From Corporate Governance Watch

Arthur Levitt is unhappy with the backdating of options grants to executives:

Corporate Governance Watch: Quotable Quote Backdating "represents the ultimate in greed," says Arthur Levitt, a former chairman of the Securities and Exchange Commission. "It is stealing, in effect. It is ripping off shareholders in an unconscionable way."

The most puzzling thing about the CEO compensation scandals is that one would think that those who pay--the shareholders--would already have all the tools they need to control their agents. Why don't they?

Comments

[Randolph Fritz]

The big shareholders trust the execs because they know them socially, maybe are execs themselves.

You're not radical enough, man.

[anne]

"The most puzzling thing about the CEO compensation scandals is that one would think that those who pay--the shareholders--would already have all the tools they need to control their agents. Why don't they?"

A critical question that has been repeatedly answered to little or only passing note by John Bogle, David Swensen, Warren Buffett and Charles Munger. Corporate ownership and management have become increasingly separated, as ownership is concentrated in hedge funds, mutual funds and pension funds that have an interest in trading rather than owning. Mutual fund stock turnover has been about 100% for a decade, so claims of long term ownership from fund managers are almost comical.

Even when institutions are long term stock owners, as the California state employees pension plan, there is continual pressure for the institution to take no role in corporate governance. When California's current governor was elected, the state pension plan was immediately turned from corporate activist to passive investor. Who is the governor anyway? I forget :)

[Bernard Yomtov]

"one would think that those who pay--the shareholders--would already have all the tools they need to control their agents. Why don't they?"

They have no tools whatsoever.

The SEC protects management by restricting the ability of shareholders to vote on compensation, and by not insisting that the board election process be opened up.

So management selects the Board, whose members then bribe management - with shareholders' money - to secure their own well-paid sinecures.

The legal system protects board members from liability for anything short of outright criminal behavior.

Mutual fund companies have giant conflicts of interest. Why vote against management which grants them contracts to manage retirement funds?

In other words, the system is rigged.

And of course there is a cottage industry of economists turning out papers that explain why the current levels of compensation are wholly rational.

[anne]

Brad DeLong's question is another reason I invest heavily and happily in European or other international stocks....

Were it not for Eliot Spitzer, New York's Attorney General, there would be no balancing corporate activist in government.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=6537&exhibition=7&u=99|0|...

Mourning Warbler
New York City--Central Park, The Great Hill.

Bernard Yomtov's comment is important and excellent :)

[Rich C]

There are a number of reasons. First of all, most companies are incorporated in Delaware, and Delaware law (as interpreted by the Court of Chancery) puts a lot of weight on the right of managers (including directors) to manage free from interference from the owners (shareholders). Obviously this is not an insurmountable barrier to accoutability, but it helps to create a climate in which the obvious lack of accountability is viewed as an advantage for shareholders (who have "outsourced" supervision of their capital to professional managers). Second, of course, is the nonsensical nature of elections for boards of directors, in which (for most companies) the ballot contains only the candidates selected by management, and on which there is no way to vote "no" on a candidate in anything by a symbolic way. Such votes are only symbolic because most companies (until recently all companies) have a "plurality" rather than "majority" standard for director elections: as long as a director gets more votes than any other cadidate for their seat (and there are no other candidates), then no matter how small a % of shares oustanding are cast for that director, they win election. The adoption of majority voting by companies (happening now on a company by company basis in response to shareholder activism) will help, but its still very much a minority movement. Opening up the corporate ballot (or proxy) - allowing shareholders to nominate their own, independent candidates to compete against management's selected candidates - would also help redress this situation, but this reform appears to be a dead letter now. Third, most shares - even if they are beneficially owned by individual workers or retirees - are held by mutual funds (also pension funds and endowments, though these are often much more active). Mutual funds, in turn, are effectively run by the companies that brand them (Fidelity, Vanguard, etc.) and these companies sell a variety of investment services to other companies in which the mutual funds own shares. The mutual fund managers do not have an incentive to hold corporate managers accountable, and instead may benefit from regularly supporting managers. This symbiotic relationship is especially easy to maintain as long as there are no or very few mutual funds that vote against management, file resolutions at the annual meeting, or engage corporate managers about pay practices. With the mutual funds, all the problems of corporate management are redoubled: the advisory firms (Fidelity, etc.) appoint the directors for the fund, and even when those directors must face election, they do so on the same terms (plurality standard, no competitors) as corporate directors. If anything, the situation is worse with the mutual funds, where there is not even a requirement for an annual meeting, so directors may go many years without facing their constituents.

None of these problems is unfixable, but all of them together create a "closed loop" around the corporate bureaucracy - CEOs and other executives recieve outrageous amounts of money, those fiduciaries who potentially weild power over them are coopted or bought off, and the whole system is insulated from accountability to those it serves. On top of that, the vast resources executives accrue through this system enables them to contribute handsomely to politicians, and stave off any external reform of the system.

[theCoach]

"The most puzzling thing about the CEO compensation scandals is that one would think that those who pay--the shareholders--would already have all the tools they need to control their agents. Why don't they?"

This exposes a naivete with regard to the efficacy of simple economic models. Galbraith is preparing for a come back.

[auto]

Levitt's question is a good one. Hedge funds come in all flavors and there are now many which take huge positions in companies so large that they can foce management to unlock value by doing what management would otherwise not do.

Like when hedge funds forced Wendy's to spin off Horton's.

The idea that large institutional investors are sitting idly by as corporate officers back-date option grants -- that is, steal -- is mindboggling. Hedge funds are run by some of the most greedy people on the planet. No way will they tolerate officers and directors monkeying with compensation in ways that forces the company to have to restate their results, not to mention exposing the company to prosecution and/or litigation.

Wall Street Journal reported yesterday that the University of Iowa finance professor who wrote the original article that set off the SEC inquiries has rejected working with hedge funds that want him to identify likely offenders.

Hedge funds are now payin gthis issue careful attention. But it's amazing that they missed it in the past.

[jerry]

Mod Bernard Yomtov up as +5 Insightful.

What I find intriguing is that during my experience at Haas, I found the accounting department much more on top of these governance issues and incentives (in both the accounting and micro-economics meanings) than the economists. (Professor Brett Trueman, of Haas now of Anderson in particular.)

[John]

Try "Managerial Dilemmas: The Political Economy of Hierarchy" by Gary Miller. Game Theory applied to the problem of hierarchy in business; this thread's topic is addressed specifically in many cases.

The "Business Judgment Rule" (Delaware Chancery Court) in practice:

"The corporation law does not operate on the theory that the directors, in exercising the powers to manage the firm, are obligated to follow the wishes of a majority of the shares. In fact, the directors, not shareholders, are charged with the duty to manage the firm." (Quote from the DCC.)

"... management can veto a hostile takeover for three years even though a majority of up to 85% of the shareholders agree to the takeover." (from the book; effect of Delaware "poison pill" law.)

[anne]

http://select.nytimes.com/2006/04/16/business/yourmoney/16gretchen.html

April 16, 2006

Fund Managers May Have Some Pay Secrets, Too
By Gretchen Morgenson

AMID all the talk about executive compensation and pay for performance, one group of managers has been pretty much untouched: those who run mutual funds.

Pay disclosure for them is scant, because many fund management companies are private and do not need to file pay figures with regulators. Others are subsidiaries of large organizations, and the fund executives are not necessarily among their companies' five highest-paid people, whose compensation must be detailed.

John C. Bogle, founder of the Vanguard Group and its former longtime chief executive, says that this should change, and he has written a letter to the Securities and Exchange Commission outlining his reasons.

Mr. Bogle's letter was filed in response to the S.E.C.'s request for comments on its voluminous proposal to change executive compensation disclosures at the nation's public companies. The comment period, which began in January, ended last week. Now the commission will sift through the submissions and cull the best ideas from them.

A good one is Mr. Bogle's. Runaway executive pay isn't the fault of grasping corporate managers alone; it's also the fault of the many mutual fund managers who have done little to stop the diversion of shareholder money to excessive compensation. It has been nothing short of exasperating to watch these fund managers vote for huge stock-option grants and to favor company directors who have approved absurdly rich retirement packages.

It has been especially frustrating to watch the passivity of managers who run index funds. These managers are forced to own the shares of companies that make up the indexes and cannot sell their shares as a protest against excessive compensation. They, of all fund managers, should have an interest in restraining runaway pay.

And yet, when it comes to executive pay, the silence from money management quarters has been deafening....

[anne]

What was it about hedge fund managers? A manager had to make, say, $130 million last year just to rank among the top 25 managers :) And, we expect there to be complaints about corporate executive pay.

[anne]

http://www.nytimes.com/2006/05/26/business/26hedge.html?ex=1306296000&en=118ec6a4c37a99ec&ei=5090&partner=rssuserland&emc=rss

May 26, 2006

Atop Hedge Funds, Richest of the Rich Get Even More So
By JENNY ANDERSON

Talk about minting money. In 2001 and 2002, hedge fund managers had to make $30 million to gain entry to a survey of the best paid in hedge funds that is closely followed by people in the business. In 2004, the threshold had soared to $100 million.

Last year, managers had to take home — yes, take home — $130 million to make it into the ranks of the top 25. And there was a tie for 25th place, so there were actually 26 hedge fund managers who made $130 million or more.

Just when it seems as if things cannot get any better for the titans of investing, they get better — a lot better.

James Simons, a math whiz who founded Renaissance Technologies, made $1.5 billion in 2005, according to the survey by Alpha, a magazine published by Institutional Investor. That trumps the more than $1 billion that Edward S. Lampert, known for last year's acquisition of Sears, Roebuck, took home in 2004. (Don't fret for Mr. Lampert; he earned $425 million in 2005.) Mr. Simons's $5.3 billion flagship Medallion fund returned 29.5 percent, net of fees.

No. 2 on Alpha's list is T. Boone Pickens Jr., 78, the oilman who gained attention in the 1980's going after Gulf Oil, among other companies. He earned $1.4 billion in 2005, largely from startling returns on his two energy-focused hedge funds: 650 percent on the BP Capital Commodity Fund and 89 percent on the BP Capital Energy Equity Fund.

A representative for Mr. Simons declined to comment. Calls to Mr. Pickens's company were not returned.

The magic behind the money is the compensation structure of a hedge fund. Hedge funds, lightly regulated private investment pools for institutions and wealthy individuals, typically charge investors 2 percent of the money under management and a performance fee that generally starts at 20 percent of gains.

The stars often make a lot more than this "2 and 20" compensation setup. According to Alpha's list, Mr. Simons charges a 5 percent management fee and takes 44 percent of gains; Steven A. Cohen, of SAC Capital Advisors, charges a management fee of 1 to 3 percent and 44 percent of gains; and Paul Tudor Jones II, whose Tudor Investment Corporation has never had a down year since its founding in 1980, charges 4 percent of assets under management and a 23 percent fee.

They may charge such amounts because they can. "In the end, what people want is the risk-adjusted performance," said Gordon C. Haave, director of the investing and consulting group at Asset Services Company, a $4 billion institutional advisory business. "As long as the performance is up there, in the end the investors do not care about the high fees."

If there is a downside to being so rich, it is that the money is flooding in at a time when hedge fund performance, even for some of the greats, has been less than stellar over all. Six managers made the top 25 even while posting returns in the single digits.

"You would think someone would be a little embarrassed taking all that money for humdrum returns," said John C. Bogle, founder of the Vanguard Group. "I guess people don't get embarrassed when it comes to money." ...

[save the rustbelt]

"...In other words, the system is rigged...."

Amen.

The guy in Toledo who owns 500 shares of GM has no snowball's chance in hell of impacting corporate management.

Since boards are still composed of cronies no one really represents shareholders.

I again offer the following proposal:

1. repeal Sarbanes oxley, then

2. The SEC appoints all public company directors - if you want to sell stock to the public, give the public a voice.

[Ben M]

The shareholder's position resembles that of someone carrying a counterfeit bill in their wallet. On one hand, they could examine it carefully, take the funny bill to the cops, and absorb the loss---with little hope of compensation. On the other hand, they can pretend you don't know about it, and hope the next fellow doesn't notice either? Indeed, they might studiously avert their eyes, and even hope that the fakery is of high quality.

In other words: accounting trickery is a fraud on behalf of the *current* shareholders, helping them cheat *future* shareholders. It's the Bush economy in a miniature.

[NeilS]

I wouldn't have any problem with hedge fund managers and their clients making so much money if I wasn't sure that when the funds start hemorrhaging (and they will), the taxpayer will cover their losses 'for the good of the economy.'

If you're really rich the rule is high return and no risk. I wonder how many economic models include that feature of the US economy.

Why is executive compensation in Europe less avaricious than it is in the US?

[Esq.]

Rather than repeal sarbanes oxley, repeal limitations on the class action lawyers. Invite them to the party and make them the enforcers. Unlike the SEC and other alphabet agencies, the profit motive will prevent co-option.

Let them invest a million or three to take on management that abuses its fiduciary duty to shareholders. Let the D & O insurers limit their policies to offer no protection if x, y or z occurs. Let the directors fear personal bankruptcy.

[Bernard Yomtov]

Thanks to anne, jerry, and str.

I do think that SEC appointment of directors would be a bad idea. I personally prefer a process whereby shareholders could nominate candidates through a sort of petition process. Perhaps the support of some percentage of shares would be enough to get a candidate on the ballot. Such candidates would get equal billing in the proxy statement and equal treatment in the voting procedures - no default votes for management candidates, maybe no formal management endorsements at all.

[anne]

No; there is a distinct problem. Costs are critical for investors, and costs are tearing away at investor gains in individual retirement accounts to taxable accounts to institutional gains. Costs have torn away gains through these 25 years in a way that is a distinct problem for all but the wealthiest investors.

[anne]

The difference between Vanguard investment costs, and other costs including those for hedge funds, has led to investors missing startlingly in returns to assets these 25 years.

[Ottnott]

"one would think that those who pay--the shareholders--would already have all the tools they need to control their agents. Why don't they?"

I see two likely answers to that question:

A) Shareholders aren't interested in having any control over their agents, because they believe that a management free of such controls produces a better investment return.

B) The present situation reflects deliberate effort to block and weaken any forms of shareholder control, presumably by those who benefit from very weak shareholder input.

Anyone who can read a newspaper or who has even minimal insight into human nature can rule out A.

The question is, what do we do about B? As a tiny shareholder, my voice is limited to a once-yearly "vote" on board candidates selected by management (and, occasionally, by a large shareholder). And I don't even really get to vote. I can either say "yes" or I can "withhold".

In fact, the most influence I've had on company management by far was critical (but factual and informed) posts on a stock message board. I had the scary experience of being sued by the company for my posts. In the end, the company dropped the suit right after a meeting in which my attorneys made the opposing attorneys understand that the opposing attorneys faced a strong possibility of Rule 11 sanctions*.

It was still a very assymetrical situation, however. I would have had to cave if not for the existence of attorneys willing to take my case at no cost to me and the related fact that California has an anti-SLAPP law. I certainly wouldn't argue that message boards are evidence that shareholders have a voice in company operations.

*"SANCTIONS, RULE 11 - Federal Rule of Civil Procedure 11 provides that a district court may sanction attorneys or parties who submit pleadings for an improper purpose or that contain frivolous arguments or arguments that have no evidentiary support."
http://www.lectlaw.com/def2/s110.htm

[Francis]

try reading Prof. Bainbridge. He apparently holds the position that stockholders SHOULD be passive. Where the restraint on executive compensation is supposed to come from is a mystery to me.

[Rob]

Seriously Brad, when all it takes to get a majority of proxies is to wine and dine the right half dozen or so mutual fund managers there is going to be little control.

[david]

I've been struck by how closely the spike in executive pay has paralleled to spike in corporate governance activism. Maybe the one is driving the other, but the shriller Bob Monks gets, the more that useless executives suck straight from the pipe. Weird.

[Scott Martens]

Shareholders believe that they can more readily make a profit by selling a firm's stock rather than voting for different management. I thought that was what everyone understood these days. It's the logical corollary of a system where a company buys back its stock to keep up the price rather than pay a dividend. That's the free market in action: When the only lever of control you have is the decision to buy or sell, stockholder oversight is considered superfluous.

[elliottg]

Review Carly Fiorina's (Hewlett vs. HP) perjury in her testimony to understand how much the system is rigged against shareholders large or small.

[anne]

http://www.nytimes.com/2006/06/01/business/01bonus.html

June 1, 2006

Big Bonuses Still Flow, Even if Bosses Miss Goals
By GRETCHEN MORGENSON

It was the kind of mistake that wage slaves can only dream of. Because of what the company called an "improper interpretation" of his employment contract, Sheldon G. Adelson, chairman, chief executive and treasurer of the Las Vegas Sands Corporation, received $3.6 million in salary and bonus last year, almost $1 million more than prescribed under the company's performance plan.

Four more top executives of the Las Vegas Sands, which owns the Venetian Resort Hotel and Casino, received more than they should have. The total in excess bonus payments for the five men was $2.8 million.

The compensation committee of the board conceded that it had made an error. But it said that "the outstanding performance of the company in 2005" justified the extra money, and it allowed the executives to keep it.

Shareholders of Las Vegas Sands did not fare as well. The value of their holdings fell 18 percent last year.

As executive pay packages have rocketed in recent years, their defenders have contended that because most are tied to company performance, they are both earned and deserved. But as the Las Vegas Sands example shows, investors who plow through company filings often find that executive compensation exceeds the amounts allowed under the performance targets set by the directors.

Executives of companies as varied as Halliburton, the military contractor and oil services concern; Assurant, an insurance company; and Big Lots, a discount retailer, all received bonuses and other pay outside the performance parameters set by the boards of those companies.

It is the equivalent of moving the goalposts to shorten the field, compensation experts say.

"Lowering the hurdles is especially disconcerting because very often the goals are not set all that high to begin with," said Lucian Bebchuk, professor at Harvard Law School and author with Jesse Fried of "Pay Without Performance." Mr. Bebchuk said shareholders should be especially alert to increases in bonuses because more companies were shifting away from stock options and into cash incentives.

Some employment agreements actually stipulate that they will provide bonuses even if company performance declines. The agreement struck in 2004 by Peter Chernin, president and chief operating officer of the News Corporation, entitles him to a bonus even if earnings per share fall at the company. If earnings rise by 15 percent in any given year, Mr. Chernin's bonus is $12.5 million. But if they fall 6.25 percent, Mr. Chernin's bonus is $4.5 million, and an earnings decline of 14 percent translates to a $3.52 million bonus.

Last year, Mr. Chernin received $8.3 million in salary and $18.9 million in bonus pay. A company spokesman declined to comment on the bonus structure. He confirmed that the company's chief executive, Rupert Murdoch, has a similar bonus arrangement. Company filings show that Mr. Murdoch received a bonus of $18.9 million last year.

While bonus and other incentive pay figures are included in company filings, shareholders hoping to calculate precisely what performance objectives executives must meet to receive such pay can be confounded.

Descriptions of bonus targets are typically vague and often include a laundry list of measures that the board may or may not consider. The board may factor in sales, earnings, stock price, capital expenditures, cash flow, even inventory levels. Company officials often explain the practice by saying that too-specific information on performance hurdles can give away corporate secrets or invite rival organizations to lure executives away by offering them contract terms that are easier to achieve.

Compensation experts counter that lists of vague hurdles may allow carefully chosen measurements to be met in both fair weather and foul....

[anne]

http://www.nytimes.com/2006/06/01/business/01bonus.html?ex=1306814400&en=9e238607fa6a7afa&ei=5090&partner=rssuserland&emc=rss

Big Bonuses Still Flow, Even if Bosses Miss Goals
By GRETCHEN MORGENSON

With Links to Board, Chief Saw His Pay Soar (May 24, 2006)

Executives Take Company Planes as if Their Own (May 10, 2006)

Stock Options at Wholesale; Why Count on Prices Rising? (April 29, 2006)

Investors vs. Pfizer: Guess Who Has the Guns? (April 23, 2006)

[Related articles.]

[Barry]

Brad, there was an article in the NYT about the Home Depot shareholders' meeting. It's moved behind the Select wall, so go through your library system:

http://select.nytimes.com/gst/tsc.html?URI=http://select.nytimes.com/2006/05/27/business/27nocera.html&OQ=_rQ3D1&OP=4b981125Q2FZqmEZDpQ20Q7CQ7CDZQ2411yZ1LZQ243ZEQ7EpKJmppZQ243JQ7CUmQ20_XnDld

The level of sheer 'f*ck you all' that Home Depot expressed is amazing.

[Juno888]

A critical question that has been repeatedly answered to little or only passing note by John Bogle, David Swensen, Warren Buffett and Charles Munger. Corporate ownership and management have become increasingly separated, as ownership is concentrated in hedge funds, mutual funds and pension funds that have an interest in trading rather than owning. Mutual fund stock turnover has been about 100% for a decade, so claims of long term ownership from fund managers are almost comical.