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By Damion Rallis, Senior Research Associate

With the holiday shopping season in full swing, we noticed a recent surge in insider sales and a sharp share price drop at department store operator Kohl's Corporation (NYSE:KSS) and decided to take a deeper look. While the market was clearly reacting swiftly to the retailer's disappointing earnings results, from our perspective, Kohl's ESG rating and Litigation Model score have been consistently low for some time now.

GMI Ratings' Litigation Risk model has been flashing warning signs about Kohl's for several ratings periods. Having been in High Risk territory since the summer of 2011, the company currently has a 4.6% probability of Class Action Litigation occurring within the next 12 months. This places the company in the 7th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 93% of all rated companies in this region.

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Similarly, the company's ESG rating has been in steady decline since November 2008 when our assessment of Kohl's long-term sustainability risk was favorable. Due mainly to KeyMetrics™ red flags in the areas of board and pay, the company's ESG percentile score has declined over 67% and its overall "C" rating is on the cusp of slipping further to a "D," an indication of high risk.

Kohl's most recent stock drop occurred last week when its share price closed on November 28 at $51.15 and then fell to $45.02 the very next day, a significant decline of about 12%. The drop coincided with the company's poor sales results in which total sales decreased 4.9 percent and comparable store sales decreased 5.6 percent from the four-week month ended November 26, 2011. Year to date, total sales increased 0.4 percent and comparable store sales decreased 1.1 percent.

In addition, while the company said that the Mid-Atlantic and Northeast were the most challenging regions due to weak sales early in the month following Superstorm Sandy, this assertion was somewhat debunked by the fact that all regions reported negative sales for the month. While weak sales at Kohl's mirror an overall monthly decline in the retail industry -- 16 retailers tracked by Thomson Reuters recorded a 1.6 percent increase in same store sales; analysts expected a 3.3% increase - Kohl's sales figures are noticeably worse. According to the New York Times, "The company seemed to be the victim of its own 'showrooming' when consumers visit stores to see the merchandise but end up buying online."

While at GMI Ratings we don't tend to react to short-term sales or periodic share price drops, we do feel that the overall governance structure of a company can be a risk factor that limits its competitiveness in the long term . At Kohl's, several red flags color the company's long-term risk profile. First and foremost, there are several issues with the company's board composition that run counter to what we consider an optimally structured board. Six directors are long-tenured with over a decade of service, including four board members who have served for about 25 years. Long-tenured directors include Compensation Committee chair Frank V. Sica, five out of six members of the Executive Committee, CEO and Chairman Kevin Mansell, and Lead Director Steven A. Burd. While we recognize the benefits of experience, it becomes increasingly challenging to act independently with such extensive service. Long-tenured directors can often form relationships that may compromise their independence and therefore hinder their ability to provide effective oversight. Additionally, Mr. Sica serves on the board of JetBlue Airways Corporation (NASDAQ:JBLU) with Director Peter Boneparth. Intra-board relationships of this kind can compromise directors' ability to act individually and independently.

Also, Audit Committee chair Stephen Watson has been flagged for his service on the board of Eddie Bauer Holdings, Inc., which filed for Chapter 11 bankruptcy protection in June 2009. While this does not disqualify him for board service, it is interesting to note that Mr. Watson serves on the boards of two other companies that we cover-D-rated Regis Corporation (NYSE:RGS) and Chico's FAS (NYSE:CHS), which receives a "Very Aggressive" AGR® Rating, our lowest rating for short-term negative event risk. Another Audit Committee member, Stephanie Streeter is CEO at Libbey Inc. (NYSEMKT:LBY) and is on the board of F-rated Goodyear Tire & Rubber Company (NASDAQ:GT). A third Audit Committee member is long-tenured John Herma. The committee as structured may not be up to the task given recent reports that the company was unable to implement and maintain effective internal control over financial reporting as required by Section 404 of Sarbanes-Oxley (SOX). This violation indicates increased risk to shareholders in the form of errors, potential restatements and lack of timeliness related to key financial information. Specifically, the company identified certain errors related to its accounting for leases in August 2011 so that its financial reporting, as of January 2011, was ineffective. Furthermore, as of January 2012, the company reported that it was still unable to implement and maintain effective internal control over financial reporting regarding the accounting for leases. These material weaknesses have led to several financial restatements.

Similarly, regarding the composition of the Compensation Committee, we note that the committee is not only chaired by long-tenured director Frank Sica but he is joined by Steven A. Burd, who notably is CEO at Safeway Inc. (NYSE:SWY), a company that is rated "D' in pay and "Aggressive" in AGR, but also a company whose Say on Pay policies barely passed in 2012 with the approval of only 50.3% of shareholders. Kohl's executive compensation practices indicate poor oversight in this area. Chair and CEO Kevin Mansell's base salary ($1.3 million in 2011) exceeds the limit for deductibility under Section 162(m), which raises questions about the board's dedication to protecting shareholder interests. Mr. Mansell continues to receive generous executive perks as personal use of company aircraft ($158,892), restricted stock dividend equivalents ($106,270), supplemental health care coverage ($50,000), and an automobile expense allowance ($23,040). Because such benefits are not directly tied to performance, they are difficult to justify in terms of their correlation to company performance and ultimate benefit to shareholders.

Additionally, annual bonuses for named executive officers are based on a single financial performance measure of annual net income. In most cases, a mix of performance metrics is more appropriate, not just to prevent executives from being tempted to game results, but to ensure that they do not take actions to achieve one end that might ultimately damage another. Furthermore, long-term incentives for named executive officers continue to include market-priced stock options that simply vest based on the passage of time. To be effective, all equity awards granted for long-term incentives should include performance-vesting features. Furthermore, while named executive officers are eligible for performance-vesting restricted stock awards, the awards are contingent upon the company simply beating its peer performance index in either 2011 or 2012. This means not only that executives may be rewarded even if the company underperforms or severely underperforms peers in one of two years (this is pay for underperformance), but annual measuring periods are contrary to correctly designed long-term awards.

Equity awards amounts are determined at the discretion of the Compensation Committee so that if the CEO was deemed to have "Satisfactory" performance, he would be entitled to $1.4 million, $2.8 million for "Effective" performance, and $5.6 million for "Outstanding" performance. (We note that the CEO's fiscal 2012 long-term incentive award increased dramatically so that he is now eligible to receive awards of either $2.8 million, $4.2 million, or $8 million.) Discretionary incentive bonuses of this nature undermine the integrity of a pay-for-performance compensation philosophy. The company also does not have a clawback policy which would allow for the recovery of executive compensation in the event of fraud or financial restatements; this is especially important given the recent spate of accounting issues and financial restatements.

Finally, we return to the curious increase of insider sales at Kohl's Corporation. We note with interest that long-tenured director William Kellogg, who is a former CEO and Chairman at Kohl's and led a management buyout of the company in 1986, sold 1.5 million shares in early November valued at almost $82 million, 600,000 shares in September valued at more than $32 million, and 900,000 shares in August valued at over $46 million. Similarly, long-tenured director and former COO John Herma sold about 740,000 shares at the beginning of November for more than $40 million, about 260,000 shares in September worth over $14 million, and 500,000 shares in August worth nearly $26 million. Prior to these transactions, Mr. Kellogg had made no sales since 2009 while Mr. Herma had made no sales since 2011. Moreover, their transactions were generally made on the same days. While we are loath to assume correlations based on the magnitude and frequency of insider stock sales, in situations like this, it is natural to wonder if the data is meaningful. In any case, even if there is no story there, it is in aberration worth noting and a hallmark of our thought process at GMI Ratings to constantly evaluate both potential omens and red herrings.

Disclaimer: GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.

Source: Kohl's Slips And We're Not Surprised