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Ex-Valeant CEO's Pay Structure May Have Increased Dangerous Risk-Taking, Study Says

This article is more than 7 years old.

Former Valeant Pharmaceuticals CEO J. Michael Pearson's tenure can serve as a cautionary tale to companies across all industries who think that following best practices in corporate governance can completely safeguard them against disaster. Companies should reward their CEO's for taking risks to expand the business. But what happens when an executive's pay depends on it?

Pearson received a multi-million dollar compensation package, composed of salary, stock and option awards, and bonuses. Within his compensation package were performance stock-related goals that would reward Pearson upon meeting specified total shareholder return (TSR) targets.

A study published by the Stanford University Rock Center for Corporate Governance reports that the compensation package was, "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's pay reward would depend on his ability to take risks in order to meet the TSR targets.

By reducing the research and development budget, acquiring several different companies and cutting corporate overhead, Pearson succeeded in surpassing his stock performance goals. The Stanford researchers elaborate, "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." Pearson's contract was renewed and included, "a maximum payout of 4 times the target number of awards for 60% compounded TSR... At its peak, Pearson's stake in the company exceeded $3 billion in value."

Read FORBES' investigation: Prescription For Disaster

Pearson was riding high until 2014 when an acquisition disagreement between Valeant and Allergan drew criticism to Pearson's practices. A former CEO of Teva Pharmaceuticals stated: "Valeant will eventually run out of things to buy and once it does, it faces the problem of how does it keep on the trajectory. A company without R&D short-term and mid-term can be viable, but long-term is not."

Valeant's stock prices began to fall when Congress investigated dramatic price increases in Valeant's cardiovascular, dermatological, and ophthalmological drugs. A questionable relationship with drug distributor Philidor led to an "internal review of the company's reported financials...Valeant was forced to delay the release of its financial statements, lower future earnings guidance, and enter discussions with lenders to ease financial covenants," the Stanford researchers write. By the time Pearson stepped down, Valeant's stock had decreased from $260 to $30.

Valeant and Pearson's story can shed light on the consequences of the "pay for performance" structure that many executives receive. Several studies have shown, according to the Stanford study, that, "executives respond to stock option grants by taking actions to increase firm risk," and that "an increase in the sensitivity of CEO wealth to stock price volatility is positively associated with financial misreporting."

There is no avoiding taking risks. If a company wants to generate returns and the CEO wants to build value, risk-taking behavior is necessary. Many directors do not think that there should be a cap on compensation regardless of performance, or that there is a problem at all with CEO compensation. Measures still need to be taken, however, to ensure executive behavior does not get out of hand. So what can shareholders and boards do to reduce a dangerous level of risk-taking? Dr. David Larcker and researcher Brian Tayan, stress in their study that the question is not whether risk-taking should be allowed, but how to encourage the type of risk-reward taking that fits into the corporate strategy.

"Shareholders should first 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," the authors told FORBES. "The second step is to determine whether the board has a handle on the situation. Did the board drive the pay decision, or did the CEO lobby for it? Is the board independent enough to monitor the CEO, or are they excessively passive or deferential? Shareholders need to satisfy themselves that the board has a proper handle on the situation."

As for the board's duties, Larcker and Tayan suggest examining all decisions, "through the lens of whether they match the company's risk tolerance." Regardless whether they do align, it is the board's responsibility to scrutinize those decisions, including those involving, "new research and development, asset acquisitions, mergers and decisions about financing and capital structure."

Valeant's case is particularly troubling, as Pearson's strategic and capital structure risk aligned well with the incentives he was given and the desires of the board and major shareholders, according to Larcker and Tayan. "So on the one hand, you could argue he was given incentive to take extreme risk. On the other hand, you could argue that he made decisions that the board and shareholders wanted him to take," the authors told FORBES. Valeant followed the, "best practices that are held sacred by corporate governance experts and pay specialists." Pearson's rewards were aligned with his pay, he invested his own wealth into the company, and he had clear performance goals - and yet there was still failure. This is perhaps due to the fact that Pearson's incentives did not change to reflect a larger, more established company.

Unfortunately, there is no uniform solution that all companies can use to balance compensation and risk. "Companies are human systems and when you put incentives on real people you are not always going to get the behavior you want or expect. The board needs to keep in mind the human element of decision-making," Larcker and Tayan explained. "The lesson for companies is that you always have to consider the unintended outcomes of any compensation structure, and situations of large risk-taking require much more vigilant oversight."

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