David F. Larcker and Brian Tayan published the results of research and analysis of a classic case study of ‘pay for performance’ in April this year. They explain how the pay structure for Valeant’s CEO, Michael Pearson, and the loss of focus of the board contributed to a greater than 90% decrease in the share price over the last 5 months.

At the time of Pearson’s appointment to the CEO position in 2008, ValueAct, a 16% shareholder with a seat on the board, influenced the design of Pearson’s remuneration package. The CEO and board agreed on a changed business model to move away from in-house R & D and to aggressively acquire other drug companies, license their product and increase monopoly drug product pricing.

Pearson was given $1m fixed pay and stock and option awards including performance stock units valued at $16m that would vest after 3 years if aggressive compound TSR hurdles were met. The performance units were structured to provide an exponential reward for exceptional long-term share performance.

Significantly, the arrangement was not designed just to provide upside to Pearson. He was required to buy shares himself and purchased $5m of Valeant shares – so he really did have ‘skin in the game’.

At the time, the pay structure was highly regarded as a design that would only reward if the company performed well and the share price grew.

Over the following 5 years Pearson went on an aggressive acquisition path and the company’s share price grew exponentially to a high of US$260 before falling over the last 5 months to its current US$30. There are a number of reasons for the dramatic fall including increased investor, political and regulator scrutiny of the company’s business model and pricing practices, its lack of R & D, the long term sustainability of the business and, significantly, its reporting practices.

There was a significant mismatch between the company’s reported earnings of zero over 7 years under GAAP and its non-GAAP adjusted cash earnings of US$8bn for the same period. The differences were attributed to the ‘usual suspects’ of amortization, impairments, acquisition charges, restructuring costs and similar. (Our related article in this newsletter on the Chair of the IASB’s concern with misleading reporting is particularly relevant see HERE).

In summary, analysis of the CEO and board’s approach over the past seven years is used to demonstrate a relationship between excessive risk-taking with the potential for excessive reward.

At one stage, the value of the CEO’s stake in the company exceeded US$3bn.

Despite this experience it appears that the Valeant board has appointed a new CEO with a similarly highly leveraged compensation package.

The research suggests a checklist that investors, proxy advisers and boards would do well to consider.

•  The research suggests significant executive exposure to equity awards can lead to unanticipated or undesirable behaviours. A balance needs to be struck.
•  How does the board evaluate or determine whether the executive incentives can lead to outcomes that could negatively impact shareholder value? Does the board watch it own behaviour and increase or re-focus its scrutiny on investments when there is a clear linkage to an aggressive incentive structure?
•  While the CEO’s pay structure had all the “ideal” features investors and proxy advisers regularly call for, would the behaviour have been different if the incentives were less aggressive?
•  Should operating or non-financial measures have been included in the LTI rather than just the single performance hurdle of a compound TSR? Would, in this case, an accounting measure be a better measure of long-term results?
•  When Valeant’s operating and financial tactics eventually came under scrutiny, it raised the question whether the board, shareholders and other stakeholders had failed to identify the red flags that should have warned the company’s business model was not sustainable. This was a reminder of the pre-GFC days when all the warning signs were being ignored because of the continued growth being ‘delivered’. Remuneraion committee could consider allocating the role of “hubris buster” to one of its members to ensure more considered approach.
• Boards should evaluate whether the incentives make sense, given the company’s strategy and situation. If they see any mismatches that are striking – such as a very aggressive equity package in a normally mundane business, or a very plain-vanilla equity package in an innovative business – they need to dig deeper and understand why it was put in place.
• Determine whether the board has a handle on the situation. Does the board drive the pay decision, or is the CEO lobbying for it?
• Review if the board is independent enough to monitor the CEO, or are they excessively passive or deferential? The combined experience of the board should be more than enough to challenge the CEO in terms of expertise and experience.
• Consider if board renewal is necessary. In Valeant’s case, the CEO’s replacement has a similarly aggressive pay structure with a package that could potentially be worth US$500m!

See the research “CEO pay at Valeant – Does extreme compensation create extreme risk?” HERE.

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