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.”
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.
Since the financial crisis the Fed has urged banks to cap bonuses in cases where they could encourage executives to take too much risk. Before the crisis, banks erred by focusing too much on short-term profits and too little on risk when designing bonus plans for employees and executives, according to the Fed.
The Fed’s intent has devolved into policies advocating the use of measures besides profit, and the capping bonuses at something less than two times target bonuses. These two policies ignore two, basic propositions of incentive compensation:
1) An incentive to perform is indistinguishable from an incentive to cheat
2) A cap on bonuses is tantamount to a cap on performance
These policies are nevertheless being advocated despite any evidence whatsoever that they help shareholders. That is not surprising, however, since the Fed is not accountable to shareholders, but to political interests that could care less about investors.
I don’t usually offer investment tips, but here is one that is consistent with research on this matter: Invest in companies that pay for profit growth, and don’t limit how much their executives can make. In other words, bet against what the government is advocating.
And that means a new flood of stories about CEO pay. In the past, the stories have almost uniformly been of the “can you believe…” variety. Can you believe that CEO whose company stock dropped 20 percent still earned $5 million? Can you believe that CEO who was canned got $20 million on the way out the door? So, I was surprised to finally see an example of intrepid journalism entitled “Pay for Performance’ No Longer a Punchline.” Apparently the relationship between pay and performance is improving.
The shift in how CEOs are paid highlights the growing role of investors in shaping executive compensation—and their push to align pay more closely with corporate results.
While a welcome the change in tone, I think that both the shift to improved alignment and the role of growing investor involvement are overstated. To see why, consider two items about CEO pay that are approximately true:
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.
Citizens United unleashed a firestorm of controversy and apocalyptic visions of corporations spending “unlimited” amounts of money on political campaigns. I was on a panel recently debating the governance issues related to corporate political spending. One of the arguments against it went like this:
Such spending would invariably be proposed and executed by management. As such, it is likely to be guided by the personal preferences top management, especially the CEO.
There is a good chance that the political preferences of management may not coincide with the best interests of the company (i.e., an agency problem).
Furthermore, such spending is guaranteed to offend the sensibilities of significant portion of not only a diverse shareholder base, but of employees and customers as well, and that can’t be good for the company.
Therefore, corporate political spending–although allowed as a matter of law–should still be discouraged, if not banned, by boards and investors as a matter of good governance, if not public decency.
This point was raised by both my fellow panelists and members of the audience. The audience was largely anti-corporate, and frankly willing to accept any excuse to prevent corporations from exercising any influence on the political arena. That is probably why my retort seemed to cause nothing but a hush in the crowd. That retort was:
Agency is inherent in all organizations.
For example, the non-partisan Center for Responsive Politics says that about 92 percent of union contributions go to Democratic candidates. Yet, about 38 percent of union members vote for Republican candidates.
AARP, Sierra Club, and all kinds of broad-membership non-profits have similar agency issues.
I don’t point this out to suggest that unions or anyone else should be prevented from spending on politics, but to suggest that the existence of agency is not per se a reason to prevent one kind of organization from indulging in such spending when all other kinds of organizations, suffering from the same agency issues, are considered OK for such spending.
For the record, I believe that union leaders are probably as conscientious in allocating their political pelf in a manner that supports their organizational interests as corporate leaders are be about allocating theirs. The main difference between union and corporate spending is how lopsidedly different they are in their support for parties and candidates. Unions are remarkably monolithic in their support or “liberal” or “progressive” causes. Corporations, in contrast, ironically follow the Obama prescription, and spread the wealth around, giving about equally to both parties.
Few statements better illustrate the dismissive condescension of a government official in a headlong power-grab:
Whatever one believes about the merits of the Patient Protection and Affordable Care Act (aka ObamaCare), or whichever way the Supreme Court decides this law, the question of constitutionality was real. The concerns were there throughout the deliberations, in bipartisan opposition to the law, and in its lingering unpopularity to this day. But if one is blinded by their authoritarian ambitions, such concerns remain invisible to them.
Well, Ms. Pelosi, many of us were in fact more concerned about a dramatic and potentially unconstitutional expansion of government power over the most private part of our private lives than we were dazzled by the promise of unfettered access to low cost health care. We were serious about that concern. We didn’t deserve to be treated like dirt to be brushed off.
This video perfectly encapsulates the difference between the Mother Jones and Inc. views of the world:
So, the new definition of harsh working conditions include: Working in a quiet setting; having to bend over and to stand on your tippy toes; doing your job as fast and as well as you can. Oh the horror.
This kind of reminds me of Barbara Ehrenreich’s “Nickel and Dimed in America,” a manual on how to complain about not having everything given to you. I learned about that insipid book only because it was required reading at my kid’s Upper West Side school, apparently in the module on becoming an effete intellectual incapable of manual labor. (For those of you who were forced to endure its 240 pages of whining, here is the inspiring antidote.)
A couple of things make me hopeful. First, reality intrudes. I know a few of the kids who were indoctrinated along with mine, and—like my kids—quickly figured out that what they learned in their gym class was more important than what they learned in their social studies; the real world is a competitive place; you either learn to love hard work, or you learn to accept being an also-ran.
Second, the zeitgeist seems to be changing. I was apparently not the only person who found this ‘story’ execrable. Check out the comments on Yahoo, which draws from a far-from-conservative crowd. Nearly everyone there ridiculed this story.
That is one of the main arguments being put forth in the continuing assault on corporations in the form of new proposals for binding Say on Pay.
The short answer is “No.” Shareholders are not “owners” like Ma and Pa who own their store and have decision rights with respect to its management. Shareholders have no legal say in the operations of their company unless one changes the law to give them that say. Shareholders can’t set prices for the products their companies sell. They can’t sign off on what the companies pay for supplies, including their supply of labor. Who would give them such power, unless they wanted to destroy the corporation as we know it? The question answers itself.
People making the argument that CEO pay is different from other kinds of costs invariably avoid the implication of that argument. What they mean is that CEO pay “seems” too high (against all kinds of irrelevant standards that no one would really argue in an honest debate about the best interests of shareholders). What they leave out is the possibility that paying a lesser amount can, at least in some situations, have an impact on the company far more costly than the reduction in pay they presumably desire. In other words, the decisions by boards of what to pay their executives are strategically significant, with a profound impact on shareholder value. The Say on Pay mob ignores the existence of that impact, and makes no allowance for even well-functioning boards doing a job that can’t possibly be done as well by outside “owners.” (Please spare us the idiotic response of CEOs not possibly being worth what they are paid by their “owners.” You try to buy a $5 million home for $1 million, and see the response you’d get from the owners.)
There is no doubt some fat in the pay of some executives. But once you change the law to give shareholders an axe to wield at that kind of corporate fat, you can’t take it back just because there is a lot of blood when they try to use it.
Read the First Comment
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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