The Recipe for Agent Orange - The Projection Racket, Pt. 3
December 1, 2022·27 comments·epsilon theory archive
Public company directors are legally required to serve shareholders. Yet the structures meant to enforce this have become the mechanism through which executives systematically extract value from capital. The gap between what we're told these systems do and what they actually do has widened so much that the institution itself is now defended as the instrument of its own exploitation.
• Airline CEOs pulled $1 billion in stock compensation while flying their companies into bankruptcy, yet the board structures and compensation frameworks that permitted this are treated as proof the system works. The correlation between executive pay and shareholder returns is essentially random, yet we keep insisting the system has teeth.
• Delaware duties, the legal bedrock of shareholder protection, don't actually require directors to maximize shareholder value. They require directors not to egregiously violate standards of care compared to other directors. One is a positive obligation. The other is a permission structure.
• Directors benefit most by keeping management happy and keeping their own board seats flowing. A director maximizes personal value by opposing management as little as possible while staying within legal limits. This creates a system where constraint-satisfaction replaces value-maximization as the actual objective function.
• The narrative defenses are so effective that questioning them sounds like attacking capitalism itself. Terms like "aligned incentives," "market discipline," and "shareholder-friendly buybacks" have been embedded so deeply into the myth of free market capitalism that the structures they describe are now considered fundamental to it rather than corruptions of it.
• Institutional shareholders voting on executive compensation approve 92 percent or higher of all proposals, and their support drops only 0.5 percentage points even in years when executive pay rises while company performance collapses. The gatekeepers protecting capital have become the mechanism that enables its transfer to management.
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Comments
Wow - absolutely fantastic conclusions. B/C passive investing has become so large, their votes on proxy items need to be scrutinized more and they need to become more accountable. I really like the idea of more disclosure on SBC, but it might not go far enough b/c of the rampant corruption. Before 1982, buy-backs were illegal and considered manipulation. Until we make changes on how much capital is being used for SBC, stop buy backs all together for a time until better rules can be put in place. We also need to break some of these companies up and step-up efforts to do away with monopolies! Thanks Rusty great work! Brian
Analysis of the current situation was excellent, as usual. Your reform proposals seem entirely sensible.
But my reading of this series suggests that the real problem is that political forces have figured out how to successfully promulgate the narratives that convert the historic justification for governance rules into “yea governance!” and “yea share buybacks!” just as they used “yea college!” and “yea patriotism!” and “yea democracy!” to horribly warp other norms and institutions that once served the greater good. And figured out how to use that political power to totally capture the mainstream/business media so that they endlessly repeated the desired narratives and blocked awareness of any alternative views.
Even if initially enacted, don’t think reforms of this type could survive ongoing attacks from those political forces any more that similar reform efforts have any impact in areas such as tax law or antitrust enforcement.
The huge fund companies spent the ESG window-dressing bullshit era focusing on the ‘E’ and the ‘S’, and completely neglected the ‘G’, which is the only one that ever mattered.
Thanks for reading and thanks for joining the conversation, Brian! I, too, worry about the passive investors abdicating their duties most of all, but I don’t want to give the run-of-the-mill active long-only or hedge fund managers a pass, either. They have ignored this part of their work for far too long as well.
Once we’re back in a bull market, the ES-or-bust vibe will be back in effect. I don’t think there’s an environment where G matters again. Doesn’t do anything for anyone (except long-term value for shareholders, but who cares about that?).
Hubert, astutely observed, and the intractable problem of any BITFD proposal.
In this case, I do think that we benefit from the wonkishness of those who must be convinced. The exchanges are susceptible to narratives running against them, and the regulators do not like being on the wrong side of reputational risk. As @bhunt has observed, if we’re going to do this, it’s by creating our own effective narratives to make the dangers of these issues real to this narrow set of institutions.
As you point out, still no mean task.
Jack Bogle applauds.
Vanguard could fix a lot of this, but sadly neglects the responsibility that comes with its great power…
It’s part of the danger of seeing financial markets as a utility to deliver returns, I think. It blinds us to a lot.
Outstanding essay Rusty, made all the more compelling by your proposed remedies. Of them, it seems the most important would be the separation of Chairman and CEO - something that is required in many countries outside the U.S., and the clarification of stock-based compensation.
There is a reason many countries force the separation of owners and management, and there is no reason it cannot be the same here.
And on accounting: if one could plainly see how shareholders’ capital is going right back to insiders in the form of sterilization, then I think this racket would be over quickly. Outside shareholders, particularly active fund managers, would quickly see them as another expense.
The director limitations would be nice to have, though as you mention there are already some marketplace restrictions in place. The ‘say on pay’ clause would also be great for clarification purposes. But I think you would be over 90% of the way there with just the Chair/CEO split and clearer accounting standards.
The idea of a free lunch from indexing is likely to be another sacred cow that will be slaughtered by this bear market. The underpinnings were completely undone by negative interest rates and the valuations they allowed. While it seems obvious to active equity investors with any sort of valuation anchor in their investment process; indexing looked like a magic money machine with max monetary ease accentuated by emergency fiscal policy.
The math of losing money buying the $17 trillion bond pile that traded for negative yields at the global rate trough was obvious to everyone but those forced into those trades by indexing. Stocks always have the potential optimism that 40 multiples of pro forma revenue forecasts might turn out okay if the company invents a new category and gets all of the market share. But, the logic of buying the most of the most expensive securities fails the test of a secular bear market. The fact that the indexers did not exercise their vote with care either will be part of a change in that free lunch narrative.
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