Shareholder Value or Shareholder Democracy?

Posted by Marc Hodak on October 6, 2013 under Governance, Patterns without intention | 2 Comments to Read

The public be dammed

"The public be dammed" (sic)

Churchill famously remarked that democracy is the worst form of government, except for all the others.”  This is a great lead-in to distinguishing democracy as a collective decision making process that is useful for some purposes, but not for others.  For instance, democracy is not well suited as a decision mechanism for running a company.  You haven’t heard of a company run as a democracy?  There’s a reason for that.

In fact, when we look at the governance spectrum for companies as ranging from democracy (e.g., shareholder-run firms) to oligarchies (e.g., board-run firms) to dictatorships (e.g., “imperial CEOs”), it is worth noting that the overwhelming percentage of wealth created in this country was by imperial CEOs, folks like Ford, Disney, and Jobs.  Imperial CEOs also fail, of course, sometimes spectacularly.  When they do, corporate critics pounce and say, “See?  An imperial CEO runs the company into the ground!  If there had been more checks and balances, more shareholder involvement or awareness, this would never have happened.”  It is very hard to argue against that.  Except that no company run as a shareholder democracy has ever generated enough wealth to even be worthy of a scandal.

Today, we are hearing the drumbeat about the evils of “shareholder value.”  Here is one drummer, Lynn Stout, beating on shareholder value:

The idea that corporations should be managed to maximize shareholder value has led over the past two decades to dramatic shifts in U.S. corporate law and practice.  Executive compensation rules, governance practices, and federal securities laws, have all been “reformed” to give shareholders more influence over boards and to make managers more attentive to share price.  The results are disappointing at best.  Shareholders are suffering their worst investment returns since the Great Depression; the population of publicly-listed companies has declined by 40%; and the life expectancy of Fortune 500 firms has plunged from 75 years in the early 20th century to only 15 years today.

Stout, like many other corporate critics, is conflating the movement for shareholder value that gathered steam in the early 1980s with the movement toward shareholder democracy that gathered steam in the early 1990s.

These are different things.

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Another cost associated with CEO pay

Posted by Marc Hodak on September 22, 2013 under Executive compensation, Politics, Stupid laws, Unintended consequences | 2 Comments to Read

The SEC has finally proposed a rule on the infamous “CEO Pay ratio,” i.e., the ratio of CEO pay to that of the median worker.  There has been plenty of debate about the pros and cons of this requirement.  The primary criticism is that this ratio will not pass any cost/benefit analysis.  Every company knows this is true.  Most institutional investors know it, too, and don’t really care for this rule.  In fact, the only people likely to benefit from this rule are the unions that pushed for it. Even their benefit is speculative since the unintended consequences of this rule are difficult to fully predict.  For instance, it might encourage further outsourcing of relatively low-wage work to foreign companies, depressing employment.  In other words, we could very well see the average pay of the median worker go up, but only if you don’t count the zero wages being earned by those who are laid off as a result of this law.

Given how dubious are the benefits of this rule, let’s turn to the costs.  I have seen estimates of calculating this ratio for a large, multinational firm as high as $7.6 million.  Being in the advisory business, that seems pretty excessive to me.  By comparison, the average cost of complying with the dreaded SOX Section 404 was about $2 to $3 million for the typical company (which was about 10 times higher than the SEC estimated it would cost when they published its rules).

So, let’s say it costs about $2 to $3 million for a large company, which is a reasonable estimate for a multinational given the way the rules look right now.  Well, about 10 percent of Fortune 500 CEOs made less than that in 2012.  That’s right, we are almost certain to see quite a few companies paying more than they actually pay their CEO to figure out how much more their CEO makes than their median worker.

If this rule was really being implemented for the benefit of the shareholders, then Congress could have let each company’s shareholders opt in or opt out of this disclosure regime.  Clearly, the people pushing this ratio had no interest in giving actual shareholders a veto over this racket.

Why aren’t performance shares illegal?

Posted by Marc Hodak on September 15, 2013 under Executive compensation, Irrationality | 2 Comments to Read

A pair of recent studies show that about a quarter of the compensation earned by CEOs is now paid as restricted stock. Furthermore, one of the studies notes that an increasing portion of that stock is being granted based on performance rather than automatically vested over time, and that stock price is one of the most common performance measures used to determine the number of shares granted. In other words, if the stock price goes up (or goes higher than some benchmark), then the executive would benefit from both the larger number of shares granted and the higher price per share. If the stock price goes down, the executive will get fewer shares at a lower price, or maybe no shares at all.  The governance mavens are praising this trend.

There is a lot to like about ‘performance share’ plans, and stock-based stock grants provide an exceptional level of motivation and accountability for total shareholder returns over a wide spectrum of performance over time.  So, I’m wondering:  Why is this kind of plan legal?

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The other kind of shareholder vote

Posted by Marc Hodak on August 23, 2013 under Executive compensation | Be the First to Comment

The other Steve

The other Steve

Steve Ballmer announced his resignation, and Microsoft’s stock price shot up seven percent.  Ouch.

That investor verdict is far more damning than anything shareholders could have conveyed through a proxy vote.  It tell us pretty directly what the market thinks about Ballmer or, more specifically Ballmer’s leadership relative to anyone that Microsoft is likely to hire as his replacement.

One way to read this reaction is that Ballmer has been a roughly $19 billion drag on his company.  This deficiency might have been inferred by the fact that Microsoft’s stock has gone exactly nowhere* in the decade that Ballmer has been CEO, significantly underperforming the Nasdaq, not to mention its closest competitors Oracle, Google, and especially Apple.  I’m sure Steve Ballmer is in for many unflattering comparisons to Steve Jobs in the upcoming weeks.

I’m not here to bury Ballmer, or to praise him, but to highlight how this coda of his tenure reflects on the value of a “typical” CEO.  I often hear how a CEO doesn’t do it alone–he or she is part of a team.  I often hear people questioning whether the average CEO is worth the $15M to $20M per year that they get paid, or whether any CEO “needs” the $100 million they may have gotten paid in a year of outstanding performance.  I have answered these questions in prior blog posts, so I will encapsulate them here.

1)  Sure, a CEO is just one person on a team, but the CEO ultimately selects and manages that team, amplifying or cancelling their talents.  His or her marginal contribution is still very large.

2)  Ballmer illustrates that a CEO may be worth much less than $20 million per year.  Other CEOs, like Jobs (OK, I’m starting the comparisons), are worth much more than $20 million per year.  The stock reaction when Jobs announced his resignation was a drop of about $10 billion, although his announcement was not entirely unexpected.  So, how plausible is it that the average CEO is worth about $20 million per year?  More plausible than $2 million or $200,000 per year, although the value variance around that average is obviously very high.

3)  No person “needs” $20 million or $100 million or any such astronomical sum.  But nobody this side of the Soviet Union gets paid according to their need.  If things are working right, they get paid what they’re worth.  This correspondence is never perfect, but we haven’t yet found a better way.

By the way, Ballmer earned about $1.3 million per year in salary and bonus as CEO of Microsoft, much less than a typical Fortune 500 CEO, but not out of line for someone whose personal net worth likely went up and down about $100 million a day due to his MSFT stock holdings which, as mentioned earlier, didn’t net him anything more than he started with over his tenure.  In other words, alignment wasn’t an issue for Ballmer.  Maybe he just decided he didn’t need any more?  Maybe he wasn’t greedy enough?

* I’m being generous here by tagging the stock’s fall in his first year as an artifact of the dot-com bust.

The Dollar-A-Year CEO

Posted by Marc Hodak on July 28, 2013 under Executive compensation, Governance, Invisible trade-offs | Be the First to Comment

I am often dismayed by the popular response to “dollar-a-year CEOs.” These bosses give the media a feel-good story:  You don’t have to be greedy.  You can be a not-so-fat-cat!

Apparently it’s not just John Q. Public–several times removed from the real world of compensation governance–that buys this stuff. Just last week, a tech company CEO in a WSJ “expert” panel praised the dollar-a-year standard, and the swell guys and gals who adopt it, saying that all CEOs should be so virtuous.

These are people that are out to change the world. They are owners. They are builders. They bleed for their company and what they are creating. It’s not about the money.

His examples were Steve Jobs, Larry Ellison, Mark Zuckerburg, Meg Whitman, Larry Page.  Do you see a pattern (besides all the money)?

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Of capital and kings

Posted by Marc Hodak on July 23, 2013 under Governance, History, Invisible trade-offs | Be the First to Comment

The birth of a new British heir once again causes us governance geeks to scratch our heads at the succession mechanism formally known as primogeniture, the winner-take-all system whereby the first-born (generally male, but not always) becomes heir to substantially all of the parents’ titles and property. In the context of a monarchy, has anyone ever believed that such a mechanism would consistently yield good leaders?

The answer, of course, is “No,” but the question assumes the wrong purpose. In fact, primogeniture did not evolve as a way to select a certain quality of leader; it evolved as a way to enable society to accumulate capital.

For most of history, it was extremely difficult to preserve and grow capital from one generation to the next. Before the 19th Century, the lives of ordinary people–how they labored and what they had in their homes–were virtually indistinguishable from that of their grandparents. Things were hardly better among the aristocracy. For them, accumulated property was basically an invitation to plunder. Consequently, from the Fall of Rome to the Industrial Revolution, the vast majority of capital created by the upper classes was in the form of weaponry, and most of that was consumed in battle. It was in this neo-Hobbesian war of all against all that primogeniture evolved as a way to select kings.

The customary transfer of allegiance of powerful nobles from their king to a royal heir greatly reduced the odds of a civil war. Societies that tended to avoid civil war tended to accumulate far more capital. More capital made them more powerful, economically and militarily, creating a dynamic that eventually led to the institution of monarchical succession via primogeniture spreading throughout most of the world.

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The Conspiracy of Rules

Posted by Marc Hodak on July 10, 2013 under Governance | Be the First to Comment

This week we celebrate the 65th anniversary of the Roswell crash landing, a watershed event for conspiracy theorists everywhere. I sympathize with the hapless Air Force officers looking at the wreckage of their high-altitude weather balloon, the glass, rubber, and metal strewn around, probably including a reflective saucer-shaped instrument shell, and having to explain within the bounds of military secrecy what happened that night, only to be met with the suspicion of people wearing tin-foil hats. The chagrin of those officers must have turned to alarm as the fallen balloon was figuratively resurrected, and the flying saucer took off as one of the enduring stories of our time: A crash landing by stray aliens being covered up by the U.S. government for its own nefarious, if unspecified, purposes.

The reason I can easily sympathize with the government on this is because I have seen an even bigger conspiracy theory that I personally know to be equally ludicrous—the conspiracy of corporate leaders to control the U.S. political and economic machinery to their personal benefit. A whole phalanx of academics, journalists, and elected officials has benefited from the public’s credulous acceptance of this theory, especially with regards to executive pay.

Lest I be accused of creating my own anti-“corporate conspiracy” conspiracy theory, let me quickly add that each of these parties has participated in their part of the anti-corporate crusade according to their own particular incentives, i.e., to publish in select journals, sell newspapers or airtime, or win higher elected office. No coordination was necessary to blow this balloon beyond what reality could contain.

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The Incredible Genius of “Auxiliary Precautions”

Posted by Marc Hodak on July 1, 2013 under Governance, History | Read the First Comment

We the lucky people

As we celebrate the birth of our country this week, I think it’s worth reflecting on the United States as history’s most daring experiment in governance.

Most of us were taught the Constitution in middle or high school as a series of clauses defining the various workings of our federal government. Some concepts such as “checks and balances” managed to penetrate our pubescent fog because the idea of constraints on authority is innately appealing to young people. But few of us were left with a sense of how bold an innovation our Constitution was at the time of its adoption, or how fragile was the republic that it created. Understanding those things greatly enhances one’s appreciation of the American civilization that would emerge from that experiment.

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The Myth of the “Shareholder Value Myth”

Posted by Marc Hodak on June 20, 2013 under Governance | Read the First Comment

Lynn Stout published the The Shareholder Value Myth late last year, and it has created some stir.  In the book, she blames meltdowns like Enron and disasters like BP’s Macondo on “shareholder value thinking,” and suggests that managers and directors loosen up on this obsession.  I’m always surprised when people use Enron and BP–companies that miserably failed their shareholders–as examples of shareholder value thinking run amok.  But Stout is a respected legal scholar, and her arguments deserve a more thorough appraisal.

Stout’s disparagement of “shareholder value” begins with the disconnect between a corporate board’s legal requirement versus its economic imperative.  Contrary to popular belief, boards have no legal obligation to maximize shareholder value.  The evolution of fiduciary duties plus the business judgment rule sets the legal bar far below “maximization,” which leaves directors plenty of leeway to take risks without fear of being dragged into court every time an investment fails.  Stout believes, and I agree, that this legal order has served shareholders and our overall economy very well.  But the reason this low legal bar works is because the board’s economic imperative is far less forgiving.

If you aren’t aiming to maximize returns to your shareholders, then you’re doing something else.  There is nothing wrong with pursuing other social goals that coincide with shareholder value, but if your “success” comes at the expense of your shareholders, you will lose them.  The competition for capital is fierce.  It crosses industry lines and national borders.  It never ebbs or wanes.  There is little room for slacking off in the pursuit of shareholder value.

Stout does not so much disagree with this characterization of the shareholder value imperative as she defines it away.  She asserts that “shareholder value thinking” leads to short-term behaviors and illusory results that don’t actually lead to long-term value creation.  But what Stout is describing is not a goal problem; it’s a knowledge problem.  The market cannot distinguish what managers claim to be a focus on shareholder value versus the reality of their behavior.  If it could make that distinction, it would immediately discount sub-optimal decisions and actions into the stock price.  In other words, Stout rejects management claims that their behavior actually enhances shareholder value, yet accepts their labeling of their bad behavior as “shareholder value thinking.”

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Director pay showing up as an issue

Posted by Marc Hodak on May 22, 2013 under Executive compensation, Governance, Reporting on pay | Read the First Comment

In yesterday’s WSJ, an article reported rising criticism of directors’ pay from institutional investors.  Many of the quotes came from one such investor, T. Rowe Price.

Current pay structures don’t give directors enough of a stake in making sure the company does well, and boards need to be more creative about tying their compensation to performance, said John Wakeman, a vice president and portfolio manager at mutual-fund giant T. Rowe Price Group Inc.

“If bad people are going to be on these boards, we’ve got to stop it,” said Mr. Wakeman. “We owe it to our fund holders.”

“When you’ve gone to restricted-stock world, basically directors get paid more or less for showing up,” Mr. Wakeman said.

If Wakeman were referring to the portion of director fees paid in cash, then he would have a point about directors being paid for just “showing up,” but even that ignores the value of getting good directors to show up.  Being a good director means working.  In the world that Mr. Wakeman and I share, very few people beyond commissioned salespeople are expected to show up with zero guaranteed pay.  Does he want directors compensated with purely variable pay?

But in alluding to “pay for showing up,” he is not referring to the fixed fees earned by directors, but to their restricted stock, which accounts for more than half of their total pay.  Calling this “pay for showing up” is a curious accusation.  To some extent, someone getting restricted stock compensation is almost certain of having something of value at the end of their tenure.  But the value of restricted stock goes up and down with the share price.  You don’t get any more performance-based than that.  In other words, given both its retention and incentive characteristics, restricted stock may be the perfect compensation instrument for directors.

The point of bad people on a board is not how we pay them, but how do we prevent them or get rid of them.  It may have been the writer instead of Mr. Wakeman who conflated these appointment versus compensation issues, but such a conflation does not help us determine the right way to either get good directors onto boards or to pay them.

The article also notes that some activist investors are experimenting with incentive pay programs for directors.  The clear premise is that directors don’t have enough incentive in their current pay programs, which raises the question:  what kind of pay package would be better than a program of fees plus restricted stock?

One can argue that the proportion of that pay mix ought to be more in favor of restricted stock than it is now, or that the stock restrictions should be more demanding, such as requiring that most of the stock be held to retirement.  But as someone who has designed these things for many boards, and thinks deeply about compensation design every day, I would caution against too much experimentation.  The three basic alternatives to restricted stock are:

1.  A restricted stock-equivalent, such as a cash-settled stock appreciation plan that pays off exactly the way restricted stock would.  I would favor such a plan only because it creates an income opportunity for those of us who design them.  Otherwise, the shareholders get the same retention and alignment benefit as if they award restricted stock.

2.  An alternative equity instrument, such as stock options.  This would likely create an asymmetrical risk/reward profile for directors versus shareholders–the kind of thing that contributed to Wall Street’s troubles during the financial crisis.

3.  A non-equity based incentive plan.  This would be asking for trouble, as the Coke example in the article showed.  The only body in a company than can certify achievement of performance results is the board of directors.  Asking the board of directors to certify performance relating to their own pay creates an inherent conflict of interest.  This is a fine recipe for either manipulation of corporate results, or the continual appearance of such manipulation.  I would never institute a directors’ non-equity incentive plan for any company I advise (and have actually lost business for my refusal to do so).

The real story, here, is that pay is becoming the magic elixir for fixing all governance problems.  We don’t have a significant problem with lack of alignment between directors and shareholders.  We just have some companies that don’t perform well, and some of that lack of performance reasonably attributable to lax oversight by the board.  Too much experimentation with director pay would only make the problems worse because it would be attacking the wrong problem.