Governance Analytics

Discussion

Director Stock Ownership

Governance experts cite two factors that make directors good monitors: independence and equity. As noted by Professor Charles Elson, director of Sunbeam Corp., Nuevo Energy Co., and AutoZone, Inc., independence gives directors objectivity in reviewing management, while equity gives them the incentive to exercise that objectivity. [1]

Nevertheless, some board members have little or no equity interest in the firms they direct. According to a survey of 1,500 companies by The Corporate Library, 963 of board members owned no stock at all in their companies. [2]

Shareholders should insist that directors align their own interests with those of shareholders, for whom they act as a fiduciary, by requiring directors to own company stock. Some findings indicate that director ownership of company stock is associated with higher performance levels. According to compensation consultant Graef Crystal, a five-point increase in the aggregate stock ownership percentage among directors is associated with a 1.5 percentage point increase in annual shareholder returns.[3]

Many believe that directors should be required to put their own funds at risk by purchasing stock in the company, as opposed to only owning stock through option or stock grants given as part of a director compensation package. Increasingly, companies are requiring directors to own a specified amount of stock in the company shortly after joining the board.

The appropriate amount of stock ownership for directors and the timing of compliance with a stock ownership requirement are subject to debate. In a 2001 article published in Directors & Boards, Thomas Neff, president of Spencer Stuart, argues that companies should require directors joining a board to make a substantial personal investment in the company's stock and maintain it while serving on the board. Neff explains that a substantial investment is one that is large enough to have real meaning to the person involved. [4] Experts also suggest that stock ownership may prevent fraud. According to Elson, "The best way to avoid fraud is to have vigilant directors and compensate them with equity." Or, in the words of Warren Buffett, "Directors should eat their own cooking."[5]

Studies further show that boards move faster to rectify poor performance by replacing the CEO when directors are compensated in stock and the board is independent. [6] At Sunbeam, Elson saw his own personal investment in the firm deteriorate as controversies over the company's finances emerged, leading to the board's ouster of CEO Al Dunlap. Significant director stock ownership also results in more reasonable executive compensation levels.

Taking an opposing view, Hoffer Kaback, president of investment firm Gloucester Capital Corp., argues that stock ownership does not align the interests of directors with those of shareholders. Kaback's primary concerns are that alignment may penalize a good director for the failings of his colleagues, may cause good directors to avoid serving on boards with financial troubles, and is an unwarranted intrusion on director's personal finances. Commenting on ownership requirements, Hoffer states, "One may wonder whether companies are adopting alignment because they believe in its merits, or instead, as a defensive measure to avoid criticism for not having implemented it."[7]

Stock ownership requirements for directors enjoy support from both institutional investors and companies. A 1997 survey of institutional investors conducted for Russell Reynolds Associates found nine in ten investors believed that stock ownership and stock compensation served to align the interests of directors with those of shareholders. [8]Similarly, a 2003 survey by Pearl Meyer & Partners of directors at the 200 largest U.S. companies found that 80 percent believed directors should be required to purchase company stock, and 90 percent felt that directors should retain a portion of their stock. [9]

Director ownership guidelines are a fairly recent development. According to Pearl Meyer & Partners Inc.'s 1997 annual study of board compensation at the 200 largest U.S. industrial and service organizations, adoption of stock ownership guidelines for directors has been on the rise, doubling between 1995 and 1997. [10] By the end of 2003, Towers Perrin reported that 20 percent of Fortune 500 companies disclosed having director stock ownership guidelines. Guidelines were most prevalent at larger firms and telecommunications companies and least prevalent at utilities and industrial companies [11] According to ISS data on 5,500 U.S. companies, 362 (6.5 percent) had director ownership guidelines in 2003.

How much director ownership is enough? The majority of director ownership requirements are expressed as a multiple of annual retainer, typically five times retainer to be acquired within five years of election to the board, though some guidelines may be expressed as a number of shares or a dollar amount of stock.[12] Among companies using the latter, median ownership requirements are 3,500 shares (where expressed as a number of shares) or $180,000 (where expressed as a dollar value). [13] For Elson, the amount should be personally meaningful. "It ought to be enough so that if you lose it you get sick." His own rule is to buy $100,000 of company stock when he joins a board.[14] Directors should also be discouraged from selling stock while on the board, which sends a bad signal to shareholders. Few companies, however, have stock retention policies for directors. [15]

ISS does not advocate any specific required investment level because this could effectively restrict board membership to the independently wealthy. But in view of the fact that board service is a part-time activity for most directors and therefore does not constitute a director's primary source of income, shareholders should expect directors to invest at least some portion of their director compensation in the stock of companies of which they are directors within a year of election to the board. Without a good excuse (for example, if the director is a Jesuit), low levels of stock ownership should be considered a mark against the director.

One possible exception to a stock ownership standard would be a case in which certain directors are designated to serve by a major investor as part of an agreement involving a financial restructuring or substantial investment in a company's stock, such as in a private placement. These individuals may disclaim beneficial ownership of their company's stock ownership in the company. Nonetheless, these individuals have obvious incentives to maximize the performance of their company's investment. Therefore, do not be concerned if such individuals do not own stock.

While in principle the goal of director stock ownership is sound, shareholder proposals to establish specific minimum ownership requirements for new or continuing directors should generally be opposed. Imposing an arbitrary, across-the-board minimum ownership requirement could prevent many highly qualified individuals (such as academics or members of religious orders) from serving as directors. The decision on the level of ownership is better left to the company.

A better approach for shareholders to make clear their views on directors' ownership positions is through votes on individual director nominees. As explained above, a low stock ownership position held by a director who clearly can afford to increase his investment in a company should be taken as a negative indication of that director's commitment to shareholder interests.

Executive Stock Ownership

Executive stock ownership is essential for aligning management’s interests with those of shareholders. Although executives cannot be expected to put all their wealth in their companies, they should certainly have a vested stake in their firms’ long-term success.

Encouraging executives to behave like owners has largely been promoted over the years through the use of stock options. But despite sizable option grants, many CEOs and top officers still have small shareholdings in their companies. As a result, many firms are relying on stock ownership and retention requirements to ensure that corporate executives maintain a long-term equity interest in the company.

Most executive stock ownership guidelines were only adopted after 1990. In a 1993 survey of over 600 companies, William M. Mercer, Inc. reported that 12 percent had instituted guidelines requiring or encouraging executives to own company stock. [16] By 2002, 49 percent of the largest 250 companies had adopted formal ownership guidelines for executives, a 37-percent increase from 2001, according to Frederic W. Cook.[17] On a broader scale, ISS data showed that 463 out of 5,500 companies (8.3 percent) had executive stock ownership policies in place in 2003.

Executive stock ownership guidelines are typically expressed as a multiple of salary that must be achieved over a specified accumulation period. Once attained, executives are expected to maintain that level of ownership throughout their employment. Guidelines for CEOs generally range from 4x to 7x annual salary, with the median at 5x, while the requirements for other executives scale down to as low as 1x salary based on the executive's rank and responsibility. Accumulation periods usually range from three to five years, with five being the most common. [18]

The benefits of executive stock ownership have been supported by recent studies. Although early academic work (1971 to 2001) largely found no correlation between company performance and the amount of incentive compensation given to executives, later studies distinguish direct stock ownership (actual shares held by executives), rather than stock options, as a driver of firm performance. In an examination of 100 of the largest U.S. companies across ten industries, Clark/Bardes Consulting found strong correlations between true executive stock ownership and five-year total shareholder returns. Conversely, the study showed that companies whose executives held a high ratio of stock options to actual shares were also the lowest performers.[19] Watson Wyatt Worldwide similarly found positive correlations between executive stock ownership and financial performance, measured by three-year total shareholder returns, return on equity, and one-year growth in earnings per share. [20] Other research have shown that increases in CEO stock ownership levels is associated with improved firm performance. [21] For shareholders, the pay-for-performance implications are evident: unlike stock options, actual stock ownership provides upside opportunity as well as downside risk and shifts the focus of executives from short-term share price movements to long-term performance.

Business groups are also endorsing the concept of executive stock ownership. Following the accounting scandals and corporate abuses that came to light in 2002, the Conference Board Commission on Public Trust and Private Enterprise recommended that compensation committees require senior managers to accumulate a meaningful amount of company stock on a long-term basis and specify substantial minimum holding periods for equity received as compensation. The Business Roundtable similarly advocated that executives “build and maintain significant continuing equity investment in the corporation” through stock ownership guidelines and holding periods in its six principles of executive compensation released in November 2003.[22] In December 2003, a blue ribbon commission of the National Association of Corporate Directors (NACD) produced its own series of recommendations on executive compensation to ensure they have a long-term stake in the company:

Require executives to purchase some stock on their own
Set minimal stock ownership guidelines
Attach longer holding periods on stock acquired through option exercise or grants
Restrict executives' ability to exercise options and/or sell the stock in less than a year of exercise
Encourage top executives to hold stock at least six months after leaving the company [23]

Retention Ratios and Holding Periods

Although formal ownership requirements can encourage executives to acquire and hold company stock, they also have drawbacks. Targets may be too easy to achieve in a rising market or if executives can apply equity awards, such as restricted stock, bonus stock, stock options, or company stock contributions to 401(K) plans, to their ownership requirement. Conversely, executives may face a financial burden in a declining market when more shares must be acquired to bring up the value of their holdings. And while ownership guidelines can help curtail abusive trading practices, they cannot prevent it. Because executives are free to sell any excess stakes over the guideline amount, they can still engage in insider stock sales prior to a significant decline in the share price.

An alternative approach is the use of a retention ratio or holding period. Such guidelines require executives to hold a percentage of the shares they receive from stock option exercise or other equity awards (net of income taxes owed) either for a specified period of time (a holding period) or for their full term of employment with the company (a retention ratio). For example, executives may be obliged to hold 50 percent of the shares received from stock options or stock grants for two years.

Unlike traditional stock ownership requirements, holding periods and retention ratios provide for continuous stock accumulation by executives, irrespective of the value of their share holdings, while minimizing the possibility of abusive short-term profiteering through inside information. A disadvantage, however, is that stock retention policies--particularly if applied for full tenure--could lead to higher executive turnover if executives can only take their wealth out of the firm by leaving.

Retention approaches are becoming increasingly popular, partially as a result of shareholder pressure. In 2003, TIAA-CREF and the American Federation of State, County and Municipal Employees (AFSCME) each submitted proposals at several companies advocating, respectively, either the use of a holding period or a 75-percent retention ratio. According to a 2003 report by Frederic W. Cook & Co., of the top 250 companies that have executive ownership guidelines, 23 percent are applying a retention ratio or mandatory holding period, either alone or in conjunction with traditional stock ownership guidelines (i.e., shares must be retained until ownership targets are met). [24]

While it is important to encourage executive stock ownership, shareholders must be mindful that it can be accomplished in a number of ways. Therefore, shareholder proposals asking companies to adopt holding periods or retention ratios for their executives should be evaluated on a case-by-case basis. Targeted companies may already have some type of stock ownership requirement, holding period, retention ratio, or combination, which should be reviewed for stringency. A rigorous stock ownership guideline, for example, should go beyond the standard 5x salary for CEOs, to, say, 7x to 10x, with the multiple declining for other executives. It is also important to consider how easily the stock ownership threshold can be met. Do equity awards count towards the ownership requirement or would the executive need to make a personal investment in company stock? Alternatively, a company with a less aggressive stock ownership requirement should couple it with a short-term holding period (six months to one year). A meaningful retention ratio may also be an effective substitute to traditional stock ownership guidelines-- i.e., at least 50 percent of stock received from equity awards (on a net proceeds basis) must be held for the executive's tenure with the company. In addition to any guidelines currently in place, shareholders should take into account actual officer stock ownership at the company and the degree to which it meets or exceeds the proponent's suggested holding period/retention ratio or the company's own stock ownership policies or retention requirements.

Stock Ownership Requirements

Discussion

Director Stock Ownership

Executive Stock Ownership

Retention Ratios and Holding Periods

Notes