A few weeks back, Hillary Clinton unveiled her proposed tax complication scheme and other proposals to combat “short-termism.” People generally being more conservative with regards to their own professions than other people’s professions, I was tempted to suggest that trusting Hillary (or any politician) to remedy whatever was ailing corporate America was like trusting a medieval doctor to cure…well, just about anything. You just know that whatever the ailment, the treatment will involve bleeding the patient. But recalling the above-noted bias, I realized that I was merely responding to quackery with quackery, and that I was in no better position to give Mrs. Clinton political advice than she was at giving anyone economic advice.
So I refrained from calling her out on her proposal, including addressing the irony of politicians accusing corporations of short-termism, and left it to the pundits to debate her prescriptions. What I didn’t expect is a spate of articles refuting her diagnosis, i.e., that corporate America was suffering from an acute case of short-termism.
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The CEO Pay Ratio mandated by Dodd-Frank is finally here. The rule sounds simple enough: Companies must disclose the ratio of their CEO’s pay to that of their median worker. Interesting information, perhaps, but the SEC supposedly exists for a more lofty purpose than mandating nice-to-know data. It must, by law, act in the interests of investors. In fact, the Administrative Procedures Act requires the SEC to “base . . . decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.”
The CEO Pay Ratio rule is, indeed, of great interest to certain people. Union leaders believe that the rule will give them another crowbar with which to negotiate their members’ wages and benefits. Class warriors believe it will give them more ammo to shame corporations into reducing inequality. Fair enough. But the SEC does not normally allow itself to be used by unions for getting involved in labor relations, or by class warriors in anti-corporate crusading. So, why are they bothering with this rule?
Quite simply, because Dodd-Frank requires them to. The CEO Pay Ratio provision was inserted into the law, without debate, at the last minute by Senator Menendez. His rationale, explained after the fact, was, “This simple benchmark will help investors monitor both how a company treats its average workers and whether its executive pay is reasonable.”
How, exactly, will this “simple benchmark” help investors do those things? What number, or range, for this ratio tells an investor that a company is treating its average workers well or poorly, or that a company is paying its CEO reasonably (given that CEO pay is already thoroughly disclosed)? What economic or financial standards can be created using this or other data to enable investors to figure these things out?
As someone who has been asking this over the five years it has been debated, I can assure you that those questions have never been answered, neither by the rules proponents nor by the investors they claim to want to help. That’s because there is no logical basis for believing that the pay ratio can usefully inform investors either with regards to the company’s treatment of workers or the reasonableness of their executives’ pay. Consequently, there is no scientific or economic evidence that this ratio, alone or in combination with any other data, can be used to judge how well the company is being managed, or otherwise be related to company value—i.e., the nominal concern of investors. The Pay Ratio provides no more useful information than the ratio between the company’s highest cost office space versus its average cost of warehouse space, or between its highest cost commodity inputs versus its average cost of materials.
In other words, the SEC is simply being used in an experiment in social engineering. The expectation is that this ratio will shame boards into changing how they pay their CEOs. That goal might have some redeeming value if this experiment hadn’t already been tried, twice. The “shaming” theory was, in fact, largely behind disclosure rules enacted in 1992 and in 2006. A rational person would have looked at these and similar results, and decided it was time to try another hypothesis. Alas, it appears we are not dealing with rational persons. So today, ideology trumps science.
What goes up…
Forking an extra $120 billion into the hands people paying college tuition might have had an effect in raising college tuitions. Who would have guessed? The irony is that the student loan and Pell grant programs were intended to make college more affordable for more people.
This new study doesn’t take into account the significant price discrimination practiced by colleges, which partly offsets the net cost per student, particularly for those from poorer backgrounds, versus the sticker price of tuition. Nevertheless, the average student that could once afford college by working summers now has to work a decade or longer to pay for school because of skyrocketing tuition.
So, according to the Fed study noted above, it seems that about half of tuition increase was the result of effective, if artificial, demand in the form of easy money for students. It’s certainly not because schools have gotten any better at educating their students.
Mylan’s anaphylactic reaction to a generous offer
The headline quote comes from Mylan’s Executive Chairman Robert Coury, in response to why his firm was rejecting a rather generous buyout offer from Teva.
I get it. Coury believes in the long term. He believes that “shareholders benefit from a well-run business, and to run a business well, you need to focus on all of the stakeholders we touch on a daily basis, including customers, patients, employees, suppliers, creditors and communities.” Mylan used that to defend a decision that would cause its stock to drop over 30 percent below the value of Teva’s offer, yielding a collective value deficit of $10 billion.
As a shareholder, I would love to know how Mr. Coury’s expansive focus on his stakeholders will make up for that $10 billion opportunity cost. That’s a lot of EpiPens.
Alas, Mr. Coury doesn’t have to give a [vloek] about what shareholders want to know. Even if they voted off all of the board members, he retains the sole right to appoint new ones. That’s the kind of power that would get good governance folks in America to freak out.
Or be perfectly OK with it, depending upon one’s perspective.
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“We can make them sign it. What can go wrong?”
The Germans, who are normally quite astute about the lessons of history, are now acting against Greece with what looks like a vindictive intransigence that would have made Allied negotiators at Versailles nod approvingly. The Greek’s choice now appears to be between another bailout and continued harsh austerity, or default and financial collapse. Who in Europe believes that pushing Greece into desperate economic straits is good for their stability? Will it take the rise of someone much more extreme than Tsipras to make the Germans, French, and others understand what they are really getting in exchange for avoiding a haircut on the loans, and accepting any responsibility for the bad judgments of the lenders as well as the borrowers?
Greece may have another choice. Two choices, actually: an economic choice and a political choice.
The economic choice, under a rational leadership, may enable Greece to default on their outstanding debt and quickly resurrect their access to global capital markets at reasonable rates. This choice would merely require a couple of changes in their constitution. It has been done before. To see how, we need to step further into history.
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Time to turn in your papers
Today was the last day of the comment period for the SEC’s proposed disclosure rules on pay-for-performance. My own submission offers a few relevant points:
1. There are two reasons why investors would care about pay-for-performance: (a) to judge compensation cost and (b) to judge alignment of interests between managers and owners.
2. The SEC proposal does injustice to the first reason, and completely ignores the second.
3. As a result, the proposed disclosure will create a potentially, grossly distorted view of pay-for-performance.
4. If the SEC wants good disclosure on this matter, its requirements must acknowledge the investors’ perspective with some significant changes (which I propose).
5. If they can’t or won’t make those changes (and they probably shouldn’t at this point), the SEC should revert to a principles-based disclosure, and let the market sort out whatever resonates with investors.
I consider this rule one of the most important that the SEC will devise this year. In the long run, pay-for-performance disclosure will have far more impact than the more controversial rules on CEO pay ratios and compensation clawbacks. If the disclosure rule ends up close to its current form, it could be just one more nail in the coffin of public companies.
Hey you out there: Just kidding
Let’s say that you hire a captain for your ship, and for, say, tax reasons, decide that instead of running things from the bridge he should run things from the plank. You warn him that if anything goes wrong, he goes into the drink. But rough weather comes along, and you decide you still need him, so you don’t push him over the edge. At this point, you’ve hurt your credibility and pissed off the sharks.
That appears to be what is happening as activist investors increasingly get into the game of second-guessing corporate bonus plans. On the plus side, these shareholders are digging much deeper than the typical, diversified institutional investor possibly could. Marathon Partners, for instance, is criticizing Shutterfly’s plans that reward growth without assurance that it is value-added growth, which looks like a valid criticism.
But that doesn’t mean that activists investors necessarily know more than the boards they are criticizing:
Jana Partners LLC, which recently took a $2 billion stake in Qualcomm, has urged the company to tie executive pay to measures like return on invested capital, rather than its current yardsticks of revenue and operating income, according to a Jana investor letter. Such changes “would eliminate the incentive to grow at any cost.”
Yes, it would. But return on invested capital could instead create the opposite incentive, i.e., a bias against value-added investment. (If the investors really knew what was what, they would more likely require economic profit as the compensation metric.)
Although companies should generally be given the benefit of the doubt about their plans, they don’t do themselves any favors by trotting out the specter of retention risk when discussing variable compensation. Yet we often hear companies say, or using code words to the effect of, “Hey, we have to be careful that our incentive plans aren’t too tied to performance, because if they don’t pay out, we might lose key talent.”
Notice to Corporate Boards: Nobody buys this explanation.
And, by the way, if your variable compensation plan creates retention risk when it doesn’t pay out, then your compensation program is too weighted toward variable instead of fixed compensation. In other words, your salaries are too low and your target variable compensation is too high. In a well-designed plan, salary should cover the minimum amount of pay that would be needed to keep your executives around when your company is performing poorly.
Alas, too many corporate incentive plans are poorly designed, but not for the reasons usually toted up. These plans are a mess because the most important incentive of all is the incentive created by Section 162m of the tax code to underweight salary and overweight variable compensation. That puts public companies in a bind when incentive plans don’t pay off, which is clearly (and predictably) a recurring problem.
In other words, companies may be wrong-headed for conflating alignment issues with retention issues when arguing for slack in their bonus plans, but they come by this wrong-headedness honestly; it is a logical reaction to the unintended, deeply perverse encouragement our tax laws.
Fortunately, an increasing number of companies are starting to ignore the 162m salary limits. They are realizing that the harm that higher salaries may cause their shareholders in the form of higher taxes is easily outweighed by the benefits of more rational ratio of fixed vs. variable compensation for their management, one that militates against the real retention issues that too much compensation risk might cause.
The unanticipated death of a public company top executive can often create an observable market reaction. Sometimes, this reaction is not flattering, as when the stock price jumps five to seven percent when a CEO dies because there was no other way for the shareholders to get rid of him.
On the other hand, you get examples of what happened when the market was hit with news that Ed Gilligan, American Express President and heir apparent to the CEO, passed away suddenly on Friday. Amex stock dropped about ten cents per share (after accounting for changes in the market overall)—a drop of about $100 million dollars. Which answers the question posed in this title: Yes, some people are clearly worth to their shareholders what they are being paid.
Ironically, this financial hit was the result of good governance. Amex did what it was supposed to do in clearly identifying a likely successor in case they should suddenly lose their CEO, as well as pave the way for his retirement. The value of clarity about successorship is supported by empirical evidence. So, in a sense, what Amex has lost in a worthy successor, besides whatever else Gilligan uniquely provided to the company, was simply giving back what they had previously gained from doing the right thing in establishing a clear heir to CEO Kenneth Chenault.
And now Chenault, who just lost a close colleague for whom he clearly had great affection, must once again groom another successor.
Why are drug costs are so darn high? This perennial question was once again raised at an annual medical meeting by Dr. Leonard Saltz, a senior oncologist at Memorial Sloan Kettering. He contended that newer combination cancer drug treatments costing almost $300,000 are simply not sustainable. Dr. Saltz mentioned one possible contributor to the high costs sure to excite those of us who catalogue perverse incentives:
He…called for changing the way Medicare pays for infused drugs. Doctors currently receive a percentage of the drug’s total sales price. The payment method has created a conflict of interest because cancer doctors can make more money by using the most expensive drugs, he said.
If you believe, as I do, that drug companies should make money on drugs, and doctors should make money being doctors, then the idea of doctors making money selling drugs sounds suspicious. It’s easy to be wary of brokers in any field–real estate, investments, executive search–where their income is based on how much you pay for the things they are recommending; ergo, a conflict of interest. Each of the aforementioned brokers would argue that their interest in getting a deal done as quickly as possible easily trumps getting the highest possible price, and they would have a point.
Doctors can’t say that; they don’t need to create a sense of urgency for cancer treatments. Read more of this article »
Those who have followed the Dupont/Trian contest know that the shareholders voted (barely) to retain the incumbent board. But two other, fascinating pieces of information are apparent from the aftermath of that vote regarding the investors’ reaction:
1. The market was surprised
2. The market was disappointed
A seven percent drop in the stock price is huge. Shareholders were clearly invested, so to speak, in seeing Trian win, even as they voted them down. So, while shareholders-as-voters accepted CEO Ellen Kullman’s explanation that Nelson Peltz does not know as well as she what is best for their company, shareholders-as-traders said, “Whoa, that was a terrible decision!” We assume that, being the same people, each making their judgments based on their individual, independent estimation about the future prospects of the company, and with the “wisdom of crowds” sorting out their discordant judgments into a useful, single verdict, we should see less schizoid outcomes.
Alas, this “crowd” effect works via very different mechanisms in proxy voting versus in market pricing. So, which result should management heed? Read more of this article »