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Board members should be combing through their books for insider trades — and re-examining their stock and option awards programs — after the Columbus Dispatch’s reports on the Big Lots case and the WSJ report on that case and four other companies where executives are under investigation for insider trading.  The WSJ report that at least 4,185 executives may have engaged in suspicious trades since 2004 should be giving board members and shareholders pause.

The use and spread of insider information damages our capital markets – and hurts the reputations of firms that do not comply with rules to keep our markets fair. Morgan Stanley paid $5 million for the part they played in providing information to favored analysts in the Facebook IPO. Netflix has also come under scrutiny for potential leaking of material information to a select group.

Regulation FD (fair disclosure) has been important to our capital markets and was designed to stop insider trading in its tracks so that there is a (more) level playing field for all investors. It’s important that companies comply.

Please read the article here.  (I welcome your comments at ebloxham@thevaluealliance.com)

http://management.fortune.cnn.com/2012/12/17/why-netflix-got-into-hot-water/

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Over a dozen large banks have been implicated in the Libor scandal. And the harm created by the manipulations has impacted communities across the US in the billions of dollars.

Boards at the companies involved in Libor manipulation have already paid out bonuses based on inflated earnings. Will these bonuses be clawed back?

At the same time, there are those who continue to advocate the use of bonds or interest rate swaps as a way to pay bankers. It doesn’t make sense.  The prices of those instruments can be altered by manipulating interest rates. Should we provide additional incentive for manipulations given the Libor mess?

Clearly, large banks are not fully disclosing the risks in their compensation schemes.

It’s also difficult to see how paying for fraud and harm comports with reasonable business judgment.

Here’s the article. 

http://management.fortune.cnn.com/2012/12/13/libor-and-banker-pay-an-unfortunate-marriage/

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Although most board members don’t suffer much personally if sued, no one wants the kind of publicity HP’s board is experiencing related to its Autonomy purchase. But now taxpayers are on the hook to sort this all out.

Here’s my recent article on red flags at HP. It provides a short roadmap for boards and investors that don’t want to burn through cash. And provides the inside scoop, for those who don’t know it, into phraseology that means more than one might suspect.

http://management.fortune.cnn.com/2012/11/30/hp-meg-whitman-autonomy-2/

Clearly, long term holders would benefit from some transparency into the company’s process as part of signing off on deals.

In due diligence, smart boards don’t rely just on multiple auditors or investment bankers. They use internal resources or hire outside parties to look behind the numbers and determine what’s really going on.

One CFO who recently went through an acquisition expressed it as “connecting the numbers to the business,” explaining their use of outsiders to help them get an understanding of what was really happening with the numbers, in order to arrive at a fair valuation. In contrast, the investment banks they hired just took the numbers “as is”. As a result, their valuation analyses didn’t provide much value. (Not to mention the bias related to the lack of independence/inherent conflicts of interest.) And although they hired auditors as well, they only hired them to do what they do best. They did not use them to analyse what was going on behind the surface to arrive at a solid valuation.

Certainly outside reports from analysts, short sellers and the press — and information on the web should be de rigueur reading material for the board of any company seeking to acquire another firm.

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The JP Morgan trading issues reflected a lapse in governance. But beyond risk oversight, they also called into question the way in which top executives at the largest banks are paid. Here’s a link to my article on Fortune.com.

http://management.fortune.cnn.com/2012/06/14/j-p-morgans-debacle-its-time-to-talk-exec-pay/

I had the opportunity to design incentive programs using risk based measures in the mid-90s. Implemented properly, these kinds of pay programs can work very effectively to focus executives and managers on the right measures of success. I have written on this topic over the last 15 years, including further information on the regulatory requirements of the sound compensation guidance.  (See http://www.thevaluealliance.com/publications.htm.)

Related to the New York Fed Staff report, the issues raised in the article today include issues on pay I have elaborated on in more detail in these recent articles.

http://management.fortune.cnn.com/2012/04/16/the-terrible-cost-the-u-s-pays-for-derivatives/

http://management.fortune.cnn.com/2012/01/30/ceo-pay-us-economy/

The implications for our economy are clear. The solutions may not come easily, but it is important that we work together to find them.

If you have comments on this blog post, please ignore the comments are closed notice below and just email me directly at ebloxham@thevaluealliance.com

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Privacy issues. Directors need to understand the privacy concerns of consumers and potential long term hits to reputation. How is management weighing the risks of aggressive short term access to consumer information?
Wired (Ryan Singel): Researchers Expose Cunning Online Tracking Service That Can’t Be Dodged
“Researchers at U.C. Berkeley have discovered that some of the net’s most popular sites are using a tracking service that can’t be evaded — even when users block cookies, turn off storage in Flash, or use browsers’ “incognito” functions.”
http://www.wired.com/epicenter/2011/07/undeletable-cookie/

The economy.
MarketWatch (Steve Goldstein): ISM manufacturing gauge falls to two-year low
“U.S. manufacturing activity barely grew in July, according to a key index released Monday in a demonstration of an economy struggling to expand.”
http://www.marketwatch.com/story/ism-manufacturing-gauge-falls-to-two-year-low-2011-08-01?link=MW_latest_news

The economics of directorship. At the largest companies, directors get paid over $1,000 per hour.
WSJ (Joann Lublin): Directors see Uptick in Compensation
http://online.wsj.com/article/SB10001424053111903635604576476514268460994.html?mod=googlenews_wsj

Steep decline in the market today. Are market prices indicative of CEO value creation?  (No.)

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 Eleanor Bloxham www.eleanorbloxham.com
 
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Time to eliminate stock based compensation?
FT (Diane Coyle): A couple of remedies for pay excess
 ”I would … like to see investors call time on share incentive schemes altogether.” http://www.ft.com/intl/cms/s/0/18c572e6-b973-11e0-89ee-00144feabdc0.html#axzz1TV6Z7nO5

NYT (Floyd Norris): Usual Growth Leaders Absent From Recovery
“WHY has the job picture been so bleak in the current recovery? A large part of the problem can be traced to unusual weakness in two categories: construction jobs and government jobs.”

NYT (Paul Krugman): The Centrist Cop-Out
“I joked long ago that if one party declared that the earth was flat, the headlines would read ‘Views Differ on Shape of Planet.’”
http://www.nytimes.com/2011/07/29/opinion/krugman-the-centrist-cop-out.html?src=ISMR_AP_LO_MST_FB

Krugman’s commentary is a commentary on the practice of journalism. Of course, what should happen is for the reporter, whenever possible, to go the extra step — get a picture of the earth taken from above the earth and use it in the article too or put it in front of the leaders of the flat earth party and ask the flat earth party to explain why in the face of the picture they say the earth is flat.                Of course many reporters do this – analyze the statements of respondents not just take them down. This takes time and requires the reporter to eschew the short-sightedness and/or pressures of his/her “bosses” (i.e. whoever they are trying to please or follow).

Psych Today (Nassir Ghaemi): Where are the new ideas?
“One of my Harvard teachers …Leston Havens… used to say: ‘Be careful about institutions. Between your boss’s needs and your eagerness to please, you can create a prison stronger than Alcatraz.’”
http://www.psychologytoday.com/blog/mood-swings/201011/where-are-the-new-ideas

When the focus is on satisfing one institution or one person rather than a larger purpose and higher values, neither ethics nor true innovation will flourish.

The “Where are the new ideas?” article discusses the weaknesses in the current state of academic research.  So does Paul Smalera’s article which focuses on economists.

Reuters (Paul Smalera) Krugman says Thoma’s right, except when he’s wrong
“Thoma rightly argues that too many of their academic colleagues don’t risk engaging at all — they are the ones that need to be coaxed out into the conversation, to shed some light on the dark corners of the economy before some other solid-seeming sector (technology, anyone?) implodes and nearly sinks the ship, yet again.”
http://blogs.reuters.com/paulsmalera/2011/07/26/krugman-says-thomas-right-except-when-hes-wrong/

I was invited early last decade as the only non-academic and non-FDIC executive to an FDIC conference to speak on market signals that might provide warnings of a run up in default at banking institutions. In my speech, I offered/encouraged the pure academics to reach out to practioners (like me) to select their research topics and make them relevant. (After all, that was part of the reason I was invited to speak.) No one called.

Regarding techology – technology is one of the only sectors looking to create jobs http://thevaluealliance.com/Blog/?p=47 which makes technology an even more important sector to watch.

Reuters (Felix Salmon): Chart of the day:Techs vs Industrials, Why Tech Stocks Deserve to be Cheaper than Industrials     “in an area where change is unlikely to massively disrupt your business, income streams are more predictable and therefore more valuable.”            http://blogs.reuters.com/felix-salmon/2011/07/22/chart-of-the-day-techs-vs-industrials/ http://blogs.reuters.com/felix-salmon/2011/07/25/why-tech-stocks-deserve-to-be-cheaper-than-industrials/

Besides the obvious difference in business models between industrials and tech companies, another explanation of lower P/Es at tech firms may be the governance at tech vs industrial firms. Good governance can act as a buffer and prevent issues spiraling out of control. The market places a premium on this stability. (The issue of governance which Buffett doesn’t mention is something he faced earlier this year.) http://management.fortune.cnn.com/tag/warren-buffett/ http://finance.yahoo.com/echarts?s=BRK-A+Interactive#chart1:symbol=brk-a;range=1y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

WSJ (Nassir Ghaemi):Depression in Command
“the sanest of CEOs may be just right during prosperous times, allowing the past to predict the future. But during a period of change, a different kind of leader—quirky, odd, even mentally ill—is more likely to see business opportunities that others cannot imagine.”                “As for Churchill, during his severely depressed years in the political wilderness, he saw the Nazi menace long before others did.”              “Depression … has been found to correlate with high degrees of empathy, a greater concern for how others think and feel.”
http://online.wsj.com/article/SB10001424053111904800304576474451102761640.html?mod=djemITP_h#articleTabs%3Dcomments

I highly recommend this novel in which Churchill (and the black dog of depression) are featured protoganists. Mr. Chartwell : a novel by Rebecca Hunt. http://www.amazon.com/Mr-Chartwell-Novel-Rebecca-Hunt/dp/140006940

 
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The comment period for a multi-agency proposal on compensation at financial institutions ended yesterday, leaving a gaping hole in the rules proposal. http://www.sec.gov/rules/proposed/2011/34-64140.pdf

Although a large portion of CEO compensation is paid in stock or options, the impact of incentive pay which is paid in equity, rather than cash, is entirely missing in the proposal.

But research by Professors Rüdiger Fahlenbrach and René M. Stulz in 2010, following the crisis, demonstrated why equity as its own component should not be ignored. While the knee jerk reaction is that if equity is held by executives, it will create alignment with shareholders, the research didn’t demonstrate any such benefits.

According to the research, “banks where CEOs had better incentives in terms of the dollar value of their stake [in the company] performed significantly worse than banks where CEOs had poorer incentives.” “The top … equity positions at the end of fiscal year 2006 [were] held by James Cayne (Bear Stearns, $1,062 million), Richard Fuld (Lehman Brothers, $911.5 million), Stan O’Neal (Merrill Lynch, $349 million)[and] Angelo Mozilo (Countrywide Financial, $320.9 million).”   All of those firms fared poorly in the crisis: sold in distress or in the case of Lehman, went bankrupt. http://www4.gsb.columbia.edu/rt/null?&exclusive=filemgr.download&file_id=7214553&rtcontentdisposition=filename%3DStultz_Bank%20CEO%20Incentives%20and%20the%20Credit%20Crisis%2020100508%20RMS.pdf

This finding indicates that the banks of CEOs with poorer equity ownership stakes did better — and that perhaps equity ownership exacerbates rather than ameliorates risk taking on the part of CEOs. Certainly, it is well recognized that high equity stakes would logically tend to dampen full negative disclosures.

A strong negative correlation between equity stakes and bank performance such as the research finds would seem to be a compensation mechanism that the regulators should be curious to understand in setting policy, given the apparent risk to bank performance and the huge consequences to stakeholders.

So why don’t the regulators examine the issue more closely or address it in their rules proposal?

This isn’t the first time I’ve written on the topic. Here’s what I wrote to the SEC on this in September 2009 http://www.sec.gov/comments/s7-13-09/s71309-107.pdf and to the Federal Reserve on this in November 2009 http://www.federalreserve.gov/SECRS/2009/December/20091214/OP-1374/OP-1374_112709_25335_596100224676_1.pdf.

And it’s not as if equity is a miniscule part of CEO pay. A quick review of the summary compensation tables in the latest proxies shows that the current CEOs of JP Morgan, Bank of America, Citigroup and Wells Fargo, through the crisis (over the last three years) received $127 million in equity and option awards, on average 80% of their total pay. It would appear the 80/20 rule would clearly apply warranting a look at the impact of equity.

To address compensation at financial institutions, regulators need to re-examine all the reasons equity may create these perverse effects including the fact that payments in equity may exacerbate the tendency to overpay (because of the false notion that equity and options are funny money and not real cash to the corporation). It may also encourage managers to take risks, increase the volatility of returns, extract potential windfall benefits from timed sales, and manipulate stock prices. And equity pay may do all this while diluting other shareholders and diminishing accountability to them and distracting managers from the real business of managing the business.

If regulators examine the issue carefully and reflect the impact in the rules proposal, maybe history won’t repeat itself. If they don’t, there is no reason to expect we won’t see the same movie once more.

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Earlier today Fortune posted an article I wrote on board information and shareholder oversight.
http://management.fortune.cnn.com/2010/12/21/who-is-minding-the-j-crew-store/?section=magazines_fortune

The imperial CEO is not dead.

According to a study just released today by Korn Ferry (see http://www.kornferryinstitute.com/files/pdf1/Dec_2010_E-Quiz_results.pdf) while almost all (98%) corporate leaders think CEO succession planning is important, 2/3 (65%) say they don’t have a CEO succession plan in place. (And of course, not everyone who says they have a plan will have an effective plan.)

As I noted in my Fortune article, one of the early warning signals was a 65 year old CEO and no mention of a succession plan — or board responsibility for one.

If 2/3 don’t have a CEO succession plan but almost everyone recognizes it is important, who is in charge after all?  (Answer: In 2/3 of the cases, not an effective board.)

How important is the CEO? If the CEO is worth millions, what will you do without him? (If the CEO is not worth millions, why are you paying him so much?)

I was asked today to opine on performance measures of board effectiveness. One measure: Do you have an effective, well thought out CEO succession plan? Another: What have you done to ensure that the CEO is not worth too much i.e. that the company will survive and thrive with or without him?

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I have an interest in human thought processes — particularly those that drive  decision-making and behavior. Why? Part of it is because of the ramifications those unconcious processes can have beyond what we may see i.e. the butterfly’s wings.  I think it’s also because we often see decisions we can’t understand – how was that decision arrived at? – and we want to know what drove them.

This weekend I was doing some research and came across a variety of interesting connections between what we think — and our physical being. The kinds of judgments we make apparently about people and our reaction to ideas relates to our own physicality – we are human after all. It isn’t something most of us are aware of (I don’t think) yet it does reinforce the importance of suspending disbelief and belief in our daily encounters and decision making — and being aware.

ABC news reported on several of these studies a couple of years ago. (Read their report here: http://abcnews.go.com/Health/ColdandFluNews/story?id=6096724&page=1)

For example, according to their report, a study out of Yale found those who held a cold beverage “gave more negative or ‘cold’ attributes like selfishness” to a person they were meeting, while those who held a warm beverage “rated the same person with ‘warm’ attributes like generosity.” “In a second study,they gave 53 test subjects hot or cold packs to evaluate under the guise of a product study…Afterward, the group touching the cold packs were more likely to act ‘cold-hearted’ by choosing a small giveaway prize for themselves, while the group touching the hot pack was more likely to choose a giveaway gift certificate for a friend.”  Even minor changes in movement can impact perception.

Another study “has found that whether a person is asked to push off from a desk with their hands on top, or pull in with their hands below, will influence whether they make positive or negative judgments.” (Kareem Johnson, a professor of psychology at Temple University in Philadelphia who studies human behavior is cited as the author of this work in the ABC report but that is incorrect. ABC may have been referring to the work of Joseph Priester according to Professor Johnson.)

And whether you feel socially excluded or included can impact your guess of room temperature with individual estimates ranging from 54 to 104 degrees depending on whether you feel excluded (cold) or accepted (warm) according to research at the University of Toronto published in the journal Psychological Science. (http://abcnews.go.com/Health/ColdandFluNews/story?id=6096724&page=1)

Research out in May by University of Michigan professors Lee and Schwarz (Please read here: http://sitemaker.umich.edu/wing.sing.lee/files/lee___schwarz_washing_away_dissonance_science_7may2010_ms.pdf) cites earlier studies that found “Hand-washing removes more than dirt—it also removes the guilt of past misdeeds, weakens the urge to engage in compensatory behavior” (Zhong, Liljenquist 2006), “and attenuates the impact of disgust on moral judgment” (Schnall, Benton, Harvey 2008)

It also cites past and more recent research that shows to avoid buyers remorse “People reduce dissonance by perceiving the chosen alternative as more attractive, and the rejected alternative as less attractive, after choice, thereby justifying their decision.” (Festinger 1957 and Cooper 2007).  They tested whether hand-washing had an impact and found that it does “suggesting that hand-washing psychologically removes traces of the past, including concerns about past decisions.” “Much as washing can cleanse us from traces of past immoral behavior, it can also cleanse us from traces of past decisions, reducing the need to justify them.”

The New York Times had a Freakonomics article summarizing literature on similar topics in September. http://freakonomics.blogs.nytimes.com/2010/09/01/cleanliness-is-next-to-morality/

And David Pizarro at Cornell has done an impressive amount of research in the area of judgment and influences on judgment. Please see http://www.peezer.net/publications/.

I think we are in early stages of understanding how our bodies impact our minds and decisions — but it is an important topic for our judicial system to consider – both in terms of influences on criminality and judgments of criminals.

See this article published last year by Inbar and Pizarro. http://www.astcweb.org/public/publication/article.cfm/1/21/2/How-disgust-influences-moral-and-social-and-legal-judgments

As boards make important decisions and listen to the conclusions of others and evaluate their own decision making outcomes, it’s important to keep in mind how being merely human (in live bodies and physical environments) can impact our judgments, after all.

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Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

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Insider trading has been at the forefront in the wake of the recent FBI investigations. The investigations should provide caution to board members and others priivy to confidential information on a regular basis.
See my article for Fortune http://finance.fortune.cnn.com/2010/11/29/why-the-stock-market-isnt-fair/ and Nin-Hai Tseng’s article for Fortune here http://finance.fortune.cnn.com/2010/12/01/who-is-an-insider-anyway/

It can be difficult to discern whether or not information – private or public – will result in trades. Enron is a case in point. In Jeff Skilling’s run up to the presidency of Enron, he beat the drums for Enron’s move into the trading businesses. One reason he gave the media? Trading didn’t require capital. This was an immediate red flag to me that Enron was in for trouble and anyone who read his words and understood the trading business should have known that Enron was sailing into dangerous waters. Some may have traded on that information. It was public. Yet, that information never moved the Enron stock. I think it was material – it was my tip off. But it wasn’t one for the market as a whole.

Bottom line, fairness in the capital markets is important — and it requires great care to ensure that they are. Now is a good time for boards and consulting firms to ensure that the rules and their spirit are well understood.

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Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.