A chief executive officer (CEO) wields tremendous power in a company's corporate structure. Although the board of directors has the ultimate say in most matters, the board's power is focused into the CEO. This concentration of power is good when the CEO uses his or her power to improve the company, but a bad CEO can use this same authority to run a company into the ground. In this article we will look at how a bad CEO can hurt a good company and ultimately cost the investors who own it.
Compensation - Surviving on just $140,000 a day?
Like professional athletes, CEOs sign multi-year contracts based on what their performance is predicted to be rather than getting paid an hourly or monthly wage that can be changed to suit their actual performance. The rationale behind this is that no CEO would take on the pressure of the job if the paycheck wasn't guaranteed. The problem is that the base compensation levels, not including bonuses, are sometimes inflated beyond all reasonable expectations. (Find out what it takes for a CEO to be successful in Is Your CEO Street Savvy?)
|Excess Compensation Examples:
The House of Mouse - Michael Eisner received $737 million over five years between 1996 to 2001 to head up Disney (NYSE:DIS), according to a Forbes article, "Michael Eisner: Mouse In A Gilded Mansion". During those five years, Disney\'s net income went from $1.2 million to a loss of $158,000 and Eisner managed to alienate Pixar, the one bright spot in five years of underperformance.
The Lee Raymond Effect - When Lee Raymond retired from Exxon Mobil (NYSE:XOM) he had earned $686 million in compensation during the 12 years he was CEO of the oil giant from 1993 to 2005, according to calculations done by the New York Times. That breaks down to $140,000 per day. Unlike Disney, Exxon Mobil was posting record profits for most of those years, and its stock soared in price. Yet, it is hard to believe anyone could be worth $140,000 a day, especially when the profits had more to do with naturally rising fuel costs than any spectacular innovation of Raymond\'s.
Certainly the CEOs of large corporations can point out that their salaries are a small fraction of the company's profits, but the argument of paying more simply because you can doesn't hold up. (To learn more, read Executive Compensation: How Much Is Too Much?)
Wall Street already has a better alternative to high-base salaries. Like pro athletes, many CEOs have a separate bonus structure to reward extraordinary performance. When a CEO demands a huge base salary, it usually means that investors are going to end up paying more for less. In contrast, when a CEO takes on a smaller compensation package - usually in exchange for performance-based bonuses - this signals that he or she is putting the company's interests first. This is what Warren Buffett means when he advises investors to look for managers that think like owners. If you were an owner, you wouldn't set your personal salary so high that it could hurt the business. (For more on Warren Buffet's philosophies, check out Think Like Warren Buffett.)
Tunneling into Jail
Tunneling has been a problem with both long-term CEOs and transient ones that go from company to company trying to get the most bang for their buck. Tunneling is an illegal practice that occurs when CEOs use their authority to transfer business and/or capital in a way that pads their personal bank accounts. Possible tunneling activities include: personal loan guarantees, asset sales and dilutive share measures.
Unfortunately, the laws that deal with a conflict of interest are weak because the case is often difficult to prove. For example, if a CEO happens to give a huge contract to a bidder who happens to be a golf buddy who also happens to give the CEO season tickets to the Celtics, there is still a chance that the CEO truly believed that bidder would do the best job for the money.
|Tunneling Example - The Robber Baron
Many of Ex-Hollinger CEO Conrad Black\'s decisions seem to have been based on personal gain, or the gain of a close circle of friends, rather than the good of the media company he was in charge of. After shareholder rumblings in 2003, an investigation revealed Black overpaid family and friends for every service they could conceivably provide. Special attention was paid to "non-compete" payments made to Black and other insiders following Hollinger\'s sale of various newspaper assets. The grand total came to more than $400 million over seven years.
After several lawsuits and countersuits Black was convicted on three counts of mail fraud and one count of obstruction of justice in 2007. He was sentenced to 78 months in jail.
The next section will cover conflict of interest issues and the costs of getting rid of a bad CEO.
Interesting Conflicts of Interest
Aside from outright corporate kleptocracy, conflicts of interest can cost investors in subtle ways. During the internet boom, there was a wide-spread IPO spinning scandal. Issuing firms gave pre-IPO shares to executives of various companies that could be sold after the IPO for a quick profit. In return, these executives often took their companies public through the firms that they had personally accepted shares from. Essentially this was a complicated system of bribery. Even CEOs from established firms were wooed into changing banking firms by pre-IPO shares.
The execs made money, but their companies generally lost money on the higher cost of banking services. In this case, the profits from the sale of the shares should be given to the company, as the company (i.e., shareholders) had to bear the higher costs. (To learn more, check out The Murky Waters Of The IPO Market and IPO Basics Tutorial.)
|IPO Spinning Example - The Net Detective
Clark McLeod, the former CEO of telecommunications company McLeodUSA, was forced to give back $4.4 million that he made from IPO spinning.
Eliot Spitzer, then attorney general of New York, sued McLeod alleging that from 1997 to 2000, investment bank Salomon Smith Barney secretly gave McLeod shares of 34 "hot" IPOs. The shares increased in value by more than $4.8 million on their first day of trading. During these same three years, McLeod directed more than $77 million of McLeodUSA\'s investment banking business to Salomon Smith Barney. (To learn more, read Eliot Spitzer - Man Of A Thousand Scandals.)
A Costly Goodbye
When shareholders find out they have a bad CEO at the helm, they can oust him or her, but getting rid of a bad CEO can almost be as financially painful as keeping one. Golden parachutes and other contractual elements that kick in when a CEO steps down can be as hard for shareholders to swallow as the bloated salaries.
|Golden Parachute Example - The Pfizer Pflop
Henry McKinnell, Pfizer\'s (NYSE:PFE) CEO from 2001-2006, took the company in a disastrous acquisition direction where it overpaid for companies and securities that added nothing to its drug pipeline - Pfizer\'s core business. Yet, when he walked after losing billions of shareholder dollars, he took an additional $213 million as a retirement package that included an $82 million pension, stock and other benefits. Pfizer lost more than $137 billion in market value during his tenure. (To learn how analyze a compensation structure, read Evaluating Executive Compensation.)
There are many other ways that a CEO can hurt a company, but they all boil down to a CEO putting his or her own interests before the company's. With the mystique surrounding the superstar CEOs, it is easy to forget that their job is to serve the company and its shareholders, not pad their own wallets. There are many great CEOs out there who have served quietly and helped their companies grow. Often we never hear of them because they refuse the type of compensation that makes headlines and instead focus on creating shareholder value. When you are considering investing in a company, the CEO is an important part of your decision. If a CEO is costing the company too much, it may be better to pass up the investment for a company whose management actually adds value.
To continue reading on this subject, see Putting Management Under The Microscope.