Wednesday, September 16, 2009

The trope of shareholder value

Once the crisis is over (yes, despite the fact that some have declared that the recession is over, there are signs the crisis remains) and the financial industry moves towards serious cultural adjustment, it will eventually have to consider the role of standards, compensation, and rewards. As Marshall Goldsmith recently argued in the Washington Post, financial incentives in the industry need to be more in line with desired practices (he even cites Steve Kerr's article about the folly of rewards). (see Goldsmith's article here http://views.washingtonpost.com/leadership/panelists/2009/09/aligning-rewards-and-hopes.html?hpid=smartliving0)

At many major firms now on the government doll, as well as organizations across industries, incentives remain exactly where leadership wants them -- in finding clever and resilient forms of executive compensation. The issue isn't that incentives aren't aligned with organizational goals, the problem is the goals themselves -- the goal is high executive compensation, not return to share holders – in many cases, little regard exists for long term consequences, risk or even in many cases the shareholders. It wasn't a problem of poor goal setting, it was the goals themselves, and they rewarded exactly the kind of behavior that was desired.

Another set of incentives that will need to be considered comes in the form of other people's money. CNBC reporter Charles Gasparino argues that what allowed investment banks to take on such huge risks (measured often in borrowing as much or more than 30 times equity), was the fact that these publicly traded companies were gambling with shareholder's money. (See him talk about it here http://www.cnbc.com/id/15840232?video=1253982080&play=1).

We can talk all we want about shareholder value, but until incentives are aligned with shareholder value, not simply short-term one time profits, often in the form of short term trading returns, - the whole discussion of shareholder value is simply a trope.

19 comments:

tag said...

I agree that incentives should be thoughtfully and carefully aligned with the business goals and shareholder returns, but I can't fully jump on the bandwagon of executive bashing. While shareholders have limited power, they have power nonetheless; it is well within reason for them to grill board members at annual meetings, circulate petitions and rally enough support to vote out incumbents on the board. Obviously this is more difficult done than said, in large part because meetings are infrequent and obtaining critical information may be next to impossible; plus, many people have real jobs and cannot go watch-dogging every company they've invested in. Which is why there are audit committees, placed as another check-and-balance in the system. After the Enron debacle, such committees were harshly criticized, and supposedly vamped up. Nonetheless, 8 years later I have not seen too much about audit committees whistle-blowing during the pre-sub-prime collapse. While some may argue that the snowballing of meltdown events exponentially escalated and that high-paid executives should have seen it coming, the fact that a majority of the data executives handle is also viewable by audit committees either lessens the blame we can place on executives in general or crucifies both parties (executives and audit committees). As we see in the AIG example, only a small handful of operational personnel may actually see the true ingredients inside the complex financial packages they thrive on; perhaps the fairest blame we could place on these executives is that, for the pay they received, they should have been searching more proactively and more deeply for root explanations to the absurd profits their companies were realizing. While human nature says, "Why look so deeply when something is going so well?", executive pay says, "You better." While human nature says, "Why stick your neck out or go against the tide?", executive pay says, "That's what you're paid for!" But in the end, if shareholders don't feel the need to rearrange the board, they should accept their share of the blame.

Anonymous said...

After every major financial blowup, the current one included, there are calls for reforms of executive compensation. It seems for my entire professional career the media and government has been calling for reforms of compensation, but no substantial change has resulted.

From recent media reports, it appears that the bailed out (with our tax dollars) investment firms (more accurately the banks that now own them), have received billions in tax dollars, but haven't bothered to reform their executive compensation schemes. Apparently firms are already returning to their old compensation schemes without thought to reform that might help prevent future financial meltodowns.

It seems that shareholders may clamor for reform that will change compensation to be based on long term creation of value, but the reality is that most Americans don't hold stocks for the long term, like my parents or grandparents did, and instead sell and/or change from one mutual fund to another every 6-9 months (as my investmend advisor remmonends). I think the reality is that shareholders may not care about long term value creation, but only what earnnings are for the short period they hold a fund that holds a bank or investment house.

I think if you were to ask a class how many supported long term creation of value in banks and investment houses they held, they would all raise their hands, but when the follow up question were asked of if they held stocks for the long term, they would not raise their hands.

It is going to fall on the regulators to reform the compensation structure of banks and companies, as regulators are talking about doing with banks that received bailout money, which is both reasurring and disturbing. First of all, I doubt anything will be done in a timely fashion, if the track record of regulators is any indicator. The need for reform has existed for years now. They are talking about closing the barn door long after the cow has wandered out and been trucked to the slaughterhouse by strangers. Second, I am concerned that the regulators will impair the competitiiveness of American financial firms in their over zealousness, and we will see the financial center of power move completely to Europe and Asia. Our regulators have a great record of responding too late and then not getting it right the first time and second time. Lastly, if compensation is llimited at banks are their most valuable, highly compensated, employees going to simply pack up and move to unregulated bodies such as hedge funds. Then their impact on the economy will be unchecked, and small investors will lose the opportunity to profit from their skills.

In conclusion, I hope that regulators act, they do so quickly and intelligently, in a manner that protects shareholders, prevents another financial meltdown, and keeps American financial houses the most competitive in the world.

Kristina said...

Does executive pay really say, “Look deeply when something is going so well,” and “Stick your neck out or go against the tide”? That seems to be the “B” we’re hoping for, but compensation is awarding them for “A” otherwise known as only short-term profits. Before a discussion can even begin on aligning incentives with shareholder value, boards must determine how to measure if both short-term and long-term shareholder value is being met. The short-term metrics are easy, they can be quarterly and quarterly profits indicate short-term value. But how long is long-term? One business cycle, one year or whatever is longer? Or is long-term even longer than that? And how, in the meantime, does a board evaluate if the executives’ strategies and tactics will achieve long-term value?

Alexander Westholm said...

I don't believe compensation system reform will result in a long term solution. Perhaps the reason the previous commenter has heard calls for reform for so long is that any reform will be doomed when the factors that most heavily influence that which is being reformed do not change as well. Here, those factors are the reward structures of the market itself.

The stock market has nothing to do with long term health and wellness of corporations, and everything to do with making as much money as possible in the shortest amount of time. Consequently, the companies themselves are rewarded for making decisions that result in an immediate return for investors, rather than a long haul approach. Perhaps, as was previously suggested, this is a shift from the antiquated ideal of long-term holdings to the modern day-trading mentality.

Any adjustments in executive compensation will be short lived and futile in an environment such as this. Even if bonuses were entirely removed from the picture, there would still be some form of incentive to engage in short-term profit maximization. Perhaps the perceived prestige of the firm, perhaps increased job prospects. The actual identity of the next-in-line motivating factor is irrelevant - the point is that as long as the market itself rewards companies for short-term profits, there will be incentives in publicly held companies to reward those behaviors.

Ron said...

I agree that the concept of "returning shareholder value" is often a trope. It is usually out of alignment with the long-term health benefits of companies and is often used to hide some sort of misdealing. It is usually the case that there is a high-placed group of executives within an organization that are responsible for negotiating very large (yet short-term) deals in the absence of responsible shareholder oversight. A great example of this situation is the meltdown of AOL after the merger with Time-Warner. Two AOL executives in particular (David Colburn and Myer Berlow) were responsible for the "Business Affairs" unit at AOL, which negotiated all of the large-scale ad deals with AOL's "Partners". Many of these ad deals were tied to the stock performance of AOL's partners, and hastened the bankruptcy of many companies. According to Alec Klein's excellent book (excerpted here on WashingtonPost.com -- http://www.washingtonpost.com/ac2/wp-dyn/A46842-2003Jun11), things came crashing down when the SEC launched an investigation into these deals after the AOL/Timer Warner merger. To wit, "Both men were involved in many of the transactions under scrutiny, a slew of complex and exotic deals in which the company inflated its advertising revenue to make its financial results look better than they were." The SEC would find that these two executives were not working merely to line their pockets by propping up the value of their own stock options, they wanted to keep AOL's stock price at a high level to avoid jeopardizing the merger with Time Warner. AOL's inevitable collapse can certainly be blamed on other factors (the emergence of broadband ISPs, for example), but these complex business deals hastened the decline of AOL and would also became a huge burden for Time Warner shareholders as well.

Jason said...

I agree that some executives are getting over compensated. However, I believe that if the shareholders want a change to the compensation package, they need to demand that those changes are enforced. We do live in a democratic nation, so why not let majority decide. It would be much like having a bill passed through congress:
1. Have an Executive Compensation Board perform reviews of the executives that are up for a bonus
2. Propose to the general stockholding public that a bonus be issued
3. Allow them to vote on issuing a bonus
4. Allow them to determine what that bonus would be
I know this is a rather ideal, and unreal way to inject democracy into capitalism, but if you continue with this for a moment, you come up with some interesting situations. If shareholders are truly upset about the current compensation package, they will vote down the bonus or limit it to a certain amount. This solves the problem.
-The reality is that even IF this system were set in place, I believe that the majority of the general shareholding public would not vote. People want change, but they want others to make the changes.
-The complaints about compensation live a Limited lifespan. No one was up in arms when executives were getting multi-million dollar bonuses when the economy was good. It became an outrage when the economy hit the wall. When it climbs its way out of the cellar, people will, in my opinion, forget about it.
-If the majority shareholders are the executives, of course they will vote for issuing bonuses. Perhaps this will drive the minority shareholders (who don’t want the bonus) to buy out the executives and become the dominant force?
-Even if the executives have no shares, if the majority shareholders don’t know they are the majority shareholders because all of the stock was bought in hedge funds that no one bothers to look at, again, no one will vote.

When it comes down to it, the policies aren’t going to change until the people demand change and make sure it happens. Let me know when that happens, Im going to go wait for my dividend check from being co-owner of GMC.

Erin said...

This is certainly an interesting debate, with no clear answers or solutions.

I believe that shareholders have simply come to accept enormous executive compensation packages - we may not approve, but we're not going to do anything about it as long as the value of our shares are going up (even if they could increase more without millions in exec pay per year). In exchange for some level of positive return, many people simply say "geez, the compensation packages are excessive and ridiculous", but as long as management continues to produce positive earnings by quarter, all is forgotten. This laissez-faire attitude among shareholders signals to executives and boards that they can do whatever they want, as long as they are generating positive returns. This attitude came to an abrupt halt as soon as positive returns weren't generated.

As the old saying goes "sharks don't eat sharks" (which has since been proven untrue, but I'll go with it for illustration). Management circles won't turn on each other when they are all living high on the hog.

Financial firms are in the business of making gobs of money - the laissez-faire attitude of enriched shareholders and the Wall St culture combine to breed greed among executives. I predict that cultural adjustment will be short-lived. These firms will be back in the black and returning healthy earnings, and people will once again lose interest in reforming executive compensation.

Erin said...

This is certainly an interesting debate, with no clear answers or solutions.

I believe that shareholders have simply come to accept enormous executive compensation packages - we may not approve, but we're not going to do anything about it as long as the value of our shares are going up (even if they could increase more without millions in exec pay per year). In exchange for some level of positive return, many people simply say "geez, the compensation packages are excessive and ridiculous", but as long as management continues to produce positive earnings by quarter, all is forgotten. This laissez-faire attitude among shareholders signals to executives and boards that they can do whatever they want, as long as they are generating positive returns. This attitude came to an abrupt halt as soon as positive returns weren't generated.

As the old saying goes "sharks don't eat sharks" (which has since been proven untrue, but I'll go with it for illustration). Management circles won't turn on each other when they are all living high on the hog.

Financial firms are in the business of making gobs of money - the laissez-faire attitude of enriched shareholders and the Wall St culture combine to breed greed among executives. I predict that cultural adjustment will be short-lived. These firms will be back in the black and returning healthy earnings, and people will once again lose interest in reforming executive compensation.

Natalie said...

There is much to be said about shared responsibility in this financial crisis. I won't purport to know who should shoulder more blame--the Wall Street executives from AIG and the like, government regulators, lenders,sub-prime mortgage consumers and to some extent even the media. Its nearly impossible to pinpoint one tipping point, as many of these parties fed on the follies of the other. What I will say is that none of these parties truly weighed the risk in the long-term. And as one of the previous commentators pointed out, its just not in our nature to hold onto stocks like our grandparents.

Why would we when we can check our stocks up to the minute online from our phone or turn on any variety of channels and have the ticker going across the bottom of our screen. Whole media outlets are dedicated to analyzing every move of the market. Why focus on the decisions of the long-term when there are so many decisions we can make TODAY?

We saw the volatility that the watchful eye of the media added in the interviews featured in the Frontline Special: Inside the Meltdown. In many respects, the news became the news as the uninformed and informed alike had their confidence shaken by the tremors in the market begining with Bears Sterns.

Executive pay and the general reward system/culture on Wall Street is among many elements we need to examine as we come out of this financial crisis. How the goverment can better address risky behavior and hold responsible parties accountable is another piece. But invetiably improper practices will slip through the cracks, so we need to actively educate consumers about the risk they may confront like predatory lending. This is also a perfect opportunity for the media to do a self-audit regarding how they report and contextualize the short and long-term risks/benefits of the financial sector.

Michael Briglia said...

In reading to “the trope of shareholder value”, I consistently return to a thought regarding common stockholders not exercising their right to vote, or maybe even more importantly, their power to sell or never buy the stock in the first place. Why do we invest in companies that over compensate underperforming executives at all? And if we’re not shareholders, why do we even care how much they are paid? It’s not overly difficult to review executive compensation levels and the financial performance of a company. It’s the primary reason that it’s all public information.

I hope we continue to reside and conduct business in a free market, were a significant part of our government’s role is to ensure freedoms, prevent fraud and provide fair property rights, were risk and reward are always balanced by the potential for loss. If shareholders would start selling stocks or funds that invest in companies that over compensate, I think the problem is becomes self correcting.

Erin said...

This is hard to believe, but Wall Street is already back to their old ways!

Goldman is on-track to disperse record bonuses ($16B) to their employees for the 2nd consecutive quarter!!! (http://www.nypost.com/p/news/business/damage_control_wMcWJrGnm5enlZYGHnwULI)


And leverage is back, big time! (business.theatlantic.com/2009/.../banks_increasing_leverage_again.php)

Banks have ramped up lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.
(http://www.creditwritedowns.com/2009/08/bank-leverage-forever-blowing-bubbles-part-two.html)

It seems that the exact same goals and rewards are in place, along with the same risk taking, only a couple of short months past the worst financial crisis in recent times! Goldman is worried about the negative PR they will face when 3rd quarter bonuses are doled out - they are tinkering around with how these huge sums will be paid (deferred options, etc), heaven forbid they CUT the bonus pool!

I've read a few opinion pieces whose authors seem convinced banks used their mandatory TARP funds to drive leverage back up along with their profits. Looks like Wall St outsmarted the government again, and will be back to their old massive money-making ways in no time!

tag said...

Cutting out bonuses is like cutting a leg off of a thoroughbred. Talent must be acquired, and Goldman has a knack for obtaining the best of the best. This is one reason it was able to mitigate or avoid, in large part, the anchor that pulled down many other large ships.

While hard thought must be put in to the design of incentives, simply cutting them out altogether is tantamount to handing an international plane ticket to those with the most to offer. Greed, correctly wielded, is good.

McCoy said...

I would think that Goldman cannot cut its bonus pool because it would act as a disincentive for its top earners and employees to stay on board. Investment firms are constantly looking to lure top earners away and if Goldman did cut its bonus pool the employees set to receive these bonuses would simply look elsewhere to find employment.
Smaller firms that have not taken TARP money or private firms that are not required to disclose bonuses would then have a large advantage over the firms that our tax dollars have been invested in. If these firms (TARP recipients)could not continue to keep their top earners and employees, would we, the taxpayer, ever see a return on or more importantly return of, our investment?

Anne said...

For the past two years, the workforce has endured pay cuts/salary freezes, reduced/eliminated employee programs, compressed workweeks, early retirement packages and mandatory vacations/furloughs. As the economy begins to rebound, the workforce will demand what it has hasn't gotten... and maybe even more! Those that will demand the most will be those that gave up the most, which in many cases are the "non-executives" who have struggled to make ends meet. Employee engagement is going to be the key to post-recession success. One can hope that this force encourages a shift in compensation philosophy, rewarding to foster employee engagement as opposed to short-term company performance.

BAS said...

It needs to be seen if any attention will be put on the compensation structure. As with Enron and many of the investment banks, undue risk was taken on the shareholder's money which made high returns for the companies but at the same time the onus of risk was on the shareholder's capital. Blaming the compensation and rewards structure would not alone solve the problems of the current crisis. The shareholders/stakeholders should be proactive in asking questions and push the regulator into doing through investigation. People should not be afraid to ask questions on how profits are made and what is the justification on compensation. This will put companies to ensure sustainable business practices in the future and increase oversight on operations.

Christina said...

In class we touched on the discussion of women in leadership positions and will there ever be 50-50 in the executive ranks. Related to women in leadership, incentives, etc, I particulary like the recent HBS article 'Are Your Best Female Employees a Flight Risk?' http://blogs.harvardbusiness.org/hbr/hewlett/2009/10/smart_women_stronger_companies.html

Lokesh said...

In current scenario, the top executive of organizations have various incentives to generate profits in short term. This encourages them to take the risks which can potentially generate profits. If the attempt pays off and they are successful, their pockets will be filled with millions of $'s in terms of bonuses. On the contrary, what if those attempts fail? What will happen to those executive? The worst thing that can happen is they will be fired. But very soon they will be hired by some other organization and same thing continues. So if the attempt is successful, they get millions of $'s and if they fail they just have to change the job. If we have some mechanism of punishing the executives for taking unwarranted risks, they will definitely think twice before taking any such decisions. But again such kind of techniques come with their own shortcomings. Due to fear of being punished, the executives might just stop taking risks and just start acting in conservative ways. This might result in stagnant growth of the organization.

willsull said...

Shareholder value and Executive Compensation within the Great Recession

Now that we are well into the economic era that may one day be known in history books as "the Great recession,” speculating about the future or executive compensation schemes, particularly within large corporations that were salvaged by the unprecedented financial bailout, seems to generate active debate both in the media and in the classroom.

Initially I was somewhat disappointed that in reading through initial post/comments/video/related articles on this topic, I could not catch ascertain any suggestions on potential solution(s) to the ‘trope’ presented in this blog.

The financial crisis presents a timely opportunity to consider the standards, compensations, and rewards of the “High Executive Compensation vs. Return to Shareholder” debate.

Therefore, I’ll share my thoughts on a potential solution:

Reform overall compensation schemes for executives at a certain level and/or criteria – eg: Any publicly traded Fortune 500 Company receiving bail-out funds. Subsequently, allow regulators (empowered through legislation) to pursue a policy that strictly limits (annual) bonus’ schemes for executives at these organizations, placing limits on a remuneration within a band for a stated period of time; for example, a regulation could limit bonuses’ for executives until all reforms and/or bailout funds are returned to the government. If the regulations are set appropriately, these firms should still be able to attract and retain the executive talent needed to drive a turn-around.

Alternatively, regulators could impose restrictions and/or financial incentives to corporations that allow them to only apply remuneration above a specified dollar amount in the form of company owned stock-options; then, regulators could assess reward schemes to the corporation(s) if/when executives do not cash in the prescribed stock-options before an established long-term date.

Perhaps under this scenario executives would wreak the rewards for delivering long-term benefit.

All this being said – there is of course nothing stopping companies from applying these types of policies on their own today – without regulator intervention; following the crises, shareholders may begin to welcome such proactive policies in the post ‘great recession’ era.

While the complexity involved in potential reforms may seem overwhelming – it is not an insurmountable task and will at least add a level of transparency that may certainly be welcomed by shareholders. For example, while executives at AIG may now be receiving ‘merit-based’ pay for work they did years ago – implementing strict standards that aims to differentiate the terms for a bonus from other forms of variable-based executive compensation will at least provide all stakeholders with additional transparency in these pay schemes. Consequently, maybe the next time such a market fall-down occurs AIG will not face the difficult predicament in explaining their rationale for the executive bonus schemes they have in place.

Studies show that Variable-pay programs increase motivation and productivity and reforming aspects of these programs for executives does not fit well with the free-market capitalism prevalent in society today. However, there may be ways to craft specific reforms that seek to improve the transparency of executive compensation schemes and adapt such schemes to meet the longer-term interest of the organization itself.

bkleiners said...

This is such a difficult balance to strike. When we look at sports, for example, player contracts often have incentives tied personal achievement. We have seen teams hold players out of games so they do not reach these incentives. This is a two-way street and so the task becomes even more difficult.