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Shady practices taint too many IPOs
Is corporate America still ethically challenged? Take a look at some recent IPOs, where excessive compensation, entrenched boards and other questionable practices come to light.
By Michael Brush
As headline-grabbing corruption trials proceed against former executives from Tyco and WorldCom three years after the biggest rash of corporate scandals in decades, you might think that ethics are on the mend in corporate America.
Perhaps not. Questionable practices at the top are creeping back, troubling some money managers and experts in corporate governance, the rules that guide how directors and managers behave towards shareholders.
No one is predicting the return of vodka-spouting ice sculptures of Michelangelo's David at lavish Sardinian bashes like the one sponsored by former Tyco International (TYC, news, msgs) chief Dennis Kozlowski in his heyday. But boards and top managers are starting to think it's OK again to let shareholders, who own their companies, take a back seat.
For evidence, just look at a disturbing trend among recent initial public offerings, says Linda Killian, portfolio manager at IPO Plus Aftermarket (IPOSX). More than half of last year's crop has what she describes as poor corporate governance.
With Killian's guidance, I examined the prospectuses of a dozen or so recent IPOs for signs of poor governance.
These offenses don't necessarily mean investors should avoid these stocks. Some could turn out to be solid investments. But corporate governance standards are one criterion investors can use when picking stocks. It's often better to go with a company where it's clear that managers are looking out for stockholders, not themselves.
Let's take a look at some of the more troubling cases.
Hungry, hungry hippos
What's wrong with excessive pay? It's a bad use of corporate funds. More importantly, it's a sign that boards, which set executive pay, may be too cozy with management. Boards are supposed to push managers to work hard for shareholders.
What makes a chief executive overpaid? Killian draws the line at around $500,000 per year in base salary and bonus for the smaller companies typically found among IPOs. She also dings companies that grant lots of cheap stock options.
At Domino's Pizza (DPZ, news, msgs), for example, Chairman and Chief Executive David Brandon got a $600,000 base salary in 2003. But generous extra toppings in the form of healthy bonuses were worth a whopping $4.5 million. Stock grants and options gave him another $597,000. Domino's declined to comment.
Herbalife (HLF, news, msgs) CEO Michael Johnson pulled down an impressive $4.9 million in salary, bonus and options in 2003. In December, the board's compensation committee upped Johnson's base salary to $1.1 million and awarded potential bonuses worth $1.3 million. He was also allowed to buy 1.18 million shares at prices of 88 cents and $3.52, and 203,000 preferred shares at $2.21.
Finance chief Richard Goudis says Johnson's compensation was fair, since the board's compensation committee used ranges set by outside consultants. The amount paid to Johnson is what's necessary to attract the kind of talent needed to run an international company the size of Herbalife, Goudis says. In addition, the cost of living in Beverly Hills, Calif., where Herbalife is based, is considerably higher than the national average.
Freescale Semiconductor (FSL, news, msgs), a chip company recently spun out from Motorola (MOT, news, msgs), was huge for an IPO, with a market cap of $6 billion. So we'll give it a pass on the $500,000 cutoff for chief executive pay. But CEO Michel Mayer still received a sweet deal. He gets a salary of $800,000 plus a bonus potentially worth at least that much. He also got a signing bonus of $350,000 and the company gave him $11.3 million worth of stock options.
"Those are pretty hefty initial awards," says Paul Hodgson, an analyst with the Corporate Library, which does corporate-governance research.
Mitch Haws, who handles investor relations for Freescale, says Mayer's compensation is fair because that's what it took "to attract the type of leader we need to be a successful company."
Poison pills that entrench management
In moderation, anti-takeover provisions protect shareholders by making sure their companies don't get sold for too little. But too many, and certain kinds, are bad because they make it impossible for shareholders to get rid of lazy or incompetent boards.
One type that really bugs corporate governance cops is the staggered board, where boards typically get divided into three equal-size panels. While board elections are held every year, only one panel stands at a time. Also called a classified board, this structure means it takes at least three years for shareholders to change a majority of a board.
"We find that may of these companies tend to load up with anti-takeover provisions and other governance structures that are not deemed favorable from a shareholder perspective prior to coming public," says Jill Lyons, general manager of corporate services at Institutional Shareholder Services, which does proxy voting research and corporate governance analysis for money managers.
Herbalife, Freescale, Greenfield Online (SRVY, news, msgs) and Domino's have staggered boards. Herbalife says this structure makes sense. Private investors with big stakes in the company want a stable management team as they sell their stakes over time, the company adds.
Other recent IPOs have structures that grab control from the common shareholder in other ways. At Herbalife, for example, Golden Gate Capital Management and Whitney & Co., two private equity firms, own 61% of the shares in the company. Bain Capital owns 45% of Domino's outstanding shares. So average shareholders have little clout at either company.
Herbalife's Goudis says this ownership structure is actually good for the small investor. "You have people who are extremely sophisticated who are going to make decisions that increase the value of their stake in the company, and for a small investor that is positive," he says.
Some companies have taken things a step further and created two classes of shares, with one class getting all the voting power. You guessed it -- the super-voting class stays in the hands of allies of managers and the board.
Google (GOOG, news, msgs), for example, has dual share classes that help keep control of the company in the hands of its founders, says Nayantara Hensel, who teaches at the Naval Postgraduate School's Graduate School of Business and Public Policy. This also means Google can opt out of the Nasdaq listing rules stating that that most directors need to be independent, she says. Google declined to comment.
Raiding the IPO treasure chest
In two cases, much of the money raised in recent IPOs didn't even go to the company coming public.
At Freescale, two-thirds of the $1.5 billion raised went to Motorola, which spun out Freescale. Haws at Freescale says his company got $750 million, and the IPO left it with a strong balance sheet that allowed it to raise more money by selling $1.25 billion in debt. Motorola declined to comment.
In the recent IPO of Celanese (CE, news, msgs), a chemical company, virtually all of the $1.08 billion raised was paid to the Blackstone Group, a private investment group that bought Celanese a few years back. It received the money in the form of a one-time dividend, says Tom Taulli, an IPO expert at CurrentOfferings.com. "This does not include the prior dividend that essentially paid back the Blackstone Group's initial investment," says Taulli.
What's worse, says Taulli, Celanese was loaded down with $3.2 billion in debt in the process. Celanese and Blackstone declined to comment, citing a quiet period following the IPO.
Insiders selling shares in the IPO
Heavy insider selling, of course, doesn't always portend poor stock performance. Still, it can be a red flag.
"When someone is unloading a big part of their ownership on the deal, you worry about that because it's saying they don't have a lot faith in what they are doing, or they think the IPO was overpriced," says Killian.
At Domino's, board members and top managers sold around 40 million shares when the pizza company went public. Greenfield Online executives and board members sold 2.7 million shares on or around the IPO date. CEO Dean Wiltse sold 130,480 shares, or 15% of his pre-IPO holdings.
Greenfield says the sales were justified because may of the sellers serving on the board were also venture capitalists who wanted to realize profits for their early work. Only about 20% of the sales came from executives, and they still have big holdings, the company says. Selling by managers was fair compensation for having turned the company around since 2001, the company says.
Of course, these companies still could end up being good investments. Anyone who passed on Google when it came out at $85, for example, missed out on juicy gains. The stock recently traded for $185. Killian owns shares of Celanese even though she's critical of the diversion of the IPO proceeds to Blackstone. She says the IPO had to be priced low in part because the IPO money got siphoned off by Blackstone, so she took advantage of the bargain.
Likewise, Taulli is bullish on Greenfield Online, which analysts project could see earnings growth of 50% a year for the next three years.
"I would not avoid a stock simply on corporate governance issues," says Taulli. "Corporate governance problems are certainly red flags. But if a business is strong, I think this often trumps other things."
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