Assessing The Future of Corporate Governance: More Questions Than AnswersPublished: November 20, 2002 in Knowledge@Emory
The departure of Securities and Exchange Commissioner Harvey Pitt earlier this month is more proof that the roller coaster ride surrounding corporate governance is far from over. After the debacles of Enron, WorldCom and others, Congress raced to enact a plethora of new rules to prevent further abuses. The SEC in the meantime began aggressively reviewing the books of some of Americas top companies.
But with any swift action, the questions and details are often worked out later. While disclosures of impropriety at Enron are nearly a year old, the question of how companies should proceed is still not settled. To discuss the questions of expensing stock options and corporate governance an expert panel consisting of two lawyers, two academics, two CEOs, one accountant, and a compensation consultant, gathered recently at Emory University’s Goizueta Business School to address these issues in a panel discussion entitled "The Compensation Conundrum: What Are My Options?"
Few doubt that governance reforms are needed in the corporate environment, but determining the rules that everyone will play by is not so easy. With new regulations, many entities such as The New York Stock Exchange chose to quickly enact their own recommendations for boards and oversight organizations. The implications of these actions along with changes in law and other “governance practice” recommendations were also part of the panel discussion.
While the discussion largely centered on the impact of companies opting to record as expenses the granting of stock options -- which is not a requirement currently, the influence of legislation quickly took center stage. Several speakers cited Congress’ corporate reform bill, the Sarbanes-Oxley Act, as a recent influence that reflects a more demanding regulatory and investment environment. But interpreting the bill and other governance oversight had the audience asking, how many experts does it take to decipher the new rules? The conclusion: it’s going to take all these experts and more to make sense of the new regulations.
Benn Konsynski, a professor of information and decision analysis at Goizueta and organizer of the event, opened the session by asking each of the experts for their stance on the law and other recommended reforms.
“(The legal world) likes exactitude and we have the exact opposite here,” said John Yates, a partner in the law firm on Morris, Manning, and Martin. “We are in a quandary in terms of what the new law means. We’re working with accountants and directors to try and decipher what is going on here.” Yates stressed that the language in the new law is vague, provides no guidance, and raises more issues than it resolves. His overall impression of the new law is that “there will be a lot of wasted energy spent trying to translate the law.”
Yates also pointed out that the legal dilemma is compounded because the Sarbanes-Oxley Act, passed by Congress, not by Securities and Exchange Commission rule, became effective immediately. The Act requires that effective August 29, if corporate insiders buy or sell stock in their own company, they will have just two business days to disclose the transaction. Yates wondered how companies will handle this rule without further explanation or how his law firms and others will advise their clients with such ambiguity in the language.
William R. “Billy” Parker, a partner at the accounting firm of KPMG LLP, the accounting and tax firm, agreed with Yates and noted that the questions are the same in the accounting industry. Parker went on to describe how difficult the new rules will make it to compare companies’ financials because the act of expensing options will be cost prohibitive for some publicly traded companies. “Expensing options,” he said, “is about 3% and 4% of the bottom line of a large company like Coca-Cola. It’s more than 20% for a tech company. How are we to compare the financials of companies when some are expensing and some are not?”
Speaking from his recent experience of aiding companies on determining whether or not to expense options, Parker provoked the audience to think about their own situation. “Why expense options?” he questioned. “Where did this idea come from? And how should you and your company deal with this issue? Before you do switch to expensing options, we recommend taking a deep breath. Think about your company and specifically what’s going on. If you do decide to expense the options, we recommend that you think about your entire long-term comp plans and optimize them for all management executives. This would be a good time to optimize.”
For David Leach, former CEO of Harbinger, an electronic data interchange service provider, Jack Welch’s employment contract provided the perfect frame for the discussion. According to Leach, GE agreed to pay for his laundry, newspapers, and personal use of the corporate jet, among other things. These items should have been declared. But he warned that the pendulum is in danger of swinging too far to the other extreme from no governance to too much. “The companies who have been called out recently didn’t have practices for handling their executives’ options in common; they had moral turpitude in common – they had dishonest people running these companies and they committed fraud. We’re implementing all these other changes to stop the 99.9% of honest CEOs out there who are trying to protect their shareholders, just for the tiny percent of CEOs that are dishonest.”
Leach, fearing a negative backlash from all the new regulations that would impede CEOs from doing their jobs, continued by warning, “Let’s be careful before we destroy the very basis this country was built on: entrepreneurship. People came to this country to make themselves great and (one way by which) that has been possible is through the offering of stock options. Let’s be careful before we throw all that out and go way behind the pale in trying to control the ways in which CEOs run their companies.”
James Reda, a compensation expert at Buck Consultants, a human resources consulting firm, agreed with Leach that there is real danger now of the pendulum swinging too far in the opposite direction. “There a lot of issues associated with the accounting questions,” Reda agreed. “And the pendulum is swinging back to shareholders and companies are getting spooked. Boards of directors are already bogged downed with hours of work and if we want to get them involved in these issues, it’s going to require even more time. Companies will risk being able to attract talented board members if there responsibilities are going to also include audit sessions and the like.” Reda concluded that all of this would result in a “de-glimmering” of boards, making it harder for companies to attract and retain talented board members.
From his vantage point as a board compensation expert, Reda addressed what would happen if expensing options becomes mandatory. “It will change the way companies use options in their comp packages and every company will have to go back to square one and re-visit what they’re doing.” Reda concluded, “Forget about all employee stock options and programs; that’s going to be a thing of the past and the change will happen almost over night.”
Al Hartgraves, a professor of accounting at Goizueta, took a different approach to the issue. Acknowledging that in his role as a university professor on the panel allowed him to think and theorize from an ivory tower. While he agrees that some type of regulation is needed, he notes “Left to our own devices, (companies) will invariably not do what is in the best interests of all the stake holders.” In order to build trust, Hartgraves suggests trying to insure that independent auditors are actually independent. “The Public Company Accounting Oversight Act and the Sarbanes-Oxley Act moved us in the right direction by imposing limitations on consulting. They’ve virtually closed the door on auditing firms providing consulting services,” he said.
Hartgraves went on to propose the creation of a new breed of audit firms whose primary focus would be as a watch dog for stake holders. He also suggested the creation of a two-board structure that would consist of a management advisory board and a shareholders board. This structure would be different from those in Europe that have a supervisory board and a management board. “The company’s auditors should be supervised and hired by the latter board to insure their independence,” suggested Hartgraves.
Based on Hartgraves recommendation the question was posed, is corporate self-regulation all that’s needed? KPMG’s Parker said no, but quickly commented on the problems that arise with the government trying to regulate corporations: “Any time you have some folks who are not of the industry trying to regulate the industry, you end up with some problems because the regulators don’t understand the issues of the industry.”
Just as the panel tossed around who should regulate corporations, they posed each other with the question of what’s the price of expensing options and when should options be expensed?” Hartgraves suggested, “Expense the options when you grant them because that’s when the economic cost is incurred.”
Parker modified Hartgraves answer by suggesting a company could “expense over the period of the service. If an option is going to be earned over 5 years, then you take one-fifth a year and expense that.” Parker also explained that born of that idea is the controversy surrounding what amount should be expensed. “The expense is based on factors at the option grant date and is not tied to the vesting event, so the company is pro-rating the expense on a presumption,” he explained.
The question was then raised: “Has accrual accounting out lived its usefulness or should we just be going to a cash basis accounting?” Another question that remains unanswered.
Indeed, even a room full of experts who were willing to listen to one another could not resolve the Pandora’s box of issues the law has helped create. “Clearly the panel agrees that reforms are needed, but most felt that a number of the proposals are excessive and unneeded in a healthy ethical environment,” Konsynski summarized. “Each had a story of how one regulation or recommendation was either not fully ‘thought through’ or would do more harm in areas than good in other areas. Fast thought and fast action may be the beginning of unintended and undesirable consequences. We should not be a bad servomechanism and swing too far to cripple commerce or useful innovation.”
Ultimately, reform may have to come from within. As Martin Avallone, general counsel at Mapics, a software company, commented: “It all starts at the top and a management team that has high integrity will pass that on.”