not adequately seperated - a problem which not only affects M&A decisions, but also executive compensation, performance metrics, capital allocation, and many other things that can cost shareholders. This is a growing problem that is currently policed by hedge funds, but should be addressed by Corporate America before it grows.

Mentioned Companies
Lone Star Steakhouse & Saloon Inc. (NDAQ:STAR)

Richard Causey, the last executive implicated in the downfall of Enron, was sentenced today to five and a half years in prison for his involvement in the scandal. The Chief Accountant who signed off on manipulated accounting documents plead guilty in December 2005 to securities fraud and agreed to repay $1.25 million in damages and forfeit over $250,000 in deferred compensation. The judge showed no mercy at trial as he sentenced Causey to just a half year below the maximum and imposed additional financial penalties to the judgement, although prosecutors opted not to go after his $950,000 home in a Houston suburb. Meanwhile, CEO Jeff Skilling was order to report to prison in Minnesota on December 12th to begin his 24 year sentence, although he plans an appeal.

Clearly executive compensation is a problem for many public companies, but what can shareholders do to curb the pay? Well, data from Institutional Shareholder Services - a proxy firm - suggests that activist shareholders have been stepping up in their efforts to draft resolutions to curb executive pay. An article in Business Week quoted ISS as citing as many as 170 pay proposals submitted to U.S. public companies this proxy season alone - and that number will only grow. This compares to only 140 submitted during the last proxy season in February.

Many of these resolutions are drafted in the fall months for presentation during annual meetings, the bulk of which are during the spring months. These resolutions are then brought up at the meetings where it is decided whether or not they will be put on the proxy statements. These proxy statements are then sent out to all shareholders, so any mention of executive compensation definitely raises awareness very quickly.

Several unique proposals are in development, demanding everything from better reporting on stock option grants to peer performance based compensation. These new proposals, combined with the SEC's upcoming regulations, will enable investors to better track and even regulate executive compensation. For more free, detailed executive compensation figures and analysis check out ExecutiveDisclosure.com.

Most investors are aware of the options backdating scandal that has hit the market recently, but many questions still remain: How widespread is this problem? And, are there other ways in which executives can take advantage of options to profit off of shareholders? Unfortunately, there are several studies that have concluded that option grants have uncanny timing in the the majority of public companies. In fact, it was studies like this that eventually brought the current instances of backdating fraud to the SEC's attention - in particular UI Professor Erik Lie's paper, which suggested that many option grants were given at such unpredictably opportune times that it must be been set after the fact. Obviously, this turned out to be true as the SEC continues to investigate several companies. Meanwhile, many other companies continue to practice other shady techniques to provide executives with even more money.

While backdating is currently in the spotlight, there are many other similar techniques that executives can use to profit from shareholders. One such technique is known as "bullet-dodging". This is a technique whereby option grants are awarded shortly after a negative press release, so that they are issued at the lowest possible prices. The opposite of this is "spring-loading", where executives will delay positive press releases until after option grants take place. Both of these techniques involve profiting off of non-public information; however, their usage remains widespread due to a lack of legal definitions. The SEC has yet to pursue any of these cases, and as a result there are few court cases to create more refined legal definitions. Until this happens, the practices will likely to continue and investors will have to simply be watchful. Currently, the SEC does require companies to report option grants within two days of their issuance, so it does make it possible for investors to track. Portals like ExecutiveDisclosure.com can help investors find such dates in order to somewhat predict good or bad news releases.

The options backdating scandal continues to haunt the markets today as KB Homes CEO Bruce Karatz resigned as head of the company amid an internal options investigation. A preliminary report found that the home construction company had incorrectly reported around $50 million in options grants, which the CEO agreed to repay. Several other members of the company were also found guilty, which prompted the board to fire HR head Gary Ray and encourage the resignation of VP and chief legal officer Richard Hirst. The board found that Mr. Karatz and Mr. Ray had selectively chosen grant dates under the company's stock option plan for personal gain.

According to an 8K filed by the company today:

"On November 12, 2006, the Company announced that a subcommittee of the Audit and Compliance Committee of the Board of Directors and its independent legal counsel conducting an investigation into the Company’s past stock option practices have concluded that the Company used incorrect measurement dates for financial reporting purposes for annual stock option grants during the period from 1998 to 2005. The Company expects that the incremental non-cash compensation expense arising from these errors is not likely to exceed an aggregate of $50 million, spread over the vesting periods of the options in question. The errors may also require an increased tax provision. The Company is evaluating, with its independent auditors, whether a restatement of certain previously-filed financial statements will be required. The Company has cooperated and will continue to cooperate with the inquiry of the SEC and other government agencies." (Read More)

This latest investigation has again pushed the bounds of these investigation to companies outside of the tech sector, which was hit especially hard. Although the number of investigations has slowed as of recent, there continues to be many new instances while older cases are just beginning to be settled by the SEC. So far, only a handful of executives have faced criminal charges.

Mentioned Companies
KB Home (NYSE:KBH)

We all know that the Democrats recently took control of the House and Senate, but what does this mean for executive compensation? Currently these kinds of issues are handled by the House Committee on Financial Services, which oversaw the development and implementation of laws like Sarbanes-Oxley. Prior to the elections, the chairman of this committee was Republican Michael Oxley from Ohio; however, it is likely that he will be replaced by Democrat Barney Frank from Massachusetts. Barney Frank has pledged to push legislation that will give shareholders much more control over executive compensation. One of the aspects discussed the most is the social implications of corporate profit-sharing; some believe that the stagnated middle-class could benefit from money that would otherwise be lining the pockets of upper-class executives. Essentially, they seek to close the growing income gap between executives and employees, which has grown even greater according to recent reports that executive compensation was growing at 20% per year while employee salaries remained nearly even. So far these ideas have not gained much political traction; however, this could change as the Democrats have taken control of the House and Senate and more media attention has been drawn to executive compensation.

Enron has become one of the greatest examples of fraud in corporate America - when a company with a $60 billion market cap disappears overnight, it draws some attention! But what really happened at Enron, and what can we learn from it? Well, here's the story: In early 2001, the high-flying energy company was the darling of Wall Street, trading at over $80 a share with analysts at their feet strongly recommending the stock. A few months later the stock began to slowly drop; however, so did the rest of the market, so few analysts voiced any concerns. Many just assumed that it was trading alongside the rest of its sector. Little did people know that executives were dumping millions worth of stock while trying to keep their financial statements in order for just a few more months...

The first sign of trouble came in August 2001, when Enron's CEO Jeffrey Skilling unexpectedly resigned. Shortly after, the company's chairman and previous CEO Ken Lay took over. However, by the end of the month the stock was trading at just $35 per share - less than half of its early 2001 highs. But the real news didn't hit until two months later when the company stunned Wall Street with a $638 million loss along with a $1.2 billion write-down in its book value. This turned out to be far less than the actual losses, which came as a result of losses suddenly realized on a series of partnerships setup by CFO Andrew Fastow. It turns out that Enron had guaranteed the partnerships' debt, making its true liabilities much higher than what was shown on Enron's financial statements. It was this fact that ultimately caused both investors and customers to flee, leading to the company's bankruptcy.

As if this weren't enough, investors and employees soon discovered that senior executives had received over $750 million in salaries, bonuses, and stock options for good performance in the same year before the company declared bankruptcy! It turns out that executives were bailing out of the stock while the partnership losses remained hidden. Soon after, even more conflicts of interest on Wall Street were revealed: It turns out that Enron's accounting firm, Arthur Anderson, turned a blind eye because they wanted to keep the lucrative contract they had with the company. Meanwhile, analysts continued touting the stock in order to help the investment banking side of their firms get more business from Enron in future offerings.

Luckily, financial statements and securities laws have come a long way since this scandal first started; however, there is still much work that needs to be done. With the new executive compensation disclosure requirements (recently approved by the SEC) and web portals like ExecutiveDisclosure, investors will have tools at their disposal to find problems and conflicts of interest before they become full-blown scandals like Enron or WorldCom.