by yielder » 06Apr2006 07:59
[url=http://www.nytimes.com/2006/04/06/business/06place.html?ex=1301976000&en=9efb2ddb1ae028c9&ei=5088&partner=rssnyt&emc=rss]The Coca-Cola Company announced an innovative plan yesterday for paying outside directors: If earnings per share do not rise fast enough over a three-year period, directors will receive nothing. But they will get a significant raise if earnings perform as expected.
While many companies give directors all or part of their pay in stock or stock options, Coca-Cola appears to be the first to have adopted a plan that would provide nothing if the company did not perform well.
The idea was enthusiastically supported by Warren E. Buffett, the chairman of Berkshire Hathaway and a Coca-Cola director who is stepping down from the board and will not be eligible for the payments. But it ran into criticism from corporate governance experts who expressed fear that directors could face conflicts of interest.
"We've seen all sorts of problems with managements manipulating earnings to receive incentive payments," said Paul Hodgson of the Corporate Library, a research firm specializing in governance issues. "If the audit committee is also focused on achieving earnings targets in order to receive its compensation, then you have the potential for them to be less than assiduous at detecting potential problems in financial reporting."
Mr. Buffett, in a telephone interview, discounted such fears. "I can't think of anything else that more directly aligns director interests with shareholder interests," he said. "As a shareholder, I love it." Berkshire is Coke's largest shareholder.
Mr. Buffett said the three-year period would encourage board members to think of long-term interests, and he dismissed the idea of paying directors part of their compensation in stock. "If somebody gets $150,000 in stock for a fee and the stock goes down 20 percent, they still get $120,000," he said. "I do not think the shareholders' interests are aligned there." He declined to say if he had proposed the idea to the Coke board.
Brian Foley, whose firm advises companies on compensation, responded enthusiastically to the Coke plan, saying, "This is a board that will have its feet in the fire, different from just about any other board that I can think of."
But after further thought, Mr. Foley amended that opinion. "At first blush, one wants to applaud," he said. "At second blush, one hesitates. It does have some potential dynamics that could be awkward. Maybe they get a B+."
It is unclear whether the idea will spread. Although Mr. Buffett is widely respected, some of his ideas, such as not issuing stock options or not providing earnings guidance to analysts, are not much imitated.
"It is unlikely to catch on in a big way," said Mr. Hodgson, adding that he thought that most directors would want to be sure of being paid at least some fee to compensate them for their time.
Coca-Cola in the past has paid its outside directors a fee of $125,000 a year, part in stock and part in cash, with additional payments for those who served on board committees. The new plan would give them $175,000 in stock each year, with no extra payments. Over a three-year period, each director would receive additional shares as if he or she had reinvested dividends.
In the third year, if earnings per share are 25.97 percent higher than they were in the base year — a compound rate of 8 percent a year — then the director will receive the value of the stock in cash at the market price then. But if earnings per share are lower than that, directors will forfeit the shares and have worked that year for nothing.
This means that directors in 2006 will keep their shares only if 2008 earnings exceed $2.73 a share, compared with $2.17 in 2005. Those figures are after adjusting for certain unusual items, the company said.
At any given time, a director would have three such plans at stake. It is conceivable that directors at year-end would have an incentive to bolster earnings to ensure that the target was met. But if that year's target was already going to be met — or was unreachable — they could have an incentive to delay additional profit to the following year, in hope that this would help meet the following year's target.
Mr. Buffett, who has served on the Coke board since 1989 but chose not to seek re-election at the annual meeting on April 19, said that did not concern him. "I don't know about other companies," he said, "but I can assure you that at Coke nobody is going to be tinkering with earnings. It isn't going to happen."
Yet Lynn Turner, a managing director of Glass, Lewis, a corporate advisory firm, and a former chief accountant at the Securities and Exchange Commission, noted that last year the S.E.C. issued a cease-and-desist order barring Coca-Cola from violating accounting rules.
The commission said the company had manipulated earnings from 1997 to 1999 through "channel stuffing" by offering generous credit terms at the ends of quarters to persuade Japanese distributors to buy more Coca-Cola concentrate than they needed, thus raising earnings.
The commission said that without the channel stuffing, the company would have missed earnings forecasts in 8 of the 12 quarters in that period. The S.E.C. said that while that accounting treatment was legal, Coca-Cola violated securities laws by not disclosing the channel stuffing and its effect on profits.
"I think you have to be careful about the incentives you give people," Mr. Turner said. "I'd be less nervous if they said, 'You cannot cash out until the end of 10 years, or when you leave the board.' " That, he said, would reduce the possible gain from manipulating earnings in any one year.
In the late 1990's, Coca-Cola was promising investors that its earnings per share would rise at an annual rate of 15 percent to 20 percent. In 1998, while the S.E.C. said the earnings were increased by channel stuffing, Coke's shares reached a record high of $88.94, and Coca-Cola was seen by many investors as a growth company.
But the stock price fell sharply as earnings proved disappointing in later years, and its current target is earnings growth of about 7 percent to 9 percent a year. Yesterday, the stock fell 13 cents, to $41.95.
James D. Robinson III, the chairman of the Coke board's committee on corporate governance, said in an interview that the board had ample protections in place to prevent earnings manipulation, adding:
"I am not worried about the board all of a sudden becoming corrupt to get a $175,000 payout. It's ridiculous."
He said that the board might give a $175,000 "signing bonus" to a new director whose financial condition would not allow him or her to work for nothing. But payouts after that would be based on the same formula as for other directors.
Mr. Hodgson of the Corporate Library said he was also concerned that directors might face a conflict if confronted with a possible merger that would depress earnings for a few years but that held the potential to be of great value in the long run.
Mr. Robinson said that in such a case, "if it makes the most sense for the company to do the acquisition, we will do the acquisition."
Mr. Hodgson, while critical of the Coca-Cola plan, added, "I am not philosophically against incentive plans for directors, but I think they need to be designed with more of an eye to long-term strategy than this."
Mr. Robinson said the board had considered other gauges, like stock price performance, for determining the payout, but rejected them because share prices could rise or fall as a piece of the overall market as well as because of a company's performance.
"The one thing the company can deliver is earnings and earnings per share," he said, and that made it the appropriate measure.
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