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Oracle Corporation (ORCL), Chesapeake Energy Corporation (CHK): Why Do Underperforming CEOs Make So Much?

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Last year, Oracle Corporation (NASDAQ:ORCL) CEO Larry Ellison got a $90.7 million payday despite significant shareholder disapproval. Was he paid for performance? Not necessarily. Research suggests that stocks of companies with the highest-paid CEOs underperform their industry peers.

So what explains their high pay? One place to look is the board’s governance structures, which too often permit significant conflicts of interest among those who set executive compensation.

Do the companies you own allow these conflicts? Here are a few key places you can look.

Board selection
Conflicts of interest can arise if the CEO is able to play a significant role in selecting and approving board member nominations, as this gives them some power to hand-pick rubber-stamp board members who are more likely to push through favorable compensation packages.

How can you determine if this is the case?

Take a look at the proxy sections discussing the company’s Nominating and Corporate Governance Committee. It provides valuable information about the procedure a company uses to select and approve board members, including members who will serve on the compensation committee.

For example, Chesapeake Energy Corporation (NYSE:CHK)‘s 2011 proxy statement indicates that the entire board of directors had “the authority to accept, modify, or reject the slate of nominees recommended by the Committee.” Since Aubrey McClendon was at that time serving as both the CEO and the board chairman, this means that he had a significant amount of power to choose the board members who would ultimately determine his compensation package and approve his management decisions.

According to some critics, McClendon used that power to hand-pick Chesapeake Energy Corporation (NYSE:CHK)’s board, which proceeded to offer generous compensation packages, and (according to some accounts) approved McClendon’s decision to take out about $1.1 billion in loans against his stake in company-owned wells.

Board compensation
Investors should also worry when the CEO is able to play a significant role in creating and approving board compensation packages, which can create a temptation among directors to kowtow to the CEO to preserve cushy compensation and perks.

How can you determine when this is the case?

Take a look at the proxy’s explanation of the responsibilities held by the compensation committee.

Chesapeake Energy Corporation (NYSE:CHK)’s 2011 proxy statement indicated that the compensation committee, which was entirely composed of independent members, was responsible for approving the amount of compensation directors achieve in equity. However, the proxy also indicated that the board of directors as a whole was “responsible for establishing and approving director cash compensation.”

This put McClendon, who then served as both CEO and board chairman, in a position to guide decisions regarding cash compensation packages awarded to directors — including those who set his pay.

Other questionable board connections
Suppose you’re a member of the compensation committee at Corporation A, and also the CEO of Company B, and that you recognize that Company B could profit from doing business with Corporation A. Wouldn’t you want to stay in the good graces of A’s executives to keep that opportunity open? Sure you would. And one way do to that would be to create generous compensation packages.

For this reason, investors should also be wary of any other situations in which compensation committee members’ other corporate affiliations might create a temptation to form a quid-pro-quo relationship with those whose packages they help determine.

How can you determine this?

First, look for disclosures of related-party transactions, which indicate when your company has purchased goods or services from a board member’s company.

Let’s look at a related-party transaction that occurred at Oracle Corporation (NASDAQ:ORCL), which awarded Ellison a compensation package worth $90.7 million in 2012. This egregious package garnered such strong shareholder disapproval that 58.9% of shares voted against it, even as Ellison himself owned about 23% of shares at the time.

Oracle’s 2012 proxy statement discloses that at least two out of three of its compensation committee members are associated with companies that may profit from Oracle’s decision to contract with them for goods and services. George Conrades and Naomi Seligman both serve as directors on the board of Akamai Technologies, Inc. (NASDAQ:AKAM) , and Conrades served as its CEO from 1999 until 2005. In 2011, Oracle purchased products and services from Akamai.

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