DEF 14A filings on the SEC’s EDGAR system are worth reading alongside the 10-K. They provide information on insider compensation. They are extremely helpful in figuring out the level of management’s integrity.
Here are some things to look for:
- How much are the insiders and the board of directors paid? Is it high or low for a company of their size? Usually the level of pay correlates with management’s integrity. The CEOs who are trying to make money for themselves will often have high salaries along with the board of directors. In some cases, the CEO has high pay due to very good performance and not because he/she is greedy. In that case, you should pay more attention to the board’s compensation.
- Did pay go up in years where management performed badly? An obvious red flag.
- Are there dubious related party transactions? You need to make your own judgement about whether or not the officers’ self-dealing is fair. Many related party transactions are very reasonable, but sometimes there is awful behaviour going on.
- What is the CEO’s bonuses tied to? Bonus structures should reward management for operating the business well, not for being lucky. Bonuses tied to reported GAAP earnings may lead to abuse. CEOs will be rewarded for one-time gains on selling off assets and for using aggressive accounting. If the incentive structure can be abused, is the CEO abusing it? Some CEOs have integrity and do not try to game their incentive structures.
- Did management voluntarily give up their bonuses because they felt like they did not deserve them? While rare, this is a really good sign about management’s integrity.
- Does the company pay for D&O (directors and officers) insurance? This is a red flag. D&O insurance protects insiders in the case of shareholder lawsuits. There is likely adverse selection occurring when companies purchase D&O insurance. The management teams that engage in questionable practices are more likely to purchase this insurance. It is worth searching for the phrases “D&O”, “officers insurance”, and “officers’ insurance”.
- Is the pricing of options reasonable? Use your web browser’s search function (usually Crtl-F) to look for the words “expected volatility”. Compare this figure with the ones at Morningstar’s Options screener. See my previous post on options.
I look for the same things inthe management information circulars filed on SEDAR.