Massey Energy was one of a handful of mining and energy companies that tied its chief executive officer’s bonus to safety performance in 2010. Today, former CEO Donald Blankenship goes to trial on charges stemming from a West Virginia mine explosion that killed 29 workers, the U.S. industry’s deadliest in almost four decades.
The story goes on to note that in the mining industry there is no correlation between having executive bonuses tied to safety metrics and the actual result of safer mines. In fact, many of the safest companies offer no safety bonuses for their top executives. Nevertheless, all of the people interviewed in the article claim that CEO incentives ought to be tied to safety much more than they are today.
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?
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.
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.
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.
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.
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.
The last time that CEOs were routinely kept awake at night was during the merger wave of the mid-1960s.
The frothy ’50s turned out to be high tide for American industrial dominance, a time when we were rebuilding the world after a devastating war. CEOs had it pretty cozy then. As the tide began to recede, investors began to notice the accumulated waste made possible by a decade of easy growth.A few of them saw advantage in taking over the worst governed companies in order to restructure them.At that time, they could do so without warning, which is what made this environment so frightening to CEOs. Imagine never knowing when you might get a phone call telling you that you are out. This is like going trick-or-treating and fearing the “tricks” all year long.
Corporate executives of that period had grown up in a world where being a leader meant getting along with everybody, and knowing how to use the corporate treasury to buy allegiances, including labor, business partners, and politicians.These new people on the scene—called “raiders”—were after the whole treasury, in part to prevent it from being used as the CEO’s relationship kitty.The governance mechanisms of the day gave them access to it by simply taking advantage of the stock being cheap after years of neglect.
Worried incumbent CEOs reacted by contacting their congressmen, who also knew a thing or two about incumbency.This unholy partnership took control of the narrative.Instead of investors identifying bloated companies in order to restructure them and return excess funds to remaining shareholders, the incumbents claimed that:
“In recent years we have seen proud old companies reduced to corporate shells after white-collar pirates have seized control with funds from sources which are unknown in many cases, then sold or traded away the best assets, later to split up most of the loot among themselves.”(Sen. Harrison Williams, 1965)
The media bought it.The legend of the “corporate raider” was born.The off-hand mention of “unknown” funding sources added a hint of nefariousness. (Who did they think provided the funds?Why did it matter?)The media didn’t consider that any mechanism that made the sum of the parts worth so much more than the whole might actually be socially useful.Instead, they played on the conservative discomfort of seeing old line, industrial firms disappearing at the hands of destabilizing (and generally non-WASP) upstarts, and the liberal discomfort of “money men” involved in unregulated financial activities.
Thus, in the fall of 1968, Congress passed the Williams Act.This law prevented investors from making a tender offer for shares without giving incumbent boards and management a chance to “present their case” for continued control of the company—as if they hadn’t already had years to make their case.
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.
That was the comment of a Green Party member of the EU Parliament regarding the sweeping compensation restrictions on banker’s pay in Europe. The measure would limit bonuses to the level of salary without explicit approval of a supermajority of shareholders, and up to two times salary with such approval. This is part of a package of reforms intended to reduce banking risk on the theory that highly leveraged pay structures encourage the kinds of risk that got the world into the financial mess of 2008-2009. This theory has no empirical support, but that’s never stopped the social engineers and the occasional filmmaker who know better.
The UK is in a fit about this since they understand that this measure threatens the competitiveness of European banks, and London is the center of European banking. “People will wonder why we stay in the EU if it persists in such transparently self-defeating policies,” said Boris Johnson, no stranger to populism but, alas, the Mayor of London.
Boris need not fret. Unlike the Greenies and socialists, London bankers understand exactly how liquid money can be, and will easily figure out a way to keep control of it. For example, say they have a star investment banker who has proven himself capable of bringing in $30 or $50 million worth of fees. The new law will nominally prohibit his bank employer from paying him $200,000 salary plus a bonus based on, say, 20 percent of the fees he brings in. The bank will, instead, raise his salary to $5 million, with the possibility of a $5 million bonus. This would keep the banker whole, more or less. But it can’t stop there.
Consider for a moment what an investment banker (or fixed income trader, or M&A adviser, etc.) must do to bring in $50 million in fees. They must plan and continually adapt an aggressive and creative strategy to thwart their global competitors in getting those fees first. They must then execute that strategy by waking up in a different city nearly every other day, working 60 to 90 hours a week, driving their teams crazy, then calming them again or hiring their replacements in order to maximize their productivity, and continually wondering if they might miss the next deal by days or hours because their competitors are chasing them that much faster, all the while leaving behind their families time and again because a real or potential client needs to see the analysis or the man the next day. And they must hope the global economy is good this year, or it’s all for naught. They work that hard because (a) every incremental hour on the job is potentially worth over $1,000 and (b) they won’t be young forever.
Now, if a banker had to work about 3,500 hours to earn their $10 million bonus under the old compensation program, they might get away with working much more normal hours, including watching their kids grow up, to make, say 35 to 40 percent of their new bonus opportunity. Under the new compensation structure, that would mean getting their $5 million in salary, and about $3 million in bonus. (Go ahead, check the math.) Experienced bankers know the 80-20 rule better than most, and if they can make 80 percent of their previous pay with about half the flights and half of the evenings and weekends sacrificed to the job, more than a few will try that, especially the older, more experienced ones with fewer years left before they call it quits and open their hedge fund out of the public eye.
Well, their banks can’t let that happen. Neither can they allow their fixed costs to jump that high, and they certainly can’t allow their top talent in New York or Hong Kong to go across the street to their competitors. So they will do something else. They will enact the kind of strict clawback regime that everyone has been waiting for. Eighty percent of the new, $5 million salary would be placed in escrow, and at risk of forfeiture. To the extent that the banker fails to achieve, say, $30 million in fees, his salary (in escrow) will be docked by twenty percent. If he brings in at least $50 million in fees, he will get his full $5 million salary plus $5 million bonus. That way, if the banker does pretty much what he does now, the bank can pay him pretty much the way they pay him now.
When the Greenies and other socialists in Brussels catch on to this, they will no doubt enact additional laws preventing this particular work-around. We compensation advisers will then develop others. To the extent that the Greenies and socialists tighten the screws to the point where workarounds become too difficult or costly, then the City of London will fade as a global banking center, while the diehard, remaining European banks see their fixed costs as a proportion to their revenues move sharply higher. The net effect of higher fixed costs, of course, is higher risk to the company. I know, I know; the whole purpose of this regulation was to reduce bank risk, but that’s what happens when financial illiterates make financial rules. It’s a bit like watching novice campers trying to cut down trees with blowtorches.
As with all pay rules, the people living under the evolving EU rules will have their choice of unintended consequences:
1) Encourage endless additional complexity by creating new rules to stop the workaround of the old rules;
2) Increase banking risk by forcing banks to accept a higher fixed-cost structure (more than offsetting any benefits of new capital requirements that are driving this whole process);
3) Push their banking centers to other nations, further lifting the property values of New York, Hong Kong, and Singapore.
One way or another, the Greenie who commented “I think it will really hit them” will prove correct. But like the hapless shooters that lawmakers often are, they will hit the wrong target.