Profiting From Corporate Governance 1/x

Non-GAAP, 2020-01-16

Some Theory

  • Dark arts: insiders profiting from something that’s legal but bordering unethical.

  • Practices evolve, and (for instance) nowadays options backdating is unethical and leads to scrutiny.

  • Dark arts: actions distorting the alignment between shareholders – Directors – managers to primarily benefit insiders by giving them disproportionate control and/or influence over the governance process.

  • Compensation is the telltale signal of the presence of undue influence because it drives company priorities and behaviours.

  • The idea of compensation is driving long-term shareholder value and aligning shareholders’ interests to the management’s. But when the dark arts creep into the compensation committee, priorities get distorted and best practices die.

Dark Actions

  • Committee members must be truly independent of the management and make independent (i.e. the ones that the management may not like) decisions. The most obvious dark action is compromising this independence by squeezing a bunch of cronies in.

  • Avoiding the emergence of “quid pro quo” (i.e. I scratch your back, you scratch mine) is actually very hard to tackle as favour trading is a natural part of human life. And compensation may just be one of these favours.

  • Compensation must reflect the long-term goals of the firm and be consistent with the defined criteria. [MK: I hate the term KPIs.] A dark arts specialist can provide their own set of metrics that can be manipulated via short-term actions (hence the metrics are likely to appear long-term but be short-term in substance) conflicting with the long-term goals of the firm.

  • Actively monitor and assess potential risks arising from the company’s comp practices and policies and disclose/mitigate them if necessary. But since you can only manage what you know, withholding information by the management makes the comp committee ignorant and unable to change course.

  • Chairman should be independent and control the agenda, timing and scope of the meetings. But the arguably most powerful person is the chair of the comp committee and if the one is not truly independent, this changes the Board’s power dynamics. Directors may not be able to push back due to the collegial nature of the Board functioning.

  • Equity grants must not “time the market” and be given after the release of material information that gets priced into the stock. Giving equity (size, time, type, schedules, etc.) while possessing information that can drive the price up [i.e. spring loading] is at the very least unethical.

Spring loading and Bullet Dodging

  • Spring Loading: giving equity grants prior to the disclosure of material news that is likely to positively impact the share price.  Quite obvious – this is the value stolen from shareholders via dilution.

  • Bullet Dodging: giving equity grants after the disclosure of material news that is likely to negatively impact the share price. It’s the unearned value by the shareholders.

  • As most grants work top-down (the target $ value of the grant is defined, then this value is divided by the share price as of the grant date), this is technically transparent and not illegal.

  • But what is truly telling (and many analysts are monitoring this) is the unusual timing of the grants and the terms of such grants. Out of the blue grants are a signal in themselves.

  • Spring loading and options backdating are in substance the same thing: insiders are in possession of material information and are trying to monetize this ability to create a discount option.

(more to come, I love Mike’s analysis)