Saturday, January 06, 2007

Executive Pay, Shareholder Activism, and Board Duties

Photobucket - Video and Image Hosting There is no particular reason why I should bestir myself to defend ousted Home Depot CEO Robert Nardelli: He certainly bagged sufficient swag to soften the blows of even his most outraged attacker. Yet I think it is important to incorporate into the modern morality play that his departure has become a fair recognition that by some measures his tenure as Home Depot’s CEO was successful. From 2000 (when Nardelli joined the company) to 2005, Home Depot’s revenue nearly doubled, from $45.7 billion to $81.5 billion, and during that same period Home Depot’s profit increased, from $2.6 billion to $5.8 billion. Dividends quintupled. The company’s return on capital increased almost 20 percent, a full 10 percentage points above its cost of capital.

Nevertheless, the consensus view seems to be that his ouster is a victory for shareholders, and that they have shareholder activists to thank. A typical example is the January 5, 2007 New York Times article entitled “Gadflies Get Respect and Not Just at Home Depot” (here), which states that “shareholder activists could claim one of their biggest prizes yet when Home Depot announced the resignation of its chairman and chief executive.” The article also notes that since July, activists have also successfully pushed out the CEO’s at Pfizer and Sovereign Bank.

In touting Nardelli’s ouster as a shareholder activist success story, the Times article note that he had long been “a target of shareholder ire for his large compensation and the company’s flagging share price.” It is this latter point – Home Depot’s flagging share price – that really seems to be at the heart of Nardelli’s problems. A January 3, 2007 Fortune.com article entitled “Nardelli’s Downfall: It’s All About the Stock” (here) makes the connection explicit. Gretchen Morgenstern made the same point in her January 4, 2007 New York Times article entitled “A Warning Shot By Investors to Board and Chiefs” (here, subscription required), in which she says that Nardelli’s compensation was “completely at odds with the dismal performance of Home Depot stock on his watch.”

One question that needs to be asked is how much of what happened to Home Depot’s share price had to do with Nardelli and how much it had to do with where the share price was when Nardelli took over. As PointofLaw.com points out (here), Home Depot’s share price was already at stratospheric levels when Nardelli arrived.

But the more troublesome aspect of the criticisms about Home Depot’s share price is the clear implication that Nardelli would still have a job (although he would be $210 million poorer) if he had managed to get the share price to go up. It used to be the conventional wisdom that the market determined a company’s share price, not the CEO. Moreover, it has not been that long since corporate America faced a series of crises and scandals because too many CEOs seemed to think it was their job to engineer their company’s share price rather than to run their company. Corporate activists may be congratulating themselves for their “victory” at Home Depot, but they should be very careful about the lesson here. The danger, as pointed out on the ContrarianEdge blog (here) is that “the ousting of Bob Nardelli sent a wrong message to America’s CEOs : it taught them an incorrect lesson – manage the stock, not the company.”

No one (at least not me) is going to defend the size of Nardelli’s pay package. But as Alan Sloan points out in his January 4, 2007 Washington Post column “Don’t Blame Nardelli” (here), the problem isn’t Nardelli, it is “the contract that Home Depot’s Board gave him." Home Depot’s board comes in lot of criticism over Nardelli’s compensation. A lot of other people also seem to want to blame the Home Depot board for the whole mess (see here).

Blaming directors for excessive CEO compensation has been a fruitful source of shareholder litigation in recent years. For example, shareholders sued the Disney Board for the $140 million severance paid to departing President Michael Ovitz. And the NYSE’s Board faces litigation for the $190 million pay package paid to departed CEO Richard Grasso. The names Disney and NYSE resonate here because of their mystic chords of connection with Home Depot. One of the defendant board members in the NYSE case is Kenneth Langone, who also happens to be a Home Depot board member. Langone also was a director of General Electric, and helped to recruit Nardelli to Home Depot from GE. According to a Janaury 5, 2007 New York Times article (here), shareholder activists blame Langone for both Grasso’s and Nardelli’s pay packages. The Disney connection to Home Depot is through Martin Lipton, of the Wachtell Lipton firm. According to a January 4, 2007 New York Times article (here), Lipton was not only hired to defend Nardelli and the Home Depot board against shareholder activist Relational Investors, Lipton did the same thing for Disney (and the NYSE, for that matter).

But the outcome of the Disney case should provide some some deterrence for shareholders itching to sue Home Depot’s board over Nardelli’s pay package and severance. Even though the shareholders took their case over Ovitz’s severance all the way to the Delaware Supreme Court, the Disney board ultimately prevailed. (See my article commenting on the Disney case here.)

While Nardelli’s pay package undeniably is eye-popping, there are some good reasons why CEOs deserve to be well paid. The first is that it is a tough job. According to one news report (here ), “Mr. Nardelli was an obsessive workaholic who rose at 4 a.m., logged 14-hour days and routinely worked through the weekend.” The second reason is that it is a tough job to keep. According to a January 4, 2007 Chicago Tribune article entitled “Pressure’s on for CEO’s to Deliver—Now” (here), the average tenure of a CEO is 48 months. Shareholder activists may decry CEO’s lavish severance benefits, but at one level high severance pay make perfect sense; CEO’s obviously want to provide as much deterrence as possible against a board’s quick hook, and also want protections against sudden unemployment. These comments should not be interpreted as a defense of excessive CEO compensation, but are merely intended to suggest that there may be more to CEO’s severance arrangements than mere greed alone.

All of that said, there is one aspect of Nardelli’s compensation history that I find undeniably troublesome. As noted in Gretchen Morgenstorn’s article (here), during the middle of 2004, Home Depot “quietly changed the measurement it used to calculate long-term incentive pay for executives.” Whereas the prior measure had used peer group comparisons of Home Depot’s earning per share, the new measure was based solely on Home Depot’s earning per share. Morgenstern’s article doesn’t mention it, but at the same time as this change was put in place, Home Depot was engaged in a massive share repurchase program. This obviously had the impact of driving up the company’s reported earning per share – and management’s bonus compensation. As I have previously noted (here), this practice of using share buybacks to boost EPS based executive compensation is the target of increasing criticism.

It is probably also worth noting that Home Depot and its board already face a number of lawsuits over other corporate governance and business practices. Shareholders have sued over the company’s options grant practices, which reportedly involve options backdating during a nearly 20 year period from 1981 to 2000 (see news reports here). And Home Depot and its board also faces a 2006 securities class action lawsuit (here), based on whistleblower allegations, that the Company misrepresented its financial condition by fraudulently inflating charges to vendors for defective and/or damaged merchandise; and pressured suppliers who complained about excessive chargebacks by threatening to reduce orders of their products.

A Word to the Wise: Gretchen Morgenstern’s description of Nardelli’s ouster as a “surprising defenestration” has drawn a certain amount of humorous criticism (here), but The D & O Diary takes it as a point of pride that we previously described the ouster of corporate executives over options backdating as “defenestration” – and our prior post (here) helpfully included the word’s etymology (with pictures!).

Latest Proof of How Cool the Internet Is: Want to see Nardelli’s contract with Home Depot? Here it is.

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