On Nov. 4, Bill Mann sent the following letter to CryptoLogic's
November 4, 2005
Mr. Robert Stikeman
Chairman of the Board
CryptoLogic, Inc.
55 St Clair Avenue West
3rd Floor
Toronto, Ontario M4V 2Y7
CANADA
Dear Mr. Stikeman-
I recently had the opportunity to speak with Nancy Chan-Palmateer regarding Tom Gardner's and my concerns about CryptoLogic's compensation policies. It seems that outside shareholders have shared this concern, as they have twice rejected management stock option grant proposals.
CryptoLogic is a two-time recommendation for our newsletter, Motley Fool's Hidden Gems, which means that we have brought thousands of shareholders to your door. We take our responsibility to them extremely seriously. We would not have recommended CryptoLogic if there were not much that we appreciate and admire about the company, its management, and its board. We hope in all ways that our comments are taken as intended: a way to maximize the value of CryptoLogic for outside shareholders over the longest term possible. That, to us, means that we track the corporate governance decisions by the company and its board extremely carefully. Regarding CryptoLogic's compensation policies, our concerns remain quite high, and we hope to see improvement.
I am extremely gratified to know that the "performance share units" that CryptoLogic has adopted are to be paid in cash. We remain hopeful that some of CryptoLogic's management will take advantage of the public markets and buy some shares of stock, rather than the heavy selling that they have practiced in the recent past. Regarding CryptoLogic's compensation program and the governance thereof, we believe that there is substantial room for improvement. If the LTIP that Towers Perrin (the "internationally recognized compensation consultants") designed is the best they can do, I'd suggest you never use their services for anything else, ever.
The LTIP does nothing to create a reasonable incentive that matches management's interests with shareholders. In fact, my opinion is that it creates an agency problem that places management's interests in direct opposition with shareholders, and is mostly an exercise in poor corporate governance and stewardship. Specifically:
1. The determination to pay CryptoLogic managers between 50% and 75% of that of comparable companies shows a lack of judgment. It creates an internal logic in compensation comparisons when really there is none. To quote Edgar Woolard, former CEO of DuPont and current chairman of the New York Stock Exchange's compensation committee, the notion that CEO compensation is driven by competition is "bull," and the notion that chief executives are owed vast sums for creating wealth for shareholders is "a joke." He also has some extremely unkind things to say about the compensation committees of most companies, and their dealings with outside consultants.
"Boards have been led to accept the logic that if 'our C.E.O.' is not in the top half, it implies to employees and to the general public that the board may not have confidence in the C.E.O. For some crazy reason it's been translated to, 'If you paid me at the bottom quartile, people would think you're about to get rid of me.' All that is honed by these outside consultants; they've gotten rich by providing this framework and the logic of the top quartile, and the boards have accepted it."
This fully describes the external appearance of how CryptoLogic's compensation program came into place. Woolard's recommends that companies fire their compensation consultants (and we agree), and simply set the chief executive's rate of pay at a premium to the average pay of senior managers running each corporate division at the company. Their rates of pay, unlike the CEO's are competitively set. The result is a compensation policy that no longer requires the intermediation of overpriced consultants, is logical, and is both market- and success-based.
2. The goalposts CryptoLogic uses - earnings per share and share price - are inappropriate, as they create incentives that are not in the best interest of shareholders. Share price considerations are generally out of the hands of the company - they are derivative to company performance, and are extremely sensitive to manipulation by management. Earnings per share, if anything, are worse as a measure due to the high level of subjectivity under GAAP for many inputs to calculate EPS. For example, a management could embark on a share buyback scheme during a poorly performing quarter in order to ensure that management reaches its goal and maximizes not corporate efficiency, but rather the rate of pay of the top management. In effect management has the incentive to use shareholder equity in an inefficient manner in order to increase its own compensation.
We appreciate people being paid extremely well for their efforts to add true value to the company, but believe the inputs that have been built are extremely poor, especially, as we note below, if those goals - which are not disclosed to shareholders nor contingent upon their approval - are set each year. I believe that a model based upon increases in book value per share of the company gross of dividends and buybacks constitutes a far more appropriate measure of increase in value as it takes into account CrypoLogic's capital structure and growth in equity. If Towers Perrin wished to create a compensation structure that was wholly unfriendly to shareholders, then "mission accomplished."
3. This program does not require shareholder approval, and as we've noted, comes with minimal information given to the owners of the company regarding its composition or its targets. In fact, we do not know if the targets are annually set, or if they are set in aggregate. For example, a program that states now "10% revenue growth on average over the next 5 years" is vastly different than one that resets the hurdle annually. We hope that the company will disclose additional information about this LTIP. At a minimum, some disclosure of the tenor of the program is called for. To fail to do so would display poor corporate governance.
Regarding the level of information available to shareholders about the LTIP and CryptoLogic's management compensation program, I have the following comments and recommendations:
1. The disclosures for the long term incentive plan are woefully inadequate, especially since no shareholder vote is required. There is no mention in the proxy that these are to be paid out in cash, an item that I believe shareholders would find to be extremely material. Further, I've found no further material illuminating shareholders on the accounting treatment of the PSU's. Are they expensed when granted or vested?
2. No total, maximum, or implied value of the LTIP has been disclosed to shareholders, even for 2005. This should be remedied.
3. Shareholders have been told that the measures for the LTIP would be a mix of earnings per share and share price. When we asked Ms. Chan-Palmateer, she said that the company would not give specific information on the nature of the targets, or of the maximum amounts available, or even the value of each PSU. While we do not believe that it is in the best interest of the company or of shareholders for those targets to be spelled out in gross detail, the level of disclosure available in this regard is woefully inadequate.
4. Ms. Chan-Palmateer noted to us that CryptoLogic is moving away from options programs, though the LTIP was announced in the company's proxy statement along with proposed options grants for 2005. Does the board intend to propose an options grant for management will be reduced in 2006?
5. The program is designed to keep CryptoLogic management compensated within a 50% to 75% range of comparable companies. Please disclose what the board considers to be comparable companies. Frankly the list used in the proxy to justify CryptoLogic's level of dilution offered some companies that are no more your peers than they are mine.
One final note - in our call and in corporate literature, CryptoLogic has repeated that it has made stock buybacks in order to combat dilution from stock options. We have no real reason to believe that Lewis Rose or any other member of management is so self-interested as to put his thumb on the scale to help himself at the detriment of the company, but this argument alone causes us to substantially elevate our suspicion of management's interests.
We at the Motley Fool have long made a habit of tracking transactions that directly impact shareholder equity by bypassing the income statement - especially stock buybacks. Linking stock buybacks with share dilution from options is self-interested, at best. Stock buybacks should be done only in the event where their market value is substantially lower than intrinsic value. There is no linkage between that condition and option exercise - in fact logic suggests that the two would have a negative correlation. Serial buybacks that do little but cover options issuance have a value to outside shareholders that approaches zero.
Tom and I remain ready and willing to develop a long-term dialogue with the board and management at CryptoLogic, and we want to reiterate that we are hopeful that CryptoLogic's business operations and corporate governance decisions work hand in hand to maximize returns to everyone from management to employees to outside shareholders.
Best regards-
Bill Mann
CC: Mr. Lewis N. Rose, Chief Executive Officer
Mr. Edward L. Greenspan, Director, Chairman of Compensation Committee
Mr. Randall Abramson, Director, Member of Compensation Committee
Mr. Stephen H. Friedhoff, Director, Member of Compensation Committee
Mr. Nigel Simon, Director
Ms. Nancy Chan-Palmateer, Director of Communications
CryptoLogic is a two-time recommendation for the Motley Fool Hidden Gems newsletter. Bill Mann owns no shares of any company mentioned in this article.
