Wednesday, September 5, 2012

Imperial CEOs rule supreme in corporate realm

One of the great puzzles of American economics is a phenomenon known as the “imperial CEO”.

In our free-market system there should be mechanisms to hold executive power in check. But jaw-dropping salaries and seemingly guaranteed tenure are familiar features in the corporate landscape.

The mechanism for controlling executives is simple. Shareholders elect a board of directors. Then directors decide who gets the chief executive’s job and set the pay.

Simple and elegant, perhaps. But in practice the system doesn’t seem to work well.

Take the case of Forest Laboratories, a publicly listed pharmaceutical company with $US4.5 billion in annual revenue, based in New York City.

Forest Labs built the bulk of its value on the antidepressant called Celexa, introduced in the late 1990s. A few years later Forest developed a closely related compound, the blockbuster drug Lexapro.

Despite plenty of cash to spend, Forest hasn’t been able to come up with a compelling second act. This year, it lost patent protection on Lexapro and generic versions flooded the market. Forest Labs’ first-quarter profit sank 79 per cent.

The company also pleaded guilty to obstructing justice and to fraud relating to the illegal marketing of antidepressants to children and adolescents, and distribution of an unapproved drug. Forest Labs paid a $US313 million fine in 2010 to settle the case with the United States government.

Just one year later, regulators threatened to exclude Forest’s CEO from doing any further business with the US government. That’s not an everyday threat against a corporate chieftain, and it wasn’t made lightly.

Fortunately for the company, the government backed down.

But the brouhaha attracted the unwelcome attention of activist shareholder Carl Icahn, who invests in companies he believes are mismanaged to force them to change. Icahn hasn’t always been right but along the way he’s made $US14 billion in personal winnings.

He now owns nearly 10 per cent of Forest Labs’ shares, making him one of its biggest shareholders. And for the past two years, Icahn has demanded the head of Howard Solomon, the company’s CEO.

Icahn claims Solomon puts his own interest ahead of the company. “Corporate governance failures at Forest are among the chief factors leading to its dismal results,” Icahn says. “Forest Lab’s enterprise value has declined by $US7.9 billion, or 55 per cent, during the last 10 years.”

“Moreover, we believe that Forest was inadequately prepared for the Lexapro patent cliff, resulting in an estimated 80 per cent decline in earnings.”

Icahn slams the board for generous payouts to Solomon while profits fell and the company battled charges of wrongdoing. He claims Solomon is grooming his son to take over in a dynastic succession.
And Icahn has uncovered change-of-control clauses in Forest Lab’s licensing deals that seem intended to keep management in place.

Howard Solomon, 84, has been in the top job since the 1970s. Unlike Icahn, Solomon holds under 1 per cent of the company’s shares.

Despite the many issues, the board has backed Solomon. Icahn took his case to shareholders last year but failed. And last week, shareholders re-elected Solomon and his nominees to Forest’s board, with an Icahn crony winning a single seat.

In a show of modesty, Solomon asked for his base pay not to be increased in 2012. It is expected to be a mere $US8.5 million, down from $US8.8 million.

According to Icahn, Solomon received $US60 million in cash, equity and other compensation over the past eight years while the stock price fell 50 per cent. Meanwhile, Solomon apparently sold around $US500 million worth of stock while publicly promoting the company’s prospects.

Icahn isn’t alone in his criticisms. Institutional Shareholder Services, a respected independent service, has agreed with many of Icahn’s charges.

There may be a good reason why the board backed a CEO who has been around for so long – three of the 10 directors were current or former executives of Forest, and two others were on the board for 10 years.

Solomon’s response has been consistent. The company says that Icahn is “distorting the facts” and the board claims shareholders are better off with them than with Icahn.

It seems like a good case for change. But the US shareholder process marches to its own pace.

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