Side Note: As this my first blog on the site, before I am dismissed as someone who is on a ‘fairness’ rant and who does not think that CEO’s and boards should be able to make a lot of money - I am not that person. Anyone who knows me knows that I encourage and celebrate people with the initiative to earn as much money as they possibly can. However, the key condition in my beliefs is that the money is “earned” - which means that rewards are reaped from an individual's efforts which have in turn improved the value to the firm, rather than being derived from ‘creatively’ harvesting the infused wealth of the firm's shareholders.
Retrospective: When we look back on the last 10 years my partners and I can readily recall examples of the wonderfully ‘creative’ enrichment schemes used to move shareholder value into personal piggy-banks - a couple of high- (or more accurately low-) points come to mind.
- The first is ‘Options Backdating’, which thankfully Paul Hodgson in his prior life played a pivotal role in putting to an end, was dramatic in how its creative simplicity too the markets by surprise. It was a burgeoning practice when it was uncovered with the help of governance research which not only shed the light on the issue but also discovered how effectively the leadership networks were in quickly spreading this money-making practice throughout the system. It was the system’s perspectives applied on researching the issue coupled with the rapid stakeholder dissemination of the findings, and of course the many legal suits that followed, that helped to effectively put an end to future opportunities for this type of ‘creative’ enrichment.
- And our second example was the Chesapeake Energy case, we agreed that this case easily made the list of our top ten imperial CEO situations. Chesapeake one of the most memorable cases where, in our past lives, members of our firm undertook first hand research to uncover a highly creative leveraging of power and process. The deeply networked related contracts and incestuous transactions tied to a supportive board were overlooked by those stakeholders who had taken a more complacent and less informed view of governance risks. Thankfully not all stakeholders were complacent and some were willing to dig deeper and uncover the root of the situation and the cause of the resulting drain of the shareholders' wealth.
So Problem Solved?: The shareholder outcry and subsequent lawsuits around cases such as Chesapeake and the Option’s Backdating debacle drove demands for reform and increased vigilance: And the silver-bullet governance-risk solution was again sought and the search gained renewed vigor following the global markets collapse. And with the noise around Dodd-Frank you might have thought that we have made major strides towards that silver-bullet. Through this piece of legislative heroics we now have additional regulatory safeguards such as shareholder say-on-pay initiatives and the soon to arrive relative CEO pay ratios (which deserves another posting entirely) and lots of shiny new rules and regulations. With these new legislative oversights one might think that the likelihood of the recurrence of these ‘creative’ risks is greatly diminished and that the market’s eyes are now wide-open and watchful to prevent similar situations from ever happening again…
Well to be fair, these and other changes have or may in the future tip the scale a bit closer to balance with respect to those firms who want to play by the rules; however, as with any legislation it is only those who care about rules that tend to be affected. However, despite our best efforts we can always count on is the resilience and creativity of the human spirit to enable a determined soul to find an unguarded end-run to achieve their goal. So while many are distracted by the feint to the right caused by the 'security' of these new legislative barriers, it is still ever important to scan the field to see the less visible but identifiable left-side end-run opportunities that the very few but very active fringe of creative CEO’s and their boards will find a new way to raid the shareholders’ coffers.
Current State of Creativity: So in keeping vigilant it may be good to be aware of some of the end-runs that are still employed. One top of mind activity that is done in plain sight but often overlooked is the ever popular practice of Excessive Optioning with the added plus of their being provided with little or no real performance targets. Another great opportunity for ‘creativity’ but which may often get overlooked are the excess and unearned rewards that can be reaped from mergers, acquisitions and service contracts. When the dollar value of transactions are massive it only takes a slight tip of the scale to produce dramatic results for the ‘creative at heart.’ Transaction-tied related party issues, captured boards and the lure of ‘creative’ windfall returns often make the approval of shareholder-value diminishing conditions too attractive to pass up. Some of these are easy tells for those vigilant investment activists and plaintiff’s firms who remain the strongest advocates of shareholder value - but more often than not these flags are hidden in the firm’s core governance attributes and disclosures that remain hidden until well after the damage is done.
So where does the market now stand with respect to these ‘creative’ activities? I did a quick review of recently announced plaintiff firm investigations and derivative cases to use as a simplistic measure of perceived creative efforts - that is those that have been caught. Using generic search catchalls of “Alleged Wrongdoing” and “Breach of Fiduciary Duty”, found around 40 new cases in the past six months that focused on M&A or CEO relationship related activities as the core issues driving these complaints. In the majority of the cases we reviewed the key due diligence of the board in crafting an agreement or the CEO’s relationship to a transaction were in question. Arguably many of these cases might be fueled simply by a shareholder’s 'splitting-hairs' disagreement with the transaction value set by the board: a matter for the finance crowd to deal with. However, in some cases when we dig deeper into the governance and compensation structures and the leadership and board systems we find that there is real cause for action. In fact, our current research efforts to support plaintiff firms have identified at least two current cases which on the surface used the same playbook as Chesapeake – and to our concern on the surface appear to be seen as having done so in a perfectly legal way given the existing governance structures: Where were the vigilant stakeholders when these structures were put in place?
Conclusion: These situations and others point to the importance investors being of not only vigilant but in undertaking a deeper level of informed vigilance. Whether they are undertaking engagement or litigation, to be effective in these types of situations the shareholder proponents must be willing and able to identify and isolate the underlying ‘creative’ conditions or activities that allowed the real harm to occur.
So on a positive note we take heart in the fact that our deeper dives into finding the governance based outliers can help identify the causal factors in the ‘creative’ board system which may in turn provide the means to undo these wrongs. However, without stakeholder involvement in finding these issues before they result in shareholder harm, the situation will continue and ‘creativity’ will thrive.