Dividing fiduciary attention

Posted by Marc Hodak on April 6, 2015 under Governance, History | Be the First to Comment

never give up

Regulators are saying that they may want some of that fiduciary attention that boards currently, presumably owe exclusively to their shareholders. Last year, Fed Governor Daniel Tarullo broached the idea that bank boards should perhaps account for regulatory as well as shareholder interests in their governance to address the divergence between firm-level and “macro-prudential” needs. Tarullo suggested that this division of loyalty might supplement, if not somewhat obviate the need for, the other two approaches that the government has tried, i.e., increasingly constrained incentive plan structures and increasingly detailed banking regulations.

The incentive problem has been well covered here and here, as has the downsides of proposed regulatory remedies. Dodd-Frank includes a plethora of direct regulatory constraints to moderate the risk appetite of banks, among other things. Of course, that grand legislation failed to address TBTF or the GSEs with which the big banks competed, and—surprise!—a general feeling persists that regulation may not be enough.

One the one hand, we should have expected that conclusion long before Dodd-Frank was even passed. Contrary to the prevailing narrative, banks were working under a heap of government regulations in the run-up to 2008. Those regulations may have been the wrong ones, or they may have been poorly administered, but they undoubtedly contributed to market distortions that made ‘up’ look like ‘down’ in many derivatives transactions.

Rationalizing the regulations, and accounting for the complexity that they create (and their secondary effects), would have been a good start to improving bank governance. Instead we have greater regulatory complexity than ever, which means we have more potential distortions and perverse incentives built into our financial system than ever before. Given this reality, perhaps it makes sense to throw in the towel on trying to contain the externalities of our banking system via sensible regulation, and just tell the board of directors that they must begin to internalize those potential costs by accounting for regulatory interests alongside (or perhaps ahead of) shareholder interests.

Unfortunately, that approach has yet to work well in any other industry in which it has been tried. Instead, history suggests that regulatory cures beget regulation-induced problems, which beget more regulation, etc., until the whole sector becomes in essence, if not in fact, nationalized. This state of affairs continues, often for decades, until the manifest defects of this nationalization become obvious to everyone, and the sector gets substantially deregulated. And everything is better.

Until problems crop up again, and politicians feel compelled to do “something…anything.”

Collaborator of the Month

Posted by Marc Hodak on March 30, 2015 under Uncategorized | Be the First to Comment

EthSys header

Ethical Systems (ethicalsystems.org) is featuring me, the least distinguished of its collaborators, this month on their site.

Utopian Dreams

Posted by Marc Hodak on March 23, 2015 under Governance, History, Invisible trade-offs | Be the First to Comment

Corporate Social Responsibility has become a hot topic. You can hardly talk about corporate governance these days without touching on it. In some areas, you might as well assume that CSR is in the background of every conversation about governance.

Being a history buff, I began to notice that a lot of “what corporations should be doing” sounded a little like reinventing the wheel. Corporations have, in fact, tried many things over the two centuries since they have risen to prominence. Not all of them have been run by greedy, rapacious bastards. Many of them, in fact, have been run by far-sighted, generous spirits intent on doing good while doing well. I thought that it might be worthwhile to review some of the boldest experiments in business history to see if we could learn any lessons from them.

Here are some early conclusions I have come up with.

Utopian Dreams

Squeezing the Balloon Once More, and Expecting a Different Outcome

Posted by Marc Hodak on January 23, 2015 under Executive compensation, Unintended consequences | Read the First Comment

Americans seemed, at least for now, to have reached their saturation point on direct wealth redistribution. So for those who still feel we have more redistribution to do, they are trying via the tax code.  A Democratic congressman has proposed to penalize executive pay if the company “fails [the] test of pay fairness.”  Specifically, if a public company fails to raise the average pay of its workers making less than $115,000 by a percentage equal to the overall US growth in productivity plus inflation, the government will eliminate the deductibility of top executive compensation above $1 million. What could go wrong?

Well, let’s look at a brief history of attempts to use the tax code as a vehicle for social engineering.

We begin with the tax on “golden parachute” payments in 1986. Executives being ousted in takeovers got big payouts, while many of the workers left behind got laid off. Very unfair. So the government imposed an excise tax on those “parachute payments” when they became “excessive.” They felt that such a tax would either limit the compensation or limit the deleterious M&A activity. How did that work?  Employment agreements began to proliferate for executives stipulating that shareholders pay the excise tax should it be triggered.  There were good business reasons for doing this. Given that this tax reimbursement was itself taxable, and the shareholders would be on the hook for that, too, the tax policy basically transferred a chunk of change from corporate treasuries to the U.S. Treasury. It didn’t affect the M&A activity.  And it left overall compensation largely untouched.

Read more of this article »

Returning to publishing

Posted by Marc Hodak on January 16, 2015 under Uncategorized | Be the First to Comment


Having been buried in client commitments and research has required me to update our software to enable me to post more efficiently. With that behind us, I am ready to move forward with commentary on governance. I will continue to focus on compensation governance, but will also branch out in what I will be referring as “Level 3 research” and application of mechanism design theory to governance beyond public corporations.

Coca Cola’s Reduced Options

Posted by Marc Hodak on October 2, 2014 under Executive compensation, Governance | Read the First Comment

Yesterday, Coca Cola caved in to the bad press regarding the equity plan they proposed last April–and passed by nearly 90 percent of voted shares–by altering their equity award guidelines.  It’s fun to speculate about the various forces arrayed for or against the Coke equity plan, and what Warren Buffet thinks, and how the press has reported the issues at stake.  But I’ll sidestep all the juicy speculation and bright fireworks and go straight to the only thing that matters, or ought to matter, to shareholders:  Is the new Coke policy better than the old Coke policy?

Let’s start with the policy change itself, which has three parts:

1.  Coke will be providing more transparency about the rate at which equity is being awarded (burn rate, dilution, and overhang)

2.  Coke will be using equity more sparingly in “long-term plan” awards, instead favoring cash

3.  Coke will be awarding far fewer options from their equity pool than before relative to performance-based stock

The effect of the latter two policies will be to significantly reduce the number of shares used to compensate management.  What they are NOT changing is just as important as what they are changing.

–  They are not changing the target value of “long-term plan” awards to management.  If an executive had a $1 million target long-term award, they will continue to have a $1 million long-term award; it will simply be paid more in cash than in equity.

–  They are not changing eligibility for awards.  They continue to believe that equity awards should be broad-based within the company.

So, what have the shareholders gotten out of these changes?  Well, management and the board will finally be able to step out of an unwanted limelight over pay.  Shareholders benefit from managers and directors being able to focus on business with one less distraction.  As for the economic benefits to the shareholders, that’s pretty easy to estimate, too:  Nothing.  Read more of this article »

Utopia – The TV show

Posted by Marc Hodak on September 5, 2014 under Futurama, Governance | Read the First Comment

Fox, in the kind of an understatement we have come to expect in the marketing of reality TV, is billing its new fall series “Utopia” as “television’s biggest, boldest social experiment.” The show’s premise taps into the age-old dream of creating a perfect society. This dream burns particularly brightly in the treasured eighteen to thirty-four year-old demographic, marinated in the you-can-do-anything ethos. These are the very folks who would ask: Can a group of random strangers actually create a perfect society?

No, they can’t.

It sounds almost mean to put it so bluntly, as if I wanted them to fail. Not true. Read more of this article »

ISS vs. Nucor’s Ghost

Posted by Marc Hodak on August 5, 2014 under Executive compensation, Governance | Be the First to Comment

Just published in Directors & Boards.  The summary:

Nucor’s classic incentive plan contained three elements:

1)  A fixed share of profit growth…

2)  …without limit

3)  Annual grant of standard stock options

The company was enormously successful because of this plan.  It looks like everything that shareholders care about is imbedded in this plan.  Empirical evidence strongly supports these plan elements as being good for shareholders.

Yet none of them would pass muster with ISS today.

So, if you’re a director of a public company, and you know what reason and evidence suggest, and you had a choice between adopting a Nucor-style plan or hewing to ISS’s standards, what would you do?

Unfortunately, we know what they are doing, and that it is hurting the value of public companies.

The Last Refuge of Scoundrels

Posted by Marc Hodak on July 7, 2014 under Executive compensation, Politics | Be the First to Comment

It used to be said that patriotism was the last refuge of scoundrels.  Now that patriotism is being viewed with more irony than honor among a certain portion of Americans, I think the “last refuge” has become the bashing of “fat cats.”  My evidence is a recent spate of articles on how President Obama, who is polling rather poorly these days, is once again going after Wall Street bonuses.  There is no surer way to get heads nodding again when you speak.

I nod, too, but for a different reason.  I continue to be astounded by the idea that banks had been managing the well-understood “trader’s option” problem for decades, then suddenly lost the ability to do so in the mid-2000s, and crash goes the financial system.  This explanation simply doesn’t hold water.  Neither does the idea that bankers suddenly became “greedy” in the mid-2000s, and crash went the financial system.  No.  If one wishes to develop a cogent theory about “what went wrong,” one must identify distinguishing characteristics, not common, long-imbedded ones.

I can (and have) provided many reasons why the “bonus culture” of banks has been unfairly blamed for the financial crisis.  Fahlenbrach and Stulz (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1439859) provided the best empirical evidence that it didn’t.

Now, a new paper by legal scholars Whitehead and Sepe basically blames competition for talent as undermining proper incentives.  I salute them for at least acknowledging the competition for talent in banking.  Most critics of the banking system were feverishly trying to outdo each other in how firmly they would cap banker pay in arbitrary ways at arbitrary levels without regard to the competitive issues that such rules would create in order to “solve the problem” that they claimed was at the heart of the financial crisis.  The ensuing exodus of talent at large, public U.S. banks has been unbelievable.  (Literally–people outside of the industry don’t believe me when I tell them how bad it has been.  The more polemical critics simply roll their eyes and smugly say, “Yeah, the talent to blow up the economy. Good riddance.”)  Whitehead and Sepe acknowledge the competitiveness issue, but then go on to recommend arbitrary limits on how bankers may move from one firm to another.

If you believe that you have to compete for talent in financial services, including traders, and if you understand that different forms of pay offer different expected value to potential employees, then one can readily see that the only way to increase the risk and constraints of banker pay while acknowledging the need to compete for their talents would be to increase the expected value of that constrained, riskier pay package.  Partnerships do this all the time.  They create very risky, very constrained pay packages, and manage to lure incredible talent.  Hedge funds didn’t contribute to the financial crisis, and didn’t need to get bailed out.  And no one is suggesting that we need to limit how hedge fund employees move from one firm to another in order to moderate or contain risky behavior.  What makes this work is that hedge funds don’t have to disclose how much their successful people earn.

How little President Obama and his staff know about these issues may or may not shock you.   But he doesn’t have to know anything about the economics and dynamics of incentive compensation in the financial sector, or any sector.  He just has to know the math:  “Bashing Wall Street” = “Higher poll numbers.”

The hidden risk of “at-risk” pay

Posted by Marc Hodak on May 30, 2014 under Executive compensation, Governance | Be the First to Comment

On Monday, Staples, Inc will try to win its “Say-on-Pay” vote with ISS recommending against approval the executive compensation plan.  ISS made its recommendation based on its usual arbitrary, micro-managing concerns which are not the subject of this post.  Here, I want to highlight the problem Staples created for itself, without anyone’s help, and unintentionally revealed in this pair of sentences:

The [Compensation] Committee … recognized the need to address retention of key talent and to continue to motivate associates in light of the fact that we did not pay any bonus under the Executive Officer Incentive Plan or Key Management Bonus Plan in 2013 and 2012.

As a result of the changes to the compensation program in 2013, an average of 84% of total target compensation (excluding the Reinvention Cash Award) for the NEOs was “at risk” based on performance results, and 100% of long term incentive compensation was contingent on results.

Anyone reading Staple’s proxy could be forgiven for thinking that these two sentences have nothing to do with each other, notwithstanding that they appear consecutively in this proxy.  It’s clear that neither the authors of this disclosure nor the board that approved it saw the connection, either.  But look carefully at what they are saying.

Read more of this article »