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 »

The Ford “buy their own product” myth

Posted by Marc Hodak on May 27, 2014 under Economics, Innumeracy | 3 Comments to Read

Whenever minimum wages are being debated, as they are once again, we can count on someone bringing up the old story about Ford’s $5-a-day gambit.  It goes something like this:

Ford Motor founder Henry Ford revolutionized the industrial landscape when he doubled his employees’ wages to $5 per day in 1914. The pay increase allowed his workers to buy the Model T cars they assembled every day on the factory line.

Enabling workers to “buy their own product” supposedly enables the creation of a mass market, helping producers as well as consumers.  But is that true?  And is that how Ford benefited from his wage hike?  Let’s look at the math.

In 1914, when Ford Motors instituted the $5-a-day wage, the company had about 14,000 workers making $2.25 a day, for a total wage cost of about $32 million.  Ford was selling about 250,000 cars a year at about $500 per car.  That’s about $125 million in total revenue.  So, let’s say that ALL of the increase in wages–$2.75 per day per employee for all 14,000 employees–went toward the purchase of Ford cars.  (Why that would have been impossible is a story for another time.)  That would be sales of about 20,000 more cars (yes, more than one car per worker), yielding Ford about $10 million dollars more in revenue.  So, the “buy-their-own-product” folks are asserting that Ford benefited by doubling his labor costs in order to increase his sales by less than 7 percent.  For one year.

Nope.

The buy-their-own-product rationale is as historically mistaken as it is economically ridiculous.  Ford’s stated intent in dramatically raising wages was to reduce the huge turnover his new assembly line process had created, and the high costs of dealing with that turnover.  In other words, it was a bold solution to a novel production problem.

Furthermore, far from expecting any major increase in sales (i.e., from his own workers), Ford counted on having his profits significantly reduced that year as a result of the wage increase.  In fact, he was gleefully counting on it.  Why would Ford want his profits hurt that year?  Because he was in the middle of an outrageous gambit to squeeze out his fellow investors (and new car competitors) John and Horace Dodge, and a ding to the company’s profits that year would hurt them much more than it would Ford himself.  Ford, in fact, expected to realize the benefits of lower turnover in later years once his volume was greatly expanded (which is what eventually happened).

The idea that increasing your employees’ wages to enable them to buy your product is one of those ditzy notions that requires math blinders to believe.  Yet the “buy their own product” argument will continue to be made because belief is more powerful than math.

Yes, it can be this simple

Posted by Marc Hodak on April 28, 2014 under Pay for performance | Be the First to Comment

If I were a wheelwright, I would probably raise an eyebrow at stories like “Philadelphia man invents the wheel.”  Since I create organizational incentives for a living, that was my initial reaction to this story, via the NYT:

In August, I wrote about the design and implementation of a profit-sharing plan for my business. I decided to try this because my company has a long history of producing poor (or no) profits…

The plan began with the second quarter of 2013, and here’s how it has worked out: We made a profit in three of the four quarters that followed.

It’s easy to joke about someone reinventing the wheel, but there is a difference between creating wheel, and creating a wheel that doesn’t come off when the road gets a little rough.  A good incentive plan only gets that way after considering what, exactly, we want to motivate, and designing the plan to do that using the minimum number of moving parts needed to function effectively.  I was impressed with the way this business owner went through that process, and what he ended up with:

If there is a profit, 30 percent of it goes into a profit pool. Half of that pool is split among all of the workers except me (because I keep the other 70 percent), and the other half is split just among the production employees (everyone except the two commissioned salesmen and the bookkeeper). The splits are all even, meaning lower paid and higher paid workers get the same share. If there is no profit in a quarter, there is no payout. A loss in one quarter gets subtracted from the subsequent quarter’s profits before any bonuses are paid out — but I don’t claw back previous bonus payments if there is a loss in a subsequent quarter.

Plans like this are becoming rarer, especially at larger or public companies.  Of course, no plan is perfect.  This plan was designed to encourage teamwork and a holistic focus on the business.  I’m sure this owner will at some point get grief from his most productive people for pulling along the free riders.  And he will be dealing with morale and retention issues when the market turns against his company for more than a couple of quarters.  Whatever he does to ameliorate or prevent those problems will beget others.  That’s life.

Nevertheless, his plan is impressive.  This owner did not create sports car wheels for a motorbike, and he did not create the wheels within wheels that many compensation experts would consider “best practice.”  He just thought about what he needed to get his business to the next level, and used his authority to do it right and keep it simple.

The Growing Executive Compensation Advantage of Private Versus Public Companies

Posted by Marc Hodak on April 14, 2014 under Executive compensation, Governance | Be the First to Comment

Private companies have a natural governance advantage over public companies - one that stems mainly from the presence on their boards of their largest owners. This governance advantage is reflected in the greater effectiveness of private company executive pay plans in balancing the goals of management retention and incentive alignment against cost.

Private company investor‐directors are more likely to make these tradeoffs efficiently because they have both a much stronger interest in outcomes than public company directors and more company‐specific knowledge than public company investors. Furthermore, private company boards do not have to contend with the external scrutiny of CEO pay and the growing number of constraints on compensation that are now faced by the directors of public companies.

Such constraints focus almost entirely on one dimension of compensation governance - cost - in the belief that such constraints are required to limit the ability of directors to overpay their CEOs. In practice, any element of compensation can serve to improve retention or alignment, as well as being potentially costly to shareholders. Furthermore, any proscribed compensation element can be “worked around” by plan designers, provided the company is willing to deal with the complexity. For this reason, rules intended to deter excessive CEO pay are now effectively forcing even well‐intentioned public company boards to adopt suboptimal or overly complex compensation plans, while doing little to prevent “captured” boards from overpaying CEOs.

As a result, it is increasingly difficult for public companies to put in place the kinds of simple, powerful, and efficient incentive plans that are typically seen at private companies - plans that often feature bonuses funded by an uncapped share of profit growth, or upfront “mega‐grants” of stock options with service‐based vesting.

All of this is detailed in my newest article published in the Journal of Applied Corporate Finance.

Disclosure: Too much of a good thing?

Posted by Marc Hodak on March 23, 2014 under Governance, Invisible trade-offs | Be the First to Comment

http://hdw9.com/wp-content/uploads/2013/07/dubai-in-the-fog-wallpaper.jpg

Transparency has its benefits.  It enables shareholders to see into the company they own, and thereby judge whether it’s worth owning.  The main mechanism for transparency in the corporate world is company disclosures.  Does that mean that more disclosure is better?  This article suggests otherwise:

In a coming paper in the Journal of Finance, Messrs. Loughran and McDonald suggest that size may be what really matters. They studied 66,707 10-Ks filed for the years 1994 through 2011. Controlling for factors including size and industry—bigger or highly regulated companies naturally file longer 10-Ks—they looked at how well the stock market appeared to read the performance of companies with lengthy filings.

Answer: Not so well. In the weeks after filing, shares of those with longer reports tended to be more volatile than those favoring brevity.

Somewhere along the line, disclosure became synonymous with transparency.  Particularly in eyes of many governance mavens.  Perhaps that’s because, since 1933 at least, the ability to compel disclosure has been the main tool in the federal regulatory tool chest.  When you have a hammer…

I often introduce the Enron case with its 10-K from the year before the firm’s implosion.  It’s difficult to go through that tome, including the volume of data on its infamous Special Purpose Entities, and claim that insufficient disclosure was the culprit.  Their management accurately, if literally, conveyed the complexity of its operations.

This new study begins to explain how disclosure is not the same thing as transparency, and why the “more is better” instinct may be leading us astray.

Bonuses: Economic logic leads to a “paradox”

Posted by Marc Hodak on February 25, 2014 under Executive compensation, Stupid laws | Be the First to Comment

Paradox: a statement that is seemingly contradictory or opposed to common sense and yet is perhaps true

The media in Europe are starting to call skyrocketing banker salaries across Europe the “bonus paradox.

The EU limit on bonuses to 100 percent of salary (or 200% with shareholder approval) is ushering a paradoxical parade of unintended consequences.  But just because consequences are unintended doesn’t mean they are unpredictable.

The economic ignoranti fully expected overall banker pay to be clipped by the EU measure.  José Manuel Barroso, president of the European Commission said, “This is a question of fairness.”  So, there it is.

Except that banks are not going to lose their most mobile workers for insufficient pay.  Bankers, you may not be surprised, are good with money; they know what they are worth, and they are confident about it.  They would actually prefer to be paid for performance, and are unhappy about the higher mix of fixed-to-variable compensation that effectively caps their upside, even if it leaves them more-or-less whole in expected value terms.  But they will not accept less than what the guy down the street, or in New York or Hong Kong, will pay them.

The more sophisticated proponents of this law would say that it wasn’t the level of pay they were actually after, but the structure of pay in the form of bonuses that encouraged undue risk taking.  They’re OK with the new compensation mix, and feel it will reduce financial risk.  They are wrong, too.  Yes, it is theoretically possible that perverse incentives can lead to undue risk-taking, and there was certainly some of that going on in the lead-up to the financial crisis.  But there is zero evidence that bonus structures that have been around for decades, and whose incentive effect have been understood and refined and overseen for decades, would all of a sudden in the middle of the aughts suddenly be the cause of a global catastrophe.  If you want to properly diagnose a cause, look at what has changed, not at what was always there.  If that logic doesn’t persuade, then perhaps empirical evidence would, and the evidence denies the hypothesis.  If logic and empiricism don’t sway you…then you are fully qualified to run for the legislature.

Unfortunately we are not done with paradoxes and unintended consequences. Read more of this article »