January 4, 2007
Al Gore's Dilemma
Ex-Vice President (and perhaps soon to be second time candidate for President) Al Gore found himself recently in a nettlesome dilemma. He is an outside director of Apple Computers Inc. and chaired a three person subcommittee of the board investigating the company’s executive stock option practices.
An internal investigation by outside lawyers discovered in October that the company’s founder, CEO, and intellectual center, Steve Jobs, was involved in back-dating executive stock options. Other CEOs have been fired for such conduct, but the Apple is worth much more with Steve Jobs at its head than without.
The crime appeared to be victimless. Back-dating executive stock options permitted the company to hide from Apple shareholders $84 million in compensation expenses on its income statements over five years, but Apple shareholders, whom the disclosure rule is intended to protect, did not care. They overwhelmingly wanted to keep Jobs and forgive the technical disclosure violation. Moreover, new reporting laws adopted in 2002 have made options back-dating all but impossible – there is no danger of the infraction being repeated.
In other words, the stock price of Apple has been depressed by five percent or so since October not by the financial impact of back-dating but by the prospect of losing Jobs.
What to do? Chairperson Gore could chose to stonewall, mount a full, blown technical defense, relying on lawyers to use whatever legal maneuvers they had in their arsenal to blunt any prosecutions and civil suits. Eventually the company and Mr. Jobs, having worn down the opposition in over five years of litigation could settle for cash and little or no admission of wrongdoing.
Or Chairperson Gore could choose a mea cupla plea, baring all the facts for the world to see and throwing, literally, the company and Mr. Jobs on the mercy of the courts (more accurately, several courts and numerous prosecutors). Tough choice.
Too tough apparently for Vice President Gore. He chose a middle road – blame two other officers (the Chief Financial Officer and the Chief Legal Counsel) who are no longer with the company for the problems, admit that Jobs was involved but only minorly involved, and express “complete confidence” in Mr. Jobs. Bad choice. The incomplete admission will both encourage further digging by prosecutors and compromise the integrity of pleas for leniency in court.
The Apple report concluded that "[a]lthough the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications."
There are at minimum three problems with the conclusion. First, the report is very nonspecific about many, many important details in the option grants practices. Second, the only reason the report could claim that Mr. Jobs did not benefit from the tainted options is because his tainted options were canceled and replaced by five million shares of restricted stock, which he later sold for a cool $300 million. The reports use of the word “benefit” is very literal and technical. Third, Mr. Jobs as the CEO sets company policy, he cannot, by definition of his position, be minimally involved once he “recommend[s]” the practice.
Finally, readers of the report will note that the two tainted option grants that the report admits Mr. Jobs did receive each had some very unsavory aspects. The January 12, 2000 grant of 10 million shares was one of the biggest option grants in American business history and had an immediate positive value, hidden, of millions of dollars. The second tainted option grant in October of 2001 came from a completely fabricated board of directors meeting. The board minutes were counterfeited. Faking board meetings took the scam to a whole new level.
Vice President Gore was in a tough spot. Both avenues he could have taken had substantial risks in exchange for the desired outcome, but the intermediate avenue he took accepted the maximized and cumulated the risks from both choices. Jobs and Apple, and Gore himself perhaps, may come to regret this transparent effort at waffling damage control. The truth is inconvenient.
Nardelli Exit Package
Once again we have a mediocre CEO leaving a company and enjoying an obscene severance package. Nardelli was paid $64 a year for six years and did poorly with his company when he should have done well, the market in home improvement was booming while Home Depot languished. On exit he receives another $210 million (another $34 million per year on the job). It is another "Holy Cow, did we vote for that??" moment for the Home Depot outside directors. The outside director who headed the board's compensation committee had multiple other jobs. The insiders, Langone et al., and their counsel, Marty Lipton, know the game and have played it before (both teamed up to get Grasso $140 million severance package from the NYSE). What did the outside directors understand of the deal? Of course, just as in the NYSE and Disney cases, the outside directors will publicly note that they knew what they were doing. As I have noted in my discussion of the Disney case, the compensation committee should be able to show in its minutes a table of projected payments based on potential future terminations for the claim of approval with knowledgeable to be credible. Somewhere in the minutes of the compensation committee, on the date Nardelli's salary package was approved, should have been a calculation of Nardelli exit payments based on a termination in say, five years.
SEC and Market Data Fees
The SEC is reviewing its rule that the NYSE Group can charge for the distribution of quotes on its Arca electronic exchange. Insiders to the trading markets know how important this is; to the rest of the country it is a just technical side of the trading business that desired little attention. The insiders are right. With consolidation of our securities trading exchanges (and markets) there is new focus on how those exchanges charge for their services, particularly since many of the exchanges and markets are now for-profit corporations. The SEC has taken its traditional approach to the problem -- the wrong approach-- and viewed the regulation situation as akin to regulating a public utility. In other words, the SEC approves any rates charged. The calculation of proper rates has always been extremely difficult in the past and will become more so. The markets want a rate of return on their costs, other data providers, such as Google, want free or low cost access to data, investors want free or low cost access to data. These fee decisions, when they come up, attract significant comment and, whatever the SEC's decision, stretch the SEC's ability to rationally justify its rulings. The SEC should just get out of this business, let the markets charge whatever they want, and let market participants choose among markets based on the fees (and other aspects of the trading service). Exchanges that charge too much will suffer as competitors who charge less will attract a wider distribution of their quotes and therefore more trading on their markets. The SEC needs to get out of the micro-management of the details of our securities trading markets. [See Release No. 54597 and Petition for Commission Review].
January 2, 2007
Private Equity Lessons
The success of private equity fund buyouts should raise questions about public firm governance. Here is a too common story. A publicly traded firm hires a CEO with a "golden hello" and the performance languishes. The CEO is paid handsomely regardless. A private equity firm appears, triggers the CEO's "golden parachute," pays the CEO "consulting fees" and other inducements, and buys the company or a part of the company for a "premium" over market trading price, all with the CEO's blessing. The fund releverages the capital structure and streamlines operations and then resells to the public a few years later for a substantial profit (sometimes tripling their money!). (Hertz and Vivendi are examples that come to mind.) The troublesome question: Why are the assets not better managed in the hands of the public firm managers for the benefit of the public firm shareholders? Is the agency cost in publicly traded firms as large as is suggested by the profits of private equity funds? Or have the private equity funds just picked the low hanging fruit? If the problem is endemic, where have regulations failed? Henry Manne argues in todays WSJ that we have over regulated takeovers. Others argue that we have under regulated public company managers. It does suggest that our fixation on executive salary excess is a drop in the bucket compared to losses due to sloppy management of many of our publicly traded companies.
New Wall Street Journal Format
With much fanfare, the Wall Street Journal published today its first "new look" edition. The paper is smaller, snappier, and have better section first page summaries. What is most of interest is the paper's heavy integration with two on line sites, WSJ.com, and WSJMarkets.com. I now seemingly must read the paper in front of a computer terminal to get the full benefits of the change. Will this save the printed version or just be a step in a final transition into a full on-line paper (with a printed version done as a supplement for market coverage)? I suspect the latter. It is the building of the useful websites that is the real value here.
Hedge Fund Paranoia
The New York Times is, well, amazing. In a front page, column one, article by Jenny Anderson ("Deals by Banks and Hedge Funds Raise Questions") the story is on how banks, that loan money to hedge funds, often also rent space and services to hedge funds (UBS runs a "hedge fund hotel"). This "concerns" regulators. Why? Banks are just providing a business service and may use a lower rent to attract other business connections -- just as milk prices can be a loss leader in grocery stores. This is not illegal. Ms. Anderson then links the "problem" to, first, soft dollars, and second, to front running in trading. On soft dollars, not all hedge funds use them to pay rent, and even if they do it is not a market problem unless the soft dollar returns do not benefit the fund itself (as opposed to the personal pecuniary interests of the managers) and the fund's investors do not know of the leakage. Paying rent would seem to be a fund expense. At the very end of the piece Ms. Anderson acknowledges that several of the large investment banks do not think renting space makes business sense and do not do it.
The more obvious move in the article is to mention hedge fund front running in the middle of the piece -- what does this have to do with renting space?? Nothing. Hedge funds are traders and those that front run should be prosecuted. There is no evidence that they front runner more or less than other groups of traders.
At the end of the piece she throws in a description of the "prime brokerage" business, banks that provide a variety of financial services to hedge funds. Here there is a potential problem but she does not discuss it. At issue is whether the prime brokers are overexposed to hedge funds risk, whether the brokers have risk limits and controls in place that are sensible. Several officials in the Federal Reserve have given speeches on the issue before banks asking for careful lending practices that accurately assess risk. At the core of the controversy is our belief in the integrity of our banks. Will our banks, independent actors from the hedge funds, price accurately the risks they take when they deal with hedge funds? There is no reason to believe that, on average, they do not and will not.
The article is a mess. Throw in a rambling description of legitimate business deals, add a dose of insider trading, and imply that the entire hedge fund industry is corrupting our banks. It plays on hedge fund paranoia, apparently to the delight of the New York Times daily editor.
We need to relax. Hedge funds, on average did not have a great year. Their returns, on average, did not match the popular indexes. The bloom is off the rose on the industry and investors are getting much more savvy on selecting among the funds.
January 1, 2007
Judge Selection Economics: Business Suffers
The Chief Justice's Annual Report, issued Sunday, contains facts that demonstrate the economics of judicial selection. First, federal judges are leaving the bench, not retiring, in increasing numbers. Seventeen have left the bench in the past two years. While Chief Justice Roberts worries about these numbers his concerns seem overblown. This is not a large number, given the number of federal judges on the bench. Many judges leave to engage in for-profit arbitration groups. The low number leaving is also explained, in part, by the second fact. Second, and more significantly, is the claim that fewer and fewer federal judges come from private practice. Only forty percent of the new district court judges come from private practice, although, and, I am guessing here, well over 80 percent of all licensed lawyers are in private practice. Judges come from the public sector or from law schools. Judges are no longer the cream of the private bar. The salary differential from private practice to a judge's salary is just to great. The selection of judges will, of course, reflect a functional and political slant on how the judges decide cases. I would suggest, subject of course to ridicule, that this explains why many judges are so unsympathetic to context and culture of doing business in the United States. Judges too often, with the best of intentions, do not and perhaps cannot reflect on or predict the effect of their decisions on the rigors of doing business (both on the operating side and the capital raising side) in a competitive environment.
December 31, 2006
$36 Billion Buyout
I should not end the year without mentioning the largest private equity buyout in history, the $ 36 billion purchase of Equity Office Properties Trust by Blackstone Group in November. Blackstone is betting that commercial real estate prices have bottomed and will rebound and is using cheap debt to buy the company. A deal like this makes me wonder whether our debt markets are artificially valued because the Fed is retarding interest rates. At some point this policy, now stimulating borrowing, will produce bite back.
$5.4 Billion Real Estate Deal
Tishman Speyer properties bought 80 acres of apartment buildings in Manhattan for $5.4 billion, the most expensive real estate deal presently recorded in absolute dollars. The price far exceeded any reasonable multiple on revenue (rent). One possible inference is that the new owners are gambling on loosening or avoiding the New York rent control laws, that the deal is regulatory arbitrage.