MORE ON EXECUTIVE COMPENSATION

Well, it is annual report time again and the shareholders get a view of the amount of compensation received by the CEO, which in most cases is beyond anything rational. But, then the shareholders are often offered the opportunity to cast an “advisory” vote on compensation, not that it means anything.

Annual compensation in the 8 figure and occasionally 9 figure range should make shareholders demand an answer to the question What did the CEO actually do to deserve such a ridiculously high rate of pay? How much of any corporate success is really the work of a single CEO? Conversely, how much did the CEO contribute to a shortfall or failure? Whatever the corporate results, it is suspected that hundreds or even thousands of individual executives, and not just one, were responsible. In some cases corporations were or are run by creative geniuses like Steve Jobs, Bill Gates and other founders of tech companies where it is easy to see their initiation of great ideas and products. It is easy to understand why Dr. Edwin Land of Polaroid fame became wealthy based on his company and inventions. Shareholders in companies like these never doubted the contribution of the CEOs to the success of the company. Nor do shareholders who have invested in the genius of Warren Buffet ever doubt his contribution to the success of his ventures. But, what about the others? One can see how the innovators and geniuses have earned any handsome rewards provided.

No annual reports or discussions of compensation therein ever itemize exactly what the CEO has done to deserve the compensation package awarded. Shareholders need to know if the CEO is just a “cheer leader” for the management team or an innovator who comes up with new and exciting ideas. If the CEO depends on the inputs and consensus of the management team to develop strategies, products or ideas, then that CEO may just be a cheer leader and organizer but not an innovator or a force for success. Shouldn’t the shareholders be informed as to the precise contribution of the CEO and the kind of performance evaluation made by the Board in adopting the compensation package?

It is suspected that compensation packages are often developed based on an analysis provided by a compensation consulting company citing a review of the compensation packages of “peer” companies. It is suspected that, in adopting a compensation package, the Board may rely on the consulting report to justify their approval action rather than conducting any thorough independent evaluation. If these suspicions are accurate, shouldn’t Boards of Directors, and particularly the “independent” directors undertake a thorough review and analysis of the actions and contributions of the CEO in the previous year as part of setting compensation? Shouldn’t performance awards be based on something more tangible than meeting pre-set targets which, most probably do not reveal the contribution of a single person but rather reflect the results of a large team, or, maybe only the results of a vibrant economy and robust stock market. What seems clear is that Directors, theoretically acting independently, don’t seem to be taking any steps to rein in runaway compensation.

Thinking back to the financial collapse of 2008, one must ask why the highly paid CEO’s of investment banks and commercial lenders did not foresee the collapse when all of the signs should have been readily obvious. Were they all so blind that they didn’t see? That result would be hard to imagine. So, it must have been the substantial profits being generated from the activities that induced blindness. Whatever, how many of these CEOs paid any price for their complicity in the collapse? Despite failures, how many financial CEO’s from that era are still pulling down gigantic compensation packages or were moved out with a tremendous severance package? Public memories are short but that should not be the case with Boards of Directors.

Perhaps it is time that shareholders begin demanding far greater accountability and justification for the compensation awarded to executives by Boards. In being forced to accept the levels of compensation, shouldn’t shareholders be absolutely convinced that the pay is reasonable and justified by individual performance? This means that annual reports should tell the shareholders more of what they really need to know rather than just making sure all disclosures are covered.

TRADERS RULE

What do the wild, short term swings in the Dow and other indices mean? How much of the activity causing swings is induced by short term, high frequency trading (HFT)? Is this healthy?

Viewing the wild swings from the vantage point of history suggests that short term “ups & downs” provide little, if any, insight into the medium or long term direction of the market, except in unusual circumstances. The fact that the Dow may fall 200+ points on Monday and recover 200+ points on Tuesday makes the market look irrational particularly when there has been no game changing event reported. Reports of negative news of one industry or company are micro-economic events, and logically should not influence markets in a manner that might be expected when there is a macro-economic event.

If this observation is realistic, then it might be postulated that short term, high frequency traders, judging time in terms of minutes or hours rather than months or years cause this market volatility. It seems obvious that the typical, individual investor buying or selling 100 to 1,000 or more shares of X stock would not move a market one way or another Moreover; the typical individual investor would not sell out a position on the belief that their stock would decline by $0.25 per share tomorrow. Instead, they would hold on to the stock if they continued to believe in the future of the company.

There has not yet been any definitive study indicating whether or not HFT is good or bad for the market. There is some evidence that 50% of all trades are HFT transactions. Some have argues that the market liquidity available because of trading activity is good for the typical investor both in terms of keeping transaction costs down and limiting volatility. But, there is no definitive study supporting these conclusions. Logic persuades that if 50% of the shares traded are the result of HFT activity, which, in turn is predicated on a short term view, the short term trading causes volatility. Moreover, the short term trader is more of a gambler than a typical investor. From the standpoint of the individual investor, with their investments in IRA’s, stocks and/or mutual funds, day to day volatility is unsettling and confusing.

Much of the confusion is caused by the “talking heads” at CNBC when they talk about what “investors” like and don’t like. But, are they talking about the typical individual investor? That is very doubtful since the orientation of their commentary and the commentary of their guests seems mostly framed in the short term unless they are reporting on people like Warren Buffet. Their commentary seems focused on the traders and institutions rather than individuals. While it is probably good theater for the viewer, it is doubtful that individual investors learn much that will guide a buy-sell decision now or tomorrow.

Another deviation from the sphere of typical investors is the frequent reference, by the “talking heads” to XYZ making a BET on a certain outcome. The word “bet” very frequently crops up in broadcast and print financial news. It should be obvious that short term traders, trading thousands of shares at a time, in mille-seconds, are “betting” that a stock will rise or fall in value in the very short term (minutes rather than days or months). It has been said (but not proven) that the holding time of securities bought by high frequency traders is less than 10 minutes. If they bet right they win. The typical, prudent investor does research before purchasing a security. It is doubtful that the HFT trader does any material research into the companies they trade and are in every sense gambling on an uncertain outcome that is algorithm based.

What is interesting is the fact that there are both Federal and State anti-gambling laws and 19 states disallow social gambling. The legislative purpose of these laws seem to be to protect the citizens against shady people running card and dice games for their profit or to eliminate the corruption of “fixing” in sports betting. Much has been written about prohibiting on-line, internet betting despite the practical impossibility of effectively stopping it. But, if risking money on an uncertain outcome is gambling, then Wall Street provides the largest casino in the world, although one in which there are numerous rules to protect the investor against misrepresentation and fraud.

HFT is not a strategy available to the typical investor and benefits one specific group rather than all participants. Is it otherwise bad? Probably not unless it is clearly demonstrated that HFT induces a higher degree of volatility into the market than would otherwise exists. But, this research has not been undertaken. One fact, however, jumps out. HFT activity does not appear to add anything to the GNP of the U S. To the extent that lawmakers might come to the conclusion that HFT is a form of gambling they might wish to consider a transaction tax of $0.25 per share or $10 per transaction, whichever is less, on all securities purchased and held for less than 48 hours.

One thing is sure – the stock market does not provide a level playing field.

PROXY SEASON 2014

Proxy season has begun and, again, investors should notice what should be a disquieting pattern of information presentation. To begin with, it seems that an inordinate amount of space is devoted to executive compensation leading to a non-binding vote. The notion that, through the vote shareholders have a real say in the important issues involving corporate governance only becomes apparently ridiculous after reading through the proxy material.

Without naming names (you know who they are), companies that experienced significant reduction in share values in the period from 2008 through 2013 did not seem to reflect any comparable reduction in executive compensation. Instead, compensation appears to have increased over that time period. And, even if an individual shareholder was unhappy with the compensation packages, a NO vote by an individual shareholder is useless as a governance tool as it is non-binding. Millions of shares in corporate America are owned by institutions and, unless they, jointly take action to protest executive compensation nothing will happen.

Despite the overly generous rewards to corporate executives the proxy material does not provide any disclosure of the specific contributions of the executives being rewarded that would justify their compensation levels. Shareholders must just accept, on faith alone, that they are worth it. Yet, only in rare instances are the compensations of the few the most important part of the profit picture. Today’s CEO’s have become America’s royalty with all of the accompanying perks.

It is also interesting to read the “shareholder proposals” and recognize that very few, if any, ever obtain a management recommendation for a yes vote. Management always seems to be able to write a detailed argument for voting against the shareholder proposals no matter how meritorious they may be and rarely does management ever present its own proposal covering the same issue.

Shareholders should question whether or not the “independent directors” are really “independent” or just go along with management recommendations. There are too few examples of directors challenging or opposing the recommendations of the CEO and executive management team to convince shareholders of independence. Rarely, when shareholders are asked to vote for directors (new or re-elected) are they provided information detailing the expertise of the nominees that would be most helpful in managing the company. More attention seems to be paid to “politically correct” nominees.

Despite attempts of the regulator to “level the playing field”, the investing game remains the province of the institutions and traders. The market is a trader’s market with high speed trading adding a level of de-stabilization and leading to the ability of a few to “front run” the market. Despite regulation attempts to cause full disclosure, the typical individual gets his or her information long after the “professionals” received theirs and, more importantly, long after the critical time to take action on the information.

Years ago, before the “information age” investors bought shares for the long term and what happened on a quarter to quarter basis was not the driving force. Brokers advised clients to buy a stock and “just put it away”. It those days that was a good strategy. But, now the entire focus of the market is short term with little, if any, discussion on investing in a security for the long term. This short term focus is not beneficial to the typical individual investor but rewards the short term trading accounts.

Unfortunately, this is the environment within which individual shareholders are asked to vote their proxies. It is very difficult to come up with a plan to cure the negative governance and market problems but it may be worth the effort to try.

WHO ARE THE SCHMUCKS

The movie title “Dinner for Schmucks” suggests that, perhaps the small individuals, are the SCHMUCKS invited to play the investment game and being shown up as fools. There is no question that the market today is a trader’s market as opposed to a long term investors market. Everything seems to be geared to constantly repositioning ones portfolio to take advantage of the web and flow of stocks popularity. But, it is also obvious that the small, individual investor is at a tremendous disadvantage unless they constantly monitor the market like the pros do and make instant decisions to buy and sell. Most small investors obviously don’t do that and, if they wanted to, they do not possess the research tools, computer programs and other analytical aids necessary to implement a trading strategy. Despite the advertisements for programs that will provide trading platforms, the small individual investor is just not equipped or trained to move with the pros. So, the inescapable conclusion is that the small investors are the “Schmucks invited to the dinner”.

The Wall Street Journal today had an article about two billionaire brothers being charged for violating insider trading rules through the use of several off shore entities to hide their trades from the regulators and Oracle, a giant in the high tech world was charged with defrauding the U S government. It is hard to read the WSJ daily without running into one or more articles reporting criminal behavior by a range of market players from investment bankers to money managers to corporate directors etc. Small investors must feel that they are the “schmucks” for doing everything honestly and believing that long term investments in good companies will usually reward them well while others are taking “shortcuts” to wealth building. Reading bad stuff in the WSJ must suggest that what gets reported is just the tip of the iceberg and only represents those who were caught. Is it any wonder that individual investors have lost confidence and trust in Wall Street?

Maybe the financial reform legislation will correct a great deal of the ills, particularly through the “whistleblower” provisions that reward people for reporting bad deeds. But, in the meantime, individual investors should continue to fight the abuses in the financial markets that place them at substantial disadvantage and impair the safety of their investments.

TRUST WALL STREET???

Reading Michael Lewis’s latest book, The Big Short, provides not only a fabulous story, well told, but also should put fear into the minds of investors everywhere. The bothersome question that remains is one of just how much trust should anyone place in investment banks and brokers?

Reading The Big Short leaves the impression that nothing coming out of Wall Street should be trusted. Firms like Goldman Sachs were selling their investors investments in subprime mortgages while at the same time shorting them in the belief that the values would plunge. Investment banks were creating pools of subprime mortgages and Collateral Debt Obligations in an apparent reckless manner because the rating agencies were willing to give these securities a high rating. And, the rating agencies were acting irresponsibly in both the manner of investigating the securities and issuing ratings because they were earning substantial profits by providing the ratings. What is astounding is the fact that relatively few people in the investment banks appeared to recognize the level of risk being foisted on the investors through this process. Obviously, the investors were all fools in permitting themselves to be duped by the ratings rather than questioning the composition of the securities they were buying. But that is hindsight. However, the investment bankers should have known better and should have applied the brakes very early on. Why didn’t they? It would seem that the reason was strictly attributable to the tremendous profits they were making from the activity. Despite the big losses suffered by investors and others who held the paper sold by the Wall Street firms, the movers and shakers got their bonuses and continue to get bonuses. The former CEO of Citicorp said in testimony before congress that they continued with the activity because to have discontinued it might have cost market share and/or the loss of key employees. So, is the Wall Street message one of engaging in a foolish activity just because it is so rewarding to some employees or because it raises market share?

Whether or not there was fraud or conspiracy involved in the subprime debacle remains for the regulators and courts to determine. Regardless of the outcome of investigations, the plain fact is that the greed of Wall Street almost caused a total collapse of the U S financial system and systems worldwide. What is curious is the fact that amid continued cries for fewer regulations, the Citicorp executives that testified before congress were quick to point the finger of blame at the regulators for their failure to see the crisis coming and stop the activity causing the crisis.

Stockholders should be completely skeptical of any notion that Wall Street or public companies will regulate or police themselves. That notion defies logic and lacks rational thinking. The motivation of greed can be counted on to take over behavior, particularly when it is other people’s money they are betting with. Sadly, all of the traders who contributed to the subprime mess earned big money and monstrous bonuses whether they were ultimately fired or kept their jobs. Only the investors and the public at large paid the price of their folly.

B of A EXECS SUED

A press release announced that the New York attorney General had filed civil fraud charges against Ken Lewis and Joseph Price of the Bank of America in connection with the failure to disclose Merrill losses before the shareholder vote to acquire Merrill. Whether this suit will go anywhere or not remains to be seen. Still pending are the approval of a Bank of America settlement of $150 million with the SEC arising out of the same issue. Unfortunately, if the settlement is approved, there is no indication that any part of the $150 million will accrue to the benefit of the shareholders. It would appear that the SEC will get the money. Instead, the Bank of America will pay the fine with shareholder money. But, it was the shareholders and not the SEC who were injured by the failure to disclose. Something is wrong with this picture. The judge should probably not approve the settlement unless it is clear that the money would be paid to the shareholders directly and not to the SEC. The Bank does not pay fines. They come out of shareholder funds. To penalize the shareholders for the banks failure to disclose would clearly be unfair. On he other hand, if Ken Lewis and/or Joseph Price knew about the losses, decided not to disclose them, and were found guilty or wrongdoing, then any penalty applied to them personally would go some distance to right the wrong from the shareholder viewpoint.,

SEC VS. B of A

The SEC just announced that it will be seeking to file another lawsuit against Bank of America, with regard to the Merrill acqujisition, for failure to properly disclose information to shareholders. But, they also stated that the suit would not name any executives, directors or attorneys of the Bank of America because they had no evidence that these knowingly withheld information.

That approach seems to be the most idiotic ill reasoned approach imaginable. It seems to be a FACT that when sharehoders voted to approve the Merrill acquisition, the were notinformed about the mounting losses at Merrill or the intended massive bonuses to be paid to Merrill personnel. It seems totally inconceiveable that no executive, director, accountant or attorney for the bank had any knowledge of these thngs at the time they should have been disclosed. How can the corporation be sued for failure to disclose withiut naming the individuals within the corporation responsible for that failure? Corporations only act through their officials. They do not act on their own without human intervention. So, if the Bank is clearly guilty of failure to disclose, then the individuals who participated in that failure must be held accountable. To do otherwise is not n exercise designed to protect the shareholders. Ane, what if the SEC prevails against the Bank? What if they win a big money judegment for failure to disclose? Who pays? Obviously the Bank pays and not those responsible. And, whose money does the Bank payh with? Obviously the shareholders money. If all of this is true, then it is hard to see how this new lawsuit by the SEC will in any way protect the shareholders or compensate them for the damage done by the failure to disclose. The opposite seems to be the result. The shareholders will lose again. And our government is here to help us???

Bank of America CEO Search

The Wall Street Journal of December 15, 2009 reported that talks between the B of A and Robert Kelly as the potential replacement for Kenneth Lewis as CEO had ended forcing the Board to reconsider two internal contenders.

The reason cited was pay and it was indicated that Mr. Kelly had sought a pay package of $20 million. But, that is not the only item of concern raised article. The fact that the Board appeared to prefer an outsider to internal candidates is an issue that is worth discussion.

Seeking a $20 million pay package suggests that CEO candidates and CEO’s may have a very overblown view of their worth to a company. They may be copying professional athletes who receive giant pay packages before hitting a home run, scoring a touchdown or sinking a three pointer. But, the athletes are a different story. Their presence on a team is viewed as making a material contribution to the success of the team thus giving rise to ticket sales and TV revenues that more than offset the pay. But, is there any evidence that the hiring of a CEO provides a benefit to the stockholders adequate to offset their extraordinary pay packages? To the extent that there is a shareholder benefit, it would not usually be reflected in the performance this season or next because an operating company has, in place, all of the operating plans for at least the next two years. An operating company is like a battleship in that it takes a long time to turn it around. Accordingly, the contribution of a new CRO, if any, will most likely be reflected in long term future performance rather than immediately. So, it would be reasonable to reward that performance with stock options, with exercise dates far into the future, which would have no value unless the stock price increased over time, in which case the shareholders would win too. But, up front guarantees of outrageous compensation packages make no sense. If a CEO is confident of his or her ability they should be willing to take a risk along with the shareholders and other employees. Insisting in an up-front guaranty is asking to win whether or not the shareholders win.

The other aspect of the search for a CEO is the question of why the Board decided to go outside of the Bank. Kenneth Lewis did not run the Bank alone. He was not a “one man band” and must have had a highly trained team of executives serving under him. It is impossible to imagine that there weren’t several of those executives qualified to take over as CEO. Members of the executive team must be assumed to have known more about the Bank’s business than any outsider could possibly know. Maybe the Board felt that whatever Ken Lewis was criticized for must have tainted all internal candidates. If that is so, then they would have overlooked the fact that the second, third, fourth or 64th in command (the executive team) does not take strong positions against the “chief” and hold on to their positions for long. The Board and not the “team” most probably bear responsibility for the questionable decisions of Ken Lewis due to a lack of adequate oversight on their part. Going outside to find a CEO, in an institution as large as B of A sends the wrong message to the “team” remaining behind. It says that no matter how hard you worked, no matter how qualified you are you are not going to get the top job. Is that a good message for employees to hear? Fortunately, the inability to attract Mr. Kelly or other outsiders has resulted in turning the search focus inward. One must wonder how much shareholder money was spent by the Board on the executive search when there were qualified candidates inside.

SHAREHOLDER VOTE ON EXECUTIVE PAY

It is good to see that the House has passed some new, far reaching financial regulation legislation. The bill will move to the Senate now. One element of the pending legislation is providing shareholders with an advisory vote on executive compensation. While that provision recognizes shareholder concerns over runaway compensation packages, it should not be expected to work any miracles because the vote is absolutely not binding on the officers and directors. It is advisory only. The only real control that can be expected must come from the compensation committee of the Board made up of “independent directors”. There is the rub. Most often, under the present methods of selecting “independent” director candidates and electing them, achieving a Board with a majority of truly independent directors is more of a myth than a reality (see the Post on this subject on this site). Unfortunately, no one has ever satisfactorily defined what level of total compensation is reasonable and what level becomes excessive. But, logic should dictate that instances of total compensation reaching eight figures (as in $10,000,000). It is very hard to imagine that, on a relative worth scale, one, two or three top executives in a large corporation can individually contribute enough to the corporation to be worth that level of compensation.. Stated differently, with all of the brilliant people being graduated each year from prestigious business schools, it is hard to imagine that there would be a lack of qualified candidates if a top job only paid $3,000,000 in total compensation. It would be interesting to speculate about what might really happen to the business of a corporation if its CEO suddenly died. Would the business suffer or would the team in place be able to carry on as if nothing happened? Any company totally dependent on a small cadre of top executives for its success may not represent a very safe investment.

Shareholders, particularly those owning large blocks of stock like pension funds and mutual funds, should become very pro-active in riding herd on executive compensation and making sure that executive performance is demonstrably worth the level of compensation granted.

At least for the moment, it would seem that Goldman Sachs understands the sentiment of investors and the public by foregoing top executive bonuses for 2009. But, what is sad is that the Republicans in Congress appear to oppose this new financial legislation in the misguided belief (or, maybe just stubborn opposition to any Democratic sponsored bill) that the country doesn’t need financial regulation. It is difficult to understand how fiscal conservatism is somehow inconsistent with financial regulation designed to prevent any repeat of the financial collapse of 2008.

INDEPENDENT DIRECTORS

The term “corporate governance” may be an oxymoron. The Boards of public companies are supposed to be composed of a majority of “independent directors”. Independent directors are supposed to represent the best interests of the shareholders only and not the interests of management. However, in practice this may not work out.

The method of selecting independent directors, in many cases, does not result in the selection of a “truly independent director”. Comapnies genrally have a nominating committee composed of independent directors who are charged with “nominating” new directors when a vacancy occurs. That is good. But, too often the names presented to the nominating committee for consideration are furnished by management. That is understandable because no CEO wants a director who might be “unfriendly” in any way. However, the process does not lead to the selection of a truly independent director.

Once a director has been elected, regardless of how independent he or she may have been, management has subtile methods of manipulating them to see things managements way. Those subtile methods include directors compensation packages, directors retreats, a list of perks like rides on the company jet etc. Directors, being human, begin to like the package and see management, not the shareholder, as their benfactor.

Altogether too often, people elected as directors have either business or social relationships with other directors and/or management and may serve on boards with other co-directors. This tends to make things cozy like an old boys club. What is often missing in elected directors is any real knowledge or experience in the business of the corporation. That experience often comes from on the job training.

Shareholders deserve better. But, the method of achieving better is not presently developed. For starters, corporations should be required to use an idependent search firm to identify potential directors to fill vacancies and there should be a strict set of criteria as to who is qualified to serve. Top among the criteria should be a requirement that the person have some special skill sets that will contribute to the enterprise backed up by a knowledge of the business that the company is engaged in. Next, shareholders should be given more choices than just the number of directors to be elected. The proxy material should disclose all relationships, social and business, that the nominated directors may have with other directors and management including other boards served on with other directors. Finally, the proxy material should detail he specific skills posessed by each nomineee and disclose how each nominee is expected to contribute to the future good of the company. Perhaps then shareholders would have an informed basis for voting and will be able to make sure that election of directors is not just the perperuation of an “old boys club”.