It's hard to know which companies to trust. Despite a succession of reform legislation, corporate misdeeds still go on. And while it is very difficult for investors to know if a company is cooking the books until it's too late, they don't have to be completely in the dark about questionable management activities and dealings. There is plenty of accessible valuable information that provides warning signs that executives may not be acting in the best interest of shareholders. This article will show some of the signs of dubious goings-on found in publicly available documents. (To learn more about shareholder rights and responsibilities, see Proxy Voting Gives Fund Shareholders A Say and Knowing Your Rights As A Shareholder.)
These days, it's common for top executives to receive base annual salaries in excess of $1 million. But for some executives, that income isn't enough to prevent them from taking unwarranted compensation.
The annual proxy statement - an SEC-required document - filed once a year shortly after the 10-K annual report - shows how much money executives are taking from the company in the form of salaries, bonuses, pensions, stock options and other expenses. By checking the proxy statement, you can determine whether executives' pay is in line with performance. Also, comparing one company's compensation with that of its peers will indicate whether one management team's pay is excessive.
Consider the enormous compensation lavished on Hewlett-Packard's former CEO Carly Fiorina. During her tenure, HP's share price dropped more than two-thirds. But from the time she joined the company in 1999 until she was ousted in Feb 2005, Fiorina took home more than $16 million in non-stock pay. Furthermore, HP helped her with her mortgage and relocation expenses which totaled $1.6 million between 1999 and the end of 2003. The company also paid for her personal travel expenses on HP jets and funded her retirement up to an annual $100,000. And finally, her severance package was worth about $21 million.
If executive compensation swells while performance wanes, this is likely to signal that management is not working in the interest of shareholders. For more on evaluating the job of those running a company, see Evaluating A Company's Management and Lifting The Lid On CEO Compensation.
Employee Stock Options
Broadly speaking, management ownership is a good thing - with their own money on the line, executives are more likely to act in shareholders' interests. But ownership doesn't have this desired effect when it's in the form of employee stock options (ESO), or incentive stock options: when shares go up in value, executives can make a fortune from their ESOs - but when they fall, investors lose out while executives are no worse off than before. So, while employee stock options are a key element of compensation, watch out for companies that - compared to other companies - offer a lot of ESOs to executives.
At the same time, keep an eye on companies that reprice their options, originally issuing options at one price and then, because the companies' share price plunges, exchange the old options with new ones at a lower exercise price. Companies claim that such action as an investment in the long-term health of the enterprise, saying repricing is necessary to retain talented employees during lean times. Sure, repricing is great for executives with ESOs, but shareholders still bear the brunt of diminishing share value while executives' stakes in the company stay protected.
Technology companies are the most common abusers as they tend to compensate the most with employee stock options. Consider chip-maker Broadcom. In 2004, it issued 48 million options, representing about 15% of its total shares outstanding. Of that total, 18 million options were repriced at a lower exercise price.
You can find out about executives' stock options holdings in the annual proxy statement in the document listed "DEF-14A" on the SEC's EDGAR website.
A study by research firm RateFinancials shows nearly 40% of the 500 companies of the S&P have business arrangements with parties that have personal ties to the companies or their management.
Although the vast majority of related-party transactions are legitimate, the practice grabbed headlines during the demise of Enron. The company's related-party transactions with special-purpose entities helped the energy company cook its books. Related-party transactions have figured prominently also in other corporate scandals. These transactions raise questions about whether corporate insiders are fully focused on the interests of shareholders. The deals, no matter how small, can create the impression that an insider is using company assets for personal benefit, resulting in the the company getting the short end of the stick.
Companies are required to disclose dealings they have with corporate executives and directors, and their associates and relatives. You can find the details of these dealings in the annual 10-K report under the heading "Certain Relationships and Related Transactions".
For example, on the 2004 proxy statements of two highly regarded stocks - The Gap and Best Buy – related-party agreements appear to directly benefit companies' top-level executives. Best Buy leases two stores from its chairman, and the combined rent on these two stores was about $950,000 for the fiscal year that ended Feb 28, 2004. As for the The Gap, its general contractor for store construction, Fisher Development, is owned by the brother of The Gap's chairman. Until 2002, this construction firm was the primary non-exclusive contractor for The Gap. When you see very large related-party deals, make sure to ask yourself whether they work in the favor of the company or to those running it.
Not surprisingly, excessive compensation, employee or incentive stock option repricing and suspicious related-party transactions all tend to be practiced by companies whose boards of directors are dominated by insider executives as opposed to outside directors. So be sure to check the 10-K and proxy statements to see if the board is stacked high with executives' associates, family, friends or anyone else who's likely to acquiesce to the decisions of management.
Also watch out for staggered boards, or classified boards, whose directors are not put up for re-election at the same time. The voting structure of staggered boards can delay the elimination of board members who are ineffective or who support dubious management activities. The undesirable effect is an entrenched management that is less responsive to shareholders. Also, staggered boards make takeovers and proxy fights more difficult to complete since a potential acquirer cannot force executives' dismissal at a single shareholder meeting, but must undergo a longer process.
Let's say a company that makes bricks had a board of 11 directors comprised of only four who were elected at any single general shareholder meeting. The company managers decided to take all the profits and invested it in a chain of luxury lingerie boutiques. Thanks to the staggered board, it could take years for shareholders to vote out the directors who decided to support the foolish investment decision.
Excessive management compensation, stock option repricing, related-party transactions and staggered boards are just a few practices investors should research before investing in a company. A close reading of the 10-K and proxy statement is a great way to ascertain whether a company is focused on building shareholder value or simply acting as a vehicle for managers' own interests.
It's not impossible for investors to detect a management's or board's double dealings. Find out where to look.