This week, I was a talking head on CCTV‘s The Heat with Anand Naidoo. I was brought in to comment on how poorly implemented corporate incentives could lead to the kind of scandals we have seen of late, e.g., Wells Fargo, Mylan, and VW. Being an expert on incentives and corporate scandal, it seemed like a good place for me to contribute. I believe that was also the impression of Richard Bistrong, who is an expert on corporate corruption and compliance.
Unfortunately, the interviewer instead peppered us panelists with questions about the corrupt relationship between business and politics. I was not entirely comfortable about that direction, not because I don’t have well-supported opinions on that topic, but because it just wasn’t what I was prepared to talk about. So, I kept trying to bring it back to corporate incentives, with modest success. (They cut my comment that, hey, I was a governance expert, not a political commentator.) I was ultimately able to make a few key points:
Perverse incentives were at the root of a number of the scandals
Those incentives are widespread in corporate America
It’s getting harder for public companies to monitor internal bad behavior by virtue of their increasing size
My one acknowledgment of the politics was to counter one of the comments by the far-left lobbyist they brought on as a third panelist. He suggested (several times) that Obama’s DOJ and SEC failed to do their job of wholesale jailing of bankers and executives because government prosecutors were involved in some sort of concerted effort to not prosecute criminals, what I called a reverse conspiracy theory.
Being relatively new to TV, I learned that my habit of looking up for a moment as I think about what to say may look a little shifty on camera. Need to keep my focus on the lens.
Bengt Holmstrom, a co-winner of the 2016 Nobel Economics Prize, rails against the complexity of executive pay. He’s right about that. He blames compensation consultants, but that is attacking a symptom, not a cause. The underlying cause is the proliferating regulation—formal and informal—of compensation governance. This regulation creates constraints on how Boards can design executive compensation programs. Boards rationally react to those constraints by building plans of ever-greater complexity.
The source of compensation regulations is popular disdain for high CEO pay. The intent of the regulations is to tamp down that pay, but that’s like putting nails in a board to stop a marble from rolling down. You don’t stop the marble; you just make its path more complicated.
Nevertheless, Prof. Holmstrom is a worthy scholar, one whose research has done much to inform my discipline, even if unfortunately few practitioners have actually heard of him, or heeded his conclusions.
I’ve been hearing a lot of angst about Facebook’s decision to issue a new class of non-voting shares for the express purpose of preventing dilution of Mark Zuckerberg’s control over Facebook. Mainly, the complaints are of the nature, “It’s undemocratic!” The best response I can offer: Get over it.
God did not ordain that all companies need to be governed in any particular way. Yeah, I get the benefits of a more diverse shareholder influence over the board. I get that he might abuse the outsized authority he has gained from dual class (now triple class?) shares, and act in ways that hurt minority shareholders. I would be willing to grant all that and ignore that Zuckerberg’s influence has so far been very beneficial to all shareholders, and that his board is as good as one might hope for to restrain his potential excesses.
But here’s the deal with Facebook: Zuckerberg is in control. Every current shareholder bought into that premise. There is no moral principle that says we need to adjust the charter or capital structure to accommodate our personal or collective preferences on what “good governance” ought to look like after the fact.
What about the fact that Zuckerberg has now added another layer of anti-dilution protection that wasn’t there when current shareholders bought into Facebook? Well, they bought into that, as well. They bought into the current change insofar as Facebook is, basically, the charter that enables that change and everything else that Facebook is. When you date a paranoid, you can’t complain when they add another alarm system to the house.
If you’re an outsider and don’t like the change, then don’t buy into the Zuckerberg-controlled Facebook. If you’re a shareholder who feels that he has somehow changed the relationship between you and him as shareholders, then sell your shares and pocket the gains.
I get that one day Zuckerberg might get stale, and we’ll wish he didn’t have so much control. You can sell your shares then, or in advance of that time, based on some suitable discount horizon. None of us is entitled to the kind of corporation we wish we had; we’re entitled to the corporations we buy into, warts and all.
As usual, the people most agitated about this are the governance mavens with a knee-jerk reaction against anything that undermines shareholder democracy. They react as if shareholder democracy equates to shareholder-friendly governance, notwithstanding any actual evidence to support that. Shareholders should, instead, celebrate the diversity of governance structures out there, make their bets on governance structures, as well as strategy and people everything else bundled into their bets, letting the market sort it out, and letting entrepreneurs focus on business rather than shareholder relations.
Democrat senators, the folks lamenting the hyper-politicization of certain Presidential appointees, have turned on President Obama’s nominees. They are simply refusing to fill out the short-handed Securities and Exchange Commission until the nominees pledge to implement a requirement that all corporations submit their spending to public scrutiny. Senator Schumer is one of the peeved politicos:
Schumer said the nominees are “fence-sitting” on whether to force corporations such as Koch Industries to reveal their political giving.
Keep in mind that Koch Industries is a private company, nominally beyond the SEC’s power to force disclosure. That’s how crazy the discussion has gotten regarding regulating political spending.
Why do Senators, particularly Democratic Senators, care so much about this one issue that they would stymie a Democratic President over it? Forget all the bogus arguments about whether corporations are people, or whether money is speech, etc. The basic fact about political spending is this: incumbent politicians want to control it. The first step in controlling it is knowing about it. The old knowledge that money is power is particularly apt when it comes to politicians knowing who you are supporting, and how much you are giving them. Congress wants not only the power of the purse, they want the power of everyone’s purse. And they get to go for it by decrying greed.
Some Republican politicians are happy to conspire to limit spending on political causes because all regulations on political activity inherently favor incumbents. One of the great, under-reported ironies of the last decade was Senator McCain losing a presidential election because candidate Obama felt he could do better outside of the McCain-Feingold restrictions while candidate McCain was compelled to comply with them.
Since Democrats have an overpowering inclination toward controlling everything, their push to control political spending is much more aggressive. Dodd-Frank mandated that the SEC write rules regarding corporate political spending, but it was one of hundreds of rules, and the SEC is way behind in writing them. And they can’t catch up with just three commissioners. So, the best thing is to let the Democratic-dominated commission get on with its business, right? As Senator Warren has said:
President Obama has done his job – sending…nominees to the United States Senate. Now it’s time for the Senate to do its job.
And as Senator Reid has said:
The American people expect their elected leaders to do their jobs. President Obama is performing his Constitutional duty. I hope Senate…will do theirs.
Actually, what Reid said was that Senate Republicans should do theirs, referring to the President’s appointment of a Supreme Court judge. Senator Warren was also referring to the President’s Supreme Court appointment, but is now one of the ringleaders in stifling the President’s SEC appointments based on the single issue of political spending.
Of course, Senate Democrats don’t own hypocrisy in Congress. But, if they are willing to block nominees, including the exceptionally well-qualified Lisa Fairfax (a brilliant legal scholar that I don’t always agree with), then they have thoroughly given up any high ground with regards to Senate duties and with respect for the Executive.
Regulators are finally looking at unicorns–private companies grown to over $1B–and all they see are unbridled horses. SEC Chairwoman Mary Jo White is bothered:
White echoed the concerns of some industry insiders that these tech start-ups are missing out on the market discipline public companies receive by being accountable to the whims of public shareholder. (sic)
And on top of losing out on the whimsy, White adds:
For these companies to be successful, investors must be confident that they are being treated fairly and that companies are being transparent.
That these things were written without irony shows how unmoored our discussion of corporate governance has gotten from reality. Clearly, the poor investors of Uber, Airbnb, and Snapchat must be slapping their foreheads, saying “THAT’s why success has eluded us! We need more SEC oversight!”
I’m sure the good governance mafia (GGM) will accuse me of being tone deaf with regards to the benefits of greater SEC oversight of these giant, private firms. Clearly I don’t get that without an additional two thousand pages of rules, these companies would just do whatever they want, and their shareholders would suffer. Because cheating your shareholders is how you build great businesses.
Here is an alternative view, one I recently shared at a major economic forum:
This chart shows some of the regulations that have multiplied the costs of being a public company over the last couple of decades. Yes, it’s possible that something other than these escalating public company costs led to the collapse of the IPO market. It’s possible that something other than these escalating public company costs have contributed to the dramatic decline in public companies. You have endogenous factors, omitted variables, and all that stuff. I understand.
But people who inhabit the executive suites, board rooms, and trading floors don’t need this chart to tell you what happened, especially those who grew up in the ’80s and ’90s when “going public” was the epitome of success. They will tell you that the costs of being public now outweigh the benefits for all but the largest firms. They know that a bad cost-benefit trade-off is not good for shareholders, regardless of what self-appointed “shareholder advocates” might say.
Admittedly, this all sucks for the average retail investor. Those without the net worth to be allowed to invest in private equity or venture capital opportunities are now cut out of a fast growing, lucrative market. Many of these same retail investors belong to public or union pension funds that have agitated for this two-tiered capital market, where the rich have more choices than average workers.
The SEC has long left sophisticated investors alone precisely because they need the least protection. The private companies that have these investors on their boards are presumed to be adequately governed. Yet we now have a top regulator telling some of the winningest companies on earth that they are losers for not joining her club.
I will be explaining why the public company universe has become much more concentrated in the U.S., how private equity is filling the breach on growth and innovation, and what it means for the future of management:
Also, the dangers of using financial accounting for managerial decision making. It’s a double-header.
If you’re a finance type in Dallas next week, stop on by. I promise a good show.
I spilled the beans regarding the titular question this Fall at an NACD event.
The talk was split into two TED-sized portions of about 20 minutes each. Part I is what the research suggests about pay practices, i.e., which practices are effective, which are probably a waste of money, and which actually hurt the shareholders. Part II explains the causal mechanism behind the most surprising research finding–that today’s bonus plans, on average, add no value to corporate performance.
The feedback was extremely gratifying. A couple of directors described the discussion about bonus plans and proxy advisory standards as “a tour de force.”
I have written before about he staggering decline in the number of public companies since the late 1990s, and the concurrent growth in large, private companies. Doidge, Karolyi and Stulz published a working paper trying to explain this phenomenon. Their explanation begins with two facts:
1. The number of IPOs has slumped considerably since that period
2. The number of companies delisting from an exchange has gone up over that period.
They note that the overall number of companies has risen in that period, as well, so the loss of public companies is not a function of lower overall business formation. They also noted that it wasn’t just a drop in the number of small firms due to low IPO activity driving that reduction; de-listings were occurring across all sizes of firms. Finally, they note that voluntary de-listings are a relatively small portion of the total, with M&A being the largest driver. They conclude from this that new regulations, like SOX, could not be a significant driver of de-listings, contending that they would expect to see a regulatory effect to be reflected in voluntary de-listings. They conclude that “The number of mergers is puzzlingly high compared to both U.S. history and to other countries.”
Well, it’s not puzzling if you use a more realistic model of what would be driving those results. The model I have used for over a decade is quite simple:
A company will choose to be public when the benefits of being a public company exceed its costs, otherwise it will not join, or will exit, the public sphere.
The way it exits is of secondary importance.
So, for example, the fixed cost of being a public company for a $100 million firm (net assets) shortly before SOX was just over $1 million per year. After SOX, that number jumped up to about $3 million per year. Now, the cost versus the benefit of being public comes down to the cost of capital advantage of being public. If my cost of capital is lower as a public company versus as a private company by, say, two percent ROA per year, then if I were a $100 million company, and it cost me $1 million per year (i.e., 1 percent of net assets) to be public, then I would be ahead as a public company. If the cost of being public jumps to three percent per year, then a $100 million company with a fixed cost of $3 million per year to be public would prefer to be not public.
My one disagreement with Doidge et al. is that de-listing is not necessarily the only way to go once you have figured out that you are no longer viable as a public firm. In fact, it is easier to complete an M&A deal than to escape the public markets via a going-private route. So, the M&A spike seen by Doidge et al. should be counted as a reaction to proliferating regulations. That and the fact that private companies larger than $1 billion has grown five-fold in the period since 1996, making this phenomenon one of the more spectacular cases of capital flight ever seen.
My rough estimation is that post-SOX, it was no longer worth it for the typical $100 million company to be public. In fact, given the rising costs of being public, I estimated the a company had to be between $300 and $500 million in net assets to be viable as a public company. After Dodd-Frank, with its voluminous new regulations for public companies, I estimate that few companies under $1 billion in net assets can any longer afford to be public.
The broader question that is not being asked is: Is it good for capital formation in general, and public capital markets in particular, to no longer have the full range of companies that could be publicly available for all investors?
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.
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.