CEO Pay at Valeant: Does Extreme Compensation Create Extreme Risk?

David Larcker is Professor of Accounting at Stanford University. This post is based on a paper authored by Professor Larcker and Brian Tayan, Researcher with the Corporate Governance Research Initiative at Stanford University. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

In our paper, CEO Pay at Valeant: Does Extreme Compensation Create Extreme Risk?, which was recently made publicly available on SSRN, we examine the relation between pay for performance and organizational risk.

The litmus test for an effective executive compensation program is whether it provides incentive to attract, retain, and motivate qualified executives to pursue corporate objectives that build shareholder wealth. This concept, known as “pay for performance,” reflects the degree to which executive rewards are correlated with financial outcomes that benefit shareholders.

While the concept of pay for performance is straightforward, the optimal structure is not. The board of directors must make a series of decisions about pay design that involve real tradeoffs, including whether to tie pay more closely to operating or stock price results, the balance between financial and nonfinancial targets, the balance between cash and equity awards, the size of awards, and whether allowances should be made for executives who miss targets because of economic factors outside of their control.

The board must also consider the unintended consequences of pay, including whether it encourages decisions, actions, or behaviors that are not in the interest of shareholders—such as excessive risk-taking or artificial moves to boost the value of awards. The research literature provides substantial evidence that these types of outcomes can occur. As a result, executives holding compensation awards that pay out only in the case of extreme performance likely require especially vigilant oversight by the board.

The case of Valeant Pharmaceuticals illustrates the potential risk. J. Michael Pearson was recruited as chairman and CEO of Valeant Pharmaceuticals in 2008 by ValueAct, the company’s largest shareholder. ValueAct helped to design a compensation package that encouraged a focus on long-term value creation. Pearson received a $1 million salary and package of equity awards (stock and options) valued at $16 million. Included in these were performance stock units that would vest only upon achievement of the following three-year compounded total shareholder return (TSR) targets:

  • 3-year TSR < 15 percent per year, zero shares vest.
  • 3-year TSR of 15 percent to 29 percent, 407,498 shares vest (base amount).
  • 3-year TSR of 30 percent to 44 percent, 814,996 shares vest (double the base amount).
  • 3-year TSR > 45 percent, 1,222,494 shares vest (triple the base amount).

The performance units were structured to offer an exponential payout for exceptional long-term share price performance and zero payout if base-level thresholds were missed. Pearson was also required to purchase $5 million in Valeant stock with his personal money.

Pearson moved aggressively to reshape the company. He reduced the research and development budget, slashed corporate overhead, and launched a string of acquisitions and licensing deals to bring in new products. In 2010, he purchased Canadian-based Biovail in a corporate tax inversion that permanently reduced the company’s tax basis. In 2012, he acquired Medicis Pharmaceutical for $2.6 billion, in 2013 Bausch + Lomb for $8.7 million, and in 2015 Salix Pharmaceuticals for $11 billion. Corporate revenue grew 10-fold in six years, and Valeant stock price soared.

After 2 years, Valeant stock price exceeded the highest price target for the maximum number of performance units to vest. The board renewed and extended Pearson’s contract. Pearson received additional performance units, this time with a four-year vesting term and a maximum payout of 4-times the target number of awards for 60 percent compounded TSR. The board added multiple measurement dates to protect against short-term run ups in the company’s stock price. Pearson also agreed not to sell vested shares. At its peak, Pearson’s stake in the company exceeded $3 billion in value.

However, Valeant’s fortunes began to turn following its failed attempt to acquire Allergan in 2014. The hostile battle drew renewed scrutiny of Valeant’s business practices, including its extreme reductions in R&D spending, the significant mismatch between reported GAAP and non-GAAP earnings, and its significant debt load. US Congress opened inquiries into the company’s pricing practices, and short-sellers drew attention to the company’s close relation to specialty pharmacy Philidor. Valeant’s stock, which peaked at $260, fell 90 percent to $30.

In 2016, Pearson stepped down as CEO and was replaced by Joseph Papa, former CEO of drug maker Perrigo. Papa was granted a compensation package similar in structure to Pearson’s, including approximately $30 million in performance share units subject to four-year vesting and multiple performance hurdles. If he achieved the maximum performance hurdle (compound annual TSR of 70 percent), Papa stood to receive $500 million. The maximum hurdle was set to coincide with the company’s previous all-time high stock price.

The story of Valeant raises the following questions:

  • To what extent were the problems that occurred at Valeant directly a result of the incentives placed on Pearson? Would they have occurred if the incentives were less aggressive?
  • How can shareholders tell whether the right balance has been struck between encouraging pay-for-performance and excessive risk?
  •  The performance stock units granted to Pearson had a single performance measure: TSR. Should the board have included operational or non-financial performance measures as well?
  • Did the board, shareholders, and the public fail to identify red flags that should have warned them that the company’s approach was not sustainable? Did the stock’s extremely positive performance make them complacent in their oversight?
  • Was the board correct to replicate the performance features in the compensation package offered to its new CEO, even though the company’s situation was different?

The full paper is available for download here.

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