August 2, 2005

Bigger Compensation Equals Bigger Credit Risk

This article discusses a new study (posted on issued by Moody’s that examines the empirical relationship between executive compensation and credit risk. Moody’s took three components of CEO compensation – salary, bonus, and stock option awards – to discover compensation that deviates substantially from expected pay based on firm size, past performance, etc. (described as “unexplained” compensation). They then took the “unexplained” compensation and related it to the risk of default and large rating downgrades between 1993 and 2003.

Ultimately, Moody’s found that large, positive, unexplained bonus and option awards are predictive of both default and large rating downgrades. Variations in salaries, however, do not appear to be predictive of credit risk. Moody’s concludes that high levels of unexplained compensation may indicate that board oversight is lax and, as a result, management has insufficient pressure to deliver good financial performance. Large performance-based compensation packages, in particular, may induce managers to: deliver strong short-term financial results and obscure longer-term structural problems, and pursue high risk strategies with very strong positive, but also very adverse, potential payoffs.

Shooting Fish in a Barrel ….

Last week, the SEC filed a complaint against two stock promoters in an alleged scam designed to mislead investors into believing they had inadvertently received a confidential stock tip faxed from a stockbroker to his client. The handwritten fax (available here) had the appearance of an urgent message from a financial planner intended only for his client, urging the purchase of a stock that was about to “tripple” in price. The fax was sent to more than one million recipients across the country – including the SEC’s San Francisco Office! – by stock promoters who made over half a million dollars unloading their shares on duped investors.

Inside Track with Broc Posted

Check out Broc’s interview on the return of the IPO market with M. Ridgway Barke, Chair of the Corporate Finance and Securities Practice Group at Kelley Drye & Warren, and Randi-Jean G. Hedi, Partner in the Corporate Finance and Securities Practice Group at Kelley Drye & Warren.