Executive Pay Disclosure

So, the SEC is making some regulatory changes to how executive compensation is disclosed, the idea being to build on regulations from 2006 that help people understand how stock compensation translates to actual dollars.

Under current rules, companies don't have to reveal the full value of stock options they give an executive. Instead, they must disclose in their annual proxy statements only the portion of an options award that vests that year.
The new rule will require companies to show in a summary table the estimated value of all stock-based awards on the day they are granted. The SEC's 2006 rules had relegated those totals to a separate table that investors often overlook or find hard to decipher.
An example is the case of a company that decides its CEO deserves $10 million worth of stock options, to vest in equal installments over four years. Under current rules, the company would have to include only $2.5 million -- one-fourth of the total -- in the summary table.

Well, that sounds nice. Too bad it won't really do anything worthwhile. Back in 1992, the SEC made some moves to improve transparency of executive pay, which was hailed as a good thing. At the time, it was thought that executive compensation was out of hand and needed to be reined in. Transparency was supposed to be a big step in the right direction, as most thought shareholders would complain over excessive compensation and bring things back to some semblance of normalcy. Guess what happened after that? CEO pay increased 400% between 1992 and 2000! Why? I think it was because CEO's got a good look at what their peers were making, and those who were below average complained until their boards gave them more money, which turned into a continuous cycle of companies wanting to pay "above average" for good CEO's, which naturally raises CEO pay. Good stuff eh? Notice shareholders didn't do squat to alleviate anything.
"We learn from history that we learn nothing from history." - George Bernard Shaw.

I think the real key to 'curing' executive compensation is to approach things from a different angle. Everyone seems to be focused on how much CEO's get paid. Indeed, these recent SEC disclosure moves only serve to better understand the how much aspect. But what about how they get paid? If we understand the structure of pay, perhaps we could get better compensation practices that might of their own accord bring CEO pay to what it really should be (something that should be left to the market, though so far the market has been inept). Harvard Business Review has some excellent columns on this. I quote from the second link:

Let's look at modern executive compensation in this light. It has become dominantly stock-based, such that the biggest rewards come from an increase in stock price following the establishment of the incentive compensation system. How then do executives reap incentive rewards? The answer is simple. Since a stock price is nothing but the market's consensus of expectations about the future performance of their company, executives can only reap a compensation reward if they increase the expectations of future performance above their current level.
Now apply the first test. To what extent do executives have control over increasing the market's expectations about the future performance of the company? Very little. That is proven by the degree to which expectations fluctuate dramatically more than real results of publicly-traded companies. Real results dropped slightly in the fall of 2008 and expectations plummeted to half their previous level.
Then apply the second test. Do we really want first and foremost the expectations of stock market participants to rise regardless of anything else? I guess one could say the answer is yes if expectations could rise forever. But interestingly, that has never happened with any stock - ever. Expectations fluctuate because they are the product of imagination and speculation, not actual company results. What is more true is that we would wish that real variables, like earnings per share or market share or return on invested capital, would grow from their previous levels. If they grow, then expectations and stock price will grow with a sound underpinning rather than through idle speculation.
Because it's impossible to keep expectations rising forever, executives are smart enough to do so in the short term and get out before expectations fall. The very cleverest CEOs (and those who showed no mercy to their successors) like Coke's Robert Goizueta and GE's Jack Welch were able to manage expectations wonderfully until the day of their retirement. But look at what that personal profit-maximizing behavior did to their corporations, and their hapless successors. By focusing on stock-based compensation, we have caused executives to manufacture stock market volatility rather than build long term value. And it isn't their fault; it is the fault of their boards. It is the boards who swallowed the stock-based compensation fallacy - hook, line and sinker.
Fortunately, there is a simple solution. Scrap stock-based compensation entirely and compensate executives on the basis of improving real measures such as EPS, ROIC, and market share. Those are things over which executives exert significant control and if they improve those real results, stock price will follow. It isn't hard or complicated. It just takes going back to principles.

The hard part will be to break the current system, where prospective CEO's seem to be able to dictate highly favorable compensation packages. I don't know how to get corporations to shift their compensation strategies, but I'd prefer it not be through regulation in this case. Government regulation of pay is something I am not in favor of. Goldman Sachs has taken a small step towards tying their executive pay to company performance, but as HBR points out above, they're unfortunately using the wrong metric for performance.

BlackRock's Potential Conflict of Interest

This is a somewhat alarming report.
From the WSJ:

BlackRock Inc., which scored multiple government assignments during the financial crisis, is a contender for another prestigious gig: helping state regulators size up risks in insurers' investments.
The money manager and risk-advisory outfit is among a handful of firms that have talked with officials from the National Association of Insurance Commissioners lately about possibly taking on a slice of work now done by the major ratings firms, according to regulators and an official at the NAIC.

Why is this alarming? From POGO:

Another company that is reportedly under consideration for the contract is PIMCO...
To understand why hiring a company like BlackRock or PIMCO could raise the risk for conflicts of interest, just take a look at BlackRock’s latest quarterly SEC filing. As of June 30, 2009, BlackRock is managing a whopping $1.37 trillion in assets, including $510 billion in bonds, $317 billion in cash products, $330 billion in stock funds, and $52 billion in alternative investments such as hedge funds. The company also advises clients on $166 billion in assets, including many of the same types of assets that it would be evaluating for the NAIC. And these numbers will soon be increasing thanks to BlackRock’s recent acquisition of Barclays’ investment unit, which, according to Bloomberg, will create a “company overseeing $2.7 trillion in assets—more than the Federal Reserve.”

To be fair, BlackRock told the WSJ that the company has “very strict policies and procedures in place to protect confidential client information and manage any potential conflicts of interest.” However, there's still potential for abuse if they get such a contract.

It's important to note that this is a severe strike against traditional ratings agencies, who have been increasingly viewed as major culprits in the recent crisis. However, I don't think the solution is to simply ignore them. Consider the fact, instead, that ratings agencies are for-profit institutions, which in and of itself raises conflicts of interest. A hypothetical: suppose JPMorgan goes to Moody's to ask for a rating on some assets they want to securitize. Moody's comes back with a bunch of poor grades. Well, Standard & Poor's could easily jump in with its own 'research', claiming they are able to rate the assets at a higher level which would allow JPM to create a more stable security, though in reality the assets are now of unclear strength. S&P, looking for customers, has every incentive to do something like this when regulatory enforcement is weak. That link has an SEC report about how much conflict of interest exists for ratings agencies, and how the SEC did absolutely nothing about it. All bark, no bite.
One possible solution (and I'm just throwing something out there) is for all ratings agencies (at least, all of the Big 3, or perhaps some combination of the Big 3 and other smaller firms) to be required to independently rate assets when any one of them is asked, and investors be required to use the 'average' of the three ratings. The problem there is increased cost to investors, but perhaps that would give investors incentive to do a little research of their own and not waste time on potentially risky assets. Does this make any sense?

Update: Good read from Fortune on the current state of affairs with ratings agencies.

Nice Update on SEC (Rakoff) vs. BoA

Last June, when Bank of America CEO Ken Lewis was asked by a U.S. House committee why the bank hadn't disclosed seemingly important information about its upcoming Merrill Lynch acquisition in a proxy statement last November, he had a ready response:

"I'm not a securities lawyer," he said. "I don't decide on disclosures."

...

But now, thanks to U.S. District Judge Jed Rakoff of Manhattan, the stonewall is crumbling.

...

SEC: We can't prove the individual executives did anything wrong because they tell us they simply delegated to their lawyers the task of handling the disclosure obligations.

Rakoff: Then go after the lawyers.

SEC: We don't know what the lawyers said, since the executives invoked their attorney-client privileges.

Rakoff: If the officers are saying they relied on counsel, they're automatically waiving the privilege. Plus, there's a crime-fraud exception to the privilege, so you could have asked me to order them to answer.

SEC: Not really. We haven't charged anybody with fraud. We just charged a lesser infraction -- filing a false proxy statement -- which does not require proof of a fraudulent state-of-mind, so the officers never had to formally invoke a reliance-on-counsel defense. Accordingly, neither the bank nor Merrill ever waived their attorney-client privileges either.

Rakoff: Why didn't you charge anyone with fraud?

SEC: We couldn't prove fraudulent intent.

Rakoff: Why not?

SEC: They said they relied on advice of counsel.

See why Rakoff got steamed?

This article is a great read on the status of the SEC vs. Bank of America case, mostly for that last segment on 'why Rakoff got steamed'. Hopefully, something will come of this. Transparency at the big banks, and on Wall St. in general, is badly needed. This also plays into a post on corporate governance I still need to do.