CHAPTER 9 Of Reason, Renewal, and Honesty

Changes in the investment community represent an opportunity to revamp

practices and procedures to fuel a more efficient and fair market place.

Several companies performed internal investigations and changed governance

practices in advance of regulations. But for others, the ramp-up into

these new ways has been slow, time-consuming, confusing, and costly. IR

has the duty to work closely with the board of directors and management to

clarify and accelerate the process, so that a company remains on course and

the investor is the ultimate winner.

A good IR strategy works well within the law to support the objective of

protecting or enhancing equity value. The complexities of disclosure rules

are less important to the executive who is already communicating openly

and honestly. But good communication cannot happen without understanding

what these changes mean for the sell-side and buy-side. Knowing the

ears upon which the information falls is key to a solid communications plan.

Creating a solution that protects the company, the analyst, and the buy-side

is the ultimate goal.

COMPENSATION

One area in which much of the debate has focused is compensation. A few

companies, such as Boeing, Microsoft, Coca-Cola, The Washington Post,

and Amazon, jumped ahead of potential legislation and immediately began

expensing stock options. Pending regulations also sparked innovation

around, and resurgence of, other compensation awards, such as restricted

stock, performance-based options, and stock grants.

In the case of Progressive, a Mayfield Village, Ohio–based insurance

company, the decision to scrap stock options in favor of restricted stock had

less to do with the expensing issue than with their conclusion that options

motivated some behaviors that were not in the best interest of the company.

Sealed Air of Saddle Brook, New Jersey, issued restricted stock as part of

four components: cash salary, benefits, nonperformance-based restricted

stock, and a management by objectives program. Restricted stock recipients

paid $1 per share for the stock certificates, which vested after three years.

There was no holding requirement, but management believed employees had

a tendency to hold stock after the period.

Other companies that switched to restricted stock or scaled back the options

program include Altria Group, Citigroup, Dell Computer, and Cendant

Corp.

The most effective compensation packages tend to include a combination

of incentives. Experts assert that multiple long-term goals and multiple

compensation tools are the best way to ensure superior performance. IR,

along with outside compensation experts and board members, should be

consulted in analyzing and deciding upon the optimal compensation mix

and incentive structure for any company. They should also be consulted on

how that compensation mix is likely perceived by Wall Street investors.

Table 9.1 provides a summary of compensation vehicles.

IN THE BOARDROOM

Ever since Sarbanes-Oxley and Reg FD placed management and directors

under the microscope, corporate governance, has been at the forefront of intense

scrutiny. Independent agencies came to prominence to prescribe and

oversee ways to achieve competent governance and too many companies

seemed to be in constant preparation for some bad variation of standardized

testing.

If a company has a credible management team and policies steeped in

ethical business behavior, they’ll rarely need someone else to prescribe the

right methods. The company should always control its communications

with regulators and the public, and this means dictating the terms of good

governance for itself.

There are many issues that management needs to discuss with The

Street so as not to affect current or ongoing valuation, including any and all

issues among top management or directors that may be considered material

information. IR needs to advise on how these issues will read on The Street.

The selection of directors; the turnover of directors and management; the

relations between, and the independence of, directors; and the indepen-

TABLE 9.1 Compensation Method Comparison

Nonqualified Stock Options Restricted Stock Performance Shares

Shares of stock or fixed cash value at

Grants the option to buy stock at a Outright grant of shares with restrictions beginning of period; performance

fixed price for a fixed exercise period to sale, transfer, or pledging contingency

Pros Cons Pros Cons Pros Cons

Executive and Executive and Immediate dilution Executive and

shareholder May incent short- shareholder of EPS for total shareholder Charge to

interests aligned term behavior interests aligned shares granted interests aligned earnings, marked

(if using stock) to market

No charge to Dilute EPS No executive Possible recruiting

earnings investment required disadvantage Performance Difficulty in

oriented setting

Company receives Executive No expiration to Potential performance

tax deduction investment required incent short-term manipulation near No executive targets

stock price vesting date investment

manipulation required

Can be considered

Typically exercised Incites LT “pay for Company receives

and sold, rather matriculation attendance” if tax deduction at

than held by (forfeiture upon relied upon as sole payout

employees departurte) incentive

If stock appreciates

after grant, company

Stringent vesting tax deduction Fair-market value

requirements (time- exceeds fixed charged to earnings

based) charge to earnings over restricted period

TABLE 9.1 (continued)

Nonqualified Stock Options Restricted Stock Performance Shares

Shares of stock or fixed cash value at

Grants the option to buy stock at a Outright grant of shares with restrictions beginning of period; performance

fixed price for a fixed exercise period to sale, transfer, or pledging contingency

Pros Cons Pros Cons Pros Cons

FASB/SEC may Equal rights with

require expensing common stock

in the near future (voting interest,

dividend)

Investor perception =

doing the right thing

Highly transparent

(never underwater)

Predictability of final

compensation levels

Performance-based

requirements are more

flexible than options

(based on time)

dence of auditors are just some of the factors that determine a weak or

strong organization.

Analysts and investors look at these and many other issues to judge the

accountability of the board and the accuracy of the corporation’s financial

statements when calculating the credibility of disclosure, the viability of policy

checks and balances, and the character of the company’s leadership.

Every corporate move has the potential to affect stock price. Effective IR

counsel looks at all corporate decisions, interprets the signals, and gives

management a balanced view of its potential influence on equity value. IR

can manage the process by helping the board communicate the principles by

which the company is run.

A TANGLE OF TRAPS

IR with capital markets know-how can unravel the string of complexity. In

order for a company to sustain value, management’s priority must remain on

strategy, operations, and ultimately financial performance. Reg FD, Sarbanes-

Oxley, and all the machinations of the SEC and the capital markets

are best left to legal counsel and IR specialists who fully understand these

arenas.

For example, disclosure of material off-balance-sheet obligations is a

must, and IR officers need to work closely with the board of directors and

management to advise on clarifying materiality and significance. If the timing

of insiders selling shares will trigger a misread from the markets, IR

should know this and suggest to management that a 10B51 selling program

(featuring systematic selling over time), might be better received. If a company

is making an important announcement and the stock exchange on

which it trades needs to be called beforehand to halt trading, IR needs to respond

appropriately. If a company has a private analyst call and a question

is answered in violation of Reg FD, IR must correct the error and get an allencompassing

press release out on the business wires before the market

opens the next day.

These are just a few of many basic functions IR must know as the tip of

the spear in a company’s financial communications strategy, not to mention

understanding what the investors’ concerns are from firsthand knowledge.

AND THE INVESTORS’ CONCERN IS . . .

Impact. Regardless of the event, investors want to know two things: how

does it boil down to earnings per share and how will the stock react? That’s

Of Reason, Renewal, and Honesty 55

it. The investor doesn’t necessarily care about the complexity of Sarbanes-

Oxley; they care about whether the stock is a buy or a sell relative to the new

event. That focus should be the goal of management: to release information

within the rules in such a way that quantifies an event whenever possible.

Investors respect a management team that steps up and tells it like it is.

When news is bad, investors want to know all of it, right there and then, in

a quantifiable manner. Although Reg FD and Sarbanes-Oxley have increased

requirements for corporations, auditors, analysts, and bankers, they serve to

do much more than complicate the processes. The implementation of these

regulations is an ongoing process that has blown a gust of welcome change

through the capital markets.

According to a March 5, 2004, article in The Wall Street Journal, the

change in the number of stocks followed by firms dwindled from 2000

to 2003, as follows:

Firm (global operations) 2000 2003

Merrill Lynch 3,500 2,469

Credit Suisse First Boston 3,077 2,373

Smith Barney 3,000 2,300

J.P. Morgan Chase 2,400 (FY ’01) 2,260

Goldman Sachs 2,315 1,950

Morgan Stanley 2,150 1,925

Lehman Brothers 1,650 1,605

Source: WSJ Research

Budgets also generally fell, with one exception, as shown below (numbers

shown are in millions of dollars).

Firm (U.S. Stock Research) 2000 2003

Merrill Lynch $494.6 $292.4

Credit Suisse First Boston $468.1 $284.8

Smith Barney $478.2 $269.9

J.P. Morgan Chase $149.2 $185.0

Goldman Sachs $376.8 $177.7

Morgan Stanley $386.7 $249.3

Lehman Brothers $211.6 $160.1

Source: WSJ, Sanford C. Bernstein Calculations

POST-BOOM IR

The massive investment bank consolidation of the late 1990s created a new

landscape. Where once there were dozens of players, now there are only a

few. This means fewer analysts, fewer traders, fewer salespeople. It also

means that smaller companies that once had to fight hard for the attention

of sell-side analysts now have to fight even harder. But this also created an

opportunity, because the finance professionals who left or were downsized

either started their own firms or joined smaller firms. These smaller banks

and the regional firms are stepping up to fill this research void, giving small

and mid-cap companies another place to share their story. Understanding

the shifting landscape as an opportunity, becoming the source of commission

business for these smaller firms, appealing to their analysts, and gaining research

coverage are essential.

Responsibility to navigate a landscape with less opportunity falls to the

IR function. It must combine fundamental IR execution with capital markets

advisory to help define, deliver, and create a dialogue for a company’s story.

If IR is doing its job, at any given time, value will be maximized, the cost of

capital will be reduced, and management will better be able to focus on its

business. This cycle feeds off itself, and better valuations can certainly result.

Of Reason, Renewal, and Honesty 57

Changes in the investment community represent an opportunity to revamp

practices and procedures to fuel a more efficient and fair market place.

Several companies performed internal investigations and changed governance

practices in advance of regulations. But for others, the ramp-up into

these new ways has been slow, time-consuming, confusing, and costly. IR

has the duty to work closely with the board of directors and management to

clarify and accelerate the process, so that a company remains on course and

the investor is the ultimate winner.

A good IR strategy works well within the law to support the objective of

protecting or enhancing equity value. The complexities of disclosure rules

are less important to the executive who is already communicating openly

and honestly. But good communication cannot happen without understanding

what these changes mean for the sell-side and buy-side. Knowing the

ears upon which the information falls is key to a solid communications plan.

Creating a solution that protects the company, the analyst, and the buy-side

is the ultimate goal.

COMPENSATION

One area in which much of the debate has focused is compensation. A few

companies, such as Boeing, Microsoft, Coca-Cola, The Washington Post,

and Amazon, jumped ahead of potential legislation and immediately began

expensing stock options. Pending regulations also sparked innovation

around, and resurgence of, other compensation awards, such as restricted

stock, performance-based options, and stock grants.

In the case of Progressive, a Mayfield Village, Ohio–based insurance

company, the decision to scrap stock options in favor of restricted stock had

less to do with the expensing issue than with their conclusion that options

motivated some behaviors that were not in the best interest of the company.

Sealed Air of Saddle Brook, New Jersey, issued restricted stock as part of

four components: cash salary, benefits, nonperformance-based restricted

stock, and a management by objectives program. Restricted stock recipients

paid $1 per share for the stock certificates, which vested after three years.

There was no holding requirement, but management believed employees had

a tendency to hold stock after the period.

Other companies that switched to restricted stock or scaled back the options

program include Altria Group, Citigroup, Dell Computer, and Cendant

Corp.

The most effective compensation packages tend to include a combination

of incentives. Experts assert that multiple long-term goals and multiple

compensation tools are the best way to ensure superior performance. IR,

along with outside compensation experts and board members, should be

consulted in analyzing and deciding upon the optimal compensation mix

and incentive structure for any company. They should also be consulted on

how that compensation mix is likely perceived by Wall Street investors.

Table 9.1 provides a summary of compensation vehicles.

IN THE BOARDROOM

Ever since Sarbanes-Oxley and Reg FD placed management and directors

under the microscope, corporate governance, has been at the forefront of intense

scrutiny. Independent agencies came to prominence to prescribe and

oversee ways to achieve competent governance and too many companies

seemed to be in constant preparation for some bad variation of standardized

testing.

If a company has a credible management team and policies steeped in

ethical business behavior, they’ll rarely need someone else to prescribe the

right methods. The company should always control its communications

with regulators and the public, and this means dictating the terms of good

governance for itself.

There are many issues that management needs to discuss with The

Street so as not to affect current or ongoing valuation, including any and all

issues among top management or directors that may be considered material

information. IR needs to advise on how these issues will read on The Street.

The selection of directors; the turnover of directors and management; the

relations between, and the independence of, directors; and the indepen-

TABLE 9.1 Compensation Method Comparison

Nonqualified Stock Options Restricted Stock Performance Shares

Shares of stock or fixed cash value at

Grants the option to buy stock at a Outright grant of shares with restrictions beginning of period; performance

fixed price for a fixed exercise period to sale, transfer, or pledging contingency

Pros Cons Pros Cons Pros Cons

Executive and Executive and Immediate dilution Executive and

shareholder May incent short- shareholder of EPS for total shareholder Charge to

interests aligned term behavior interests aligned shares granted interests aligned earnings, marked

(if using stock) to market

No charge to Dilute EPS No executive Possible recruiting

earnings investment required disadvantage Performance Difficulty in

oriented setting

Company receives Executive No expiration to Potential performance

tax deduction investment required incent short-term manipulation near No executive targets

stock price vesting date investment

manipulation required

Can be considered

Typically exercised Incites LT “pay for Company receives

and sold, rather matriculation attendance” if tax deduction at

than held by (forfeiture upon relied upon as sole payout

employees departurte) incentive

If stock appreciates

after grant, company

Stringent vesting tax deduction Fair-market value

requirements (time- exceeds fixed charged to earnings

based) charge to earnings over restricted period

TABLE 9.1 (continued)

Nonqualified Stock Options Restricted Stock Performance Shares

Shares of stock or fixed cash value at

Grants the option to buy stock at a Outright grant of shares with restrictions beginning of period; performance

fixed price for a fixed exercise period to sale, transfer, or pledging contingency

Pros Cons Pros Cons Pros Cons

FASB/SEC may Equal rights with

require expensing common stock

in the near future (voting interest,

dividend)

Investor perception =

doing the right thing

Highly transparent

(never underwater)

Predictability of final

compensation levels

Performance-based

requirements are more

flexible than options

(based on time)

dence of auditors are just some of the factors that determine a weak or

strong organization.

Analysts and investors look at these and many other issues to judge the

accountability of the board and the accuracy of the corporation’s financial

statements when calculating the credibility of disclosure, the viability of policy

checks and balances, and the character of the company’s leadership.

Every corporate move has the potential to affect stock price. Effective IR

counsel looks at all corporate decisions, interprets the signals, and gives

management a balanced view of its potential influence on equity value. IR

can manage the process by helping the board communicate the principles by

which the company is run.

A TANGLE OF TRAPS

IR with capital markets know-how can unravel the string of complexity. In

order for a company to sustain value, management’s priority must remain on

strategy, operations, and ultimately financial performance. Reg FD, Sarbanes-

Oxley, and all the machinations of the SEC and the capital markets

are best left to legal counsel and IR specialists who fully understand these

arenas.

For example, disclosure of material off-balance-sheet obligations is a

must, and IR officers need to work closely with the board of directors and

management to advise on clarifying materiality and significance. If the timing

of insiders selling shares will trigger a misread from the markets, IR

should know this and suggest to management that a 10B51 selling program

(featuring systematic selling over time), might be better received. If a company

is making an important announcement and the stock exchange on

which it trades needs to be called beforehand to halt trading, IR needs to respond

appropriately. If a company has a private analyst call and a question

is answered in violation of Reg FD, IR must correct the error and get an allencompassing

press release out on the business wires before the market

opens the next day.

These are just a few of many basic functions IR must know as the tip of

the spear in a company’s financial communications strategy, not to mention

understanding what the investors’ concerns are from firsthand knowledge.

AND THE INVESTORS’ CONCERN IS . . .

Impact. Regardless of the event, investors want to know two things: how

does it boil down to earnings per share and how will the stock react? That’s

Of Reason, Renewal, and Honesty 55

it. The investor doesn’t necessarily care about the complexity of Sarbanes-

Oxley; they care about whether the stock is a buy or a sell relative to the new

event. That focus should be the goal of management: to release information

within the rules in such a way that quantifies an event whenever possible.

Investors respect a management team that steps up and tells it like it is.

When news is bad, investors want to know all of it, right there and then, in

a quantifiable manner. Although Reg FD and Sarbanes-Oxley have increased

requirements for corporations, auditors, analysts, and bankers, they serve to

do much more than complicate the processes. The implementation of these

regulations is an ongoing process that has blown a gust of welcome change

through the capital markets.

According to a March 5, 2004, article in The Wall Street Journal, the

change in the number of stocks followed by firms dwindled from 2000

to 2003, as follows:

Firm (global operations) 2000 2003

Merrill Lynch 3,500 2,469

Credit Suisse First Boston 3,077 2,373

Smith Barney 3,000 2,300

J.P. Morgan Chase 2,400 (FY ’01) 2,260

Goldman Sachs 2,315 1,950

Morgan Stanley 2,150 1,925

Lehman Brothers 1,650 1,605

Source: WSJ Research

Budgets also generally fell, with one exception, as shown below (numbers

shown are in millions of dollars).

Firm (U.S. Stock Research) 2000 2003

Merrill Lynch $494.6 $292.4

Credit Suisse First Boston $468.1 $284.8

Smith Barney $478.2 $269.9

J.P. Morgan Chase $149.2 $185.0

Goldman Sachs $376.8 $177.7

Morgan Stanley $386.7 $249.3

Lehman Brothers $211.6 $160.1

Source: WSJ, Sanford C. Bernstein Calculations

POST-BOOM IR

The massive investment bank consolidation of the late 1990s created a new

landscape. Where once there were dozens of players, now there are only a

few. This means fewer analysts, fewer traders, fewer salespeople. It also

means that smaller companies that once had to fight hard for the attention

of sell-side analysts now have to fight even harder. But this also created an

opportunity, because the finance professionals who left or were downsized

either started their own firms or joined smaller firms. These smaller banks

and the regional firms are stepping up to fill this research void, giving small

and mid-cap companies another place to share their story. Understanding

the shifting landscape as an opportunity, becoming the source of commission

business for these smaller firms, appealing to their analysts, and gaining research

coverage are essential.

Responsibility to navigate a landscape with less opportunity falls to the

IR function. It must combine fundamental IR execution with capital markets

advisory to help define, deliver, and create a dialogue for a company’s story.

If IR is doing its job, at any given time, value will be maximized, the cost of

capital will be reduced, and management will better be able to focus on its

business. This cycle feeds off itself, and better valuations can certainly result.

Of Reason, Renewal, and Honesty 57