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Defaults, Excessive CEO Pay - Capital Markets - CFO.com Craig
Schneider, CFO.com July 27, 2005 Businesses that offer their chief executives unusually
large bonuses or option plans have higher bond-default rates and more
frequent and deeper rating downgrades than their peers, according to a recent
report by Moody's Investors Service. Of the 43 companies rated B3 or higher that defaulted
between 1993 and 2003, Moody's found, 22 offered their chief executives much-larger-than-expected
bonuses or stock option grants at least once. Of the 214 that experienced
"large downgrades" - three or more rating notches within 12 months
- CEO compensation was higher than expected in 140 cases. Expectations were
measured against a company's size, past operating performance, industry
conditions, and long-term rating. Among the high-paying businesses that eventually defaulted
include Enron and Covanta Energy, the report noted. Both were flagged by the
Moody's model as having high unexplained compensation in six of the seven
years leading up to their defaults in 2001. Moody's report suggested three explanations for this
correlation. First, excessive compensation may be indicative of weak
management oversight by boards of directors. Second, large pay packages that
are highly sensitive to stock price or operating performance may induce
greater risk-taking by managers, which may be consistent with the objectives
of stockholders but not bondholders. Third, large-incentive pay packages may
lead managers to focus on accounting results rather that business results -
in the extreme, enabling an environment that can lead to fraud. Christopher Mann, a Moody's vice president and author of
the report, warned against generalizing from the study, however. "The
vast majority of the firms under study never experienced a default or a large
downgrade," he said in a statement. "However, looking carefully at
compensation - along with other factors - may help to highlight the
effectiveness of a firm's governance practices." Moreover, as a result of changes to the accounting of
traditional stock options, more companies are shifting some executive
compensation toward restricted stock and performance shares, which may better
align management's interests with that of shareholders. (c) CFO Publishing Corporation 2005. All rights
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