The ROI of Violating Environmental Laws

Is Pollution Value-Maximizing? The DuPont Case is a case study by Roy Shapira and Luigi Zingales that finds even a billion dollar fine for violating environmental laws can be cost-effective in creating shareholder value. This is what we have referred to as “the externalizing machine,” the corporate structure that makes it not just possible but inevitable that corporations will maximise the upside for executives and shareholders while imposing all of the costs on the government and the community.

DuPont, one of the most respectable U.S. companies, caused environmental damage that ended up costing the company around a billion dollars. By using internal company documents disclosed in trials we rule out the possibilities that this bad outcome was due to ignorance, an unexpected realization, or a problem of bad governance. The documents rather suggest that the harmful pollution was a rational decision: under reasonable probabilities of detection, polluting was ex-ante optimal from the company’s perspective, albeit a very harmful decision from a societal perspective. We then examine why different mechanisms of control – legal liability, regulation, and reputation – all failed to deter socially harmful behavior. One common reason for the failures of deterrence mechanisms is that the company controls most of the information and its release.

The authors conclude:

There are two clear findings in this case. The first one is that inefficient pollution pays off, even when a company anticipates all the legal consequences of its behavior. While the specifics are very case contingent, the reasons why pollution occurs are not. Regulation does not work because the penalties are too low and the regulators too captured. Legal liability does not work because victims find it hard to collect the information and sue. Even when – through a series of lucky circumstances – victims win the
legal battle, the penalty comes too late to deter pollution. Market discipline in the form of reputational sanctions cannot operate given the asymmetric information, and the inability of academics and journalists to certify and widely diffuse opaque information. Even when bad news breaks, the company can still maneuver to reduce attribution of responsibility and mitigate any reputational damages.

The second finding is that the main way corporations succeed in reducing their expected liability is by suppressing and distorting information.

The only way to begin to address this balance is to ensure that incentive compensation is reliant on meeting or exceeding environmental standards and debarring board members of companies that pay multi-million dollar fines from serving on public company boards.

Building a Better Board Book

The first question we like to ask directors is about the quantity, quality, and timing of the information they receive from the company. The late Tom Wyman, who served on the General Motors board in the 1990’s, told us that the board materials were delivered “by forklift” but the board agenda never included time for questions or comments. More recently, complaints about over-emphasis on compliance rather than risk assessment and strategy have led to concerns that board briefing materials miss the forest for the trees.

A new analysis by Alex Baum (Value Act Capital), David F. Larcker (Stanford Graduate School of Business), Brian Tayan (Stanford Graduate School of Business), and Jacob Welch (Value Act Capital) assesses the current state of board books and suggests improvements.

The six significant shortcomings they identify are:

Data lacks important context

Data focuses on results (outputs) rather than drivers (inputs)

Data does not inform organic (P&L) investment decisions

Unexplained outperformance is insufficiently investigated

Accounting allocations obscure true economics

Data does not match a manager’s sphere of responsibility

The authors note:

Having access to appropriate data is critical to making sound
decisions on strategy, compensation, and capital allocation.
However, evidence suggests some directors do not receive the
information they need on important drivers of the business. In
general, what is the quality of information that public company
directors receive? Is it sufficient to make optimal decisions? If
not, how widespread is this problem? In situations where the
quality of data is lacking, what discussions should the board
use with management to improve information quality and
presentation?

Toshiba Listing Tests Ability of Tokyo Stock Exchange to Protect Investors

The Nikkei Asian Review writes that the recent decision to allow Toshiba to continue to be listed on the Tokyo Stock Exchange — by a single vote — raises questions about its ability to protect investors.

The TSE’s philosophy on how to handle corporate wrongdoing has changed considerably over the past 15 years. When Seibu Holdings unit Seibu Railway and cosmetics maker Kanebo were kicked out in 2004 and 2005, punishment was seen as the best way to protect the principles of the market, and delisting was often the first response to severe infractions. But shareholders did not take kindly to the strategy. On top of a sliding stock price, delistings robbed them of the opportunity to trade their shares at all, the argument went.

The exchange now does all it can to avoid giving companies the boot, instead supporting their rehabilitation. The “securities on alert” system was introduced in 2007 as a means of enforcing regulations without imposing undue harm on shareholders, giving companies a period of time to turn themselves around under the bourse’s supervision — 18 months, under the latest rules.

While the designation limits such activities as fundraising, shareholders can continue to trade. Major companies with the resources to make improvements “hardly ever end up delisting,” a former Financial Services Agency official said.

Toshiba pushed limits of TSE’s rehab regime

Improving Corporate Governance and a Strong Free Press are Essential for Emerging Economies

At the Dubai Global Financial Forum, Arif Naqvi, who heads the region’s largest private equity firm, Abraaj, said that the term “emerging markets” (EM) should be replaced by “global growth market.” But he emphasized that:

“The only sense in which they [emerging markets] are still emerging is in terms of governance and transparency,” he declared.

He explained that corruption, lack of transparency and a general refusal to “play the game” by EM corporates had affected the view of western and other investors, and resulted in lower valuations, higher risk assessments and a reluctance to commit capital on the part of big western investors used to their own, generally much higher, standards of governance.

Some experts now argue that governance, or rather the lack of it, is a far more important investment criterion than geography or industrial sector. A well-run, transparent company will always carry an investment premium for big western investors, regardless of where it happens to be in the world, or what business it is in.

Executives of EM companies regularly pay lip-service to the need for better governance, and in some cases actually implement policies — codes for financial reporting, remuneration and recruitment — that might facilitate it.
Corporate governance, or lack of it, may be a better guide in determining what constitutes an emerging market rather than geographical location in the modern investment world.

But the problem stubbornly remains, and the most significant factor that remains behind virtually all cases of the EM discount is simple: Government control and interference.

Emerging media necessary to help ensure global standards of corporate governance

Center for Political Accountability: Rise in Mutual Fund Support for Shareholder Resolutions on Political Contributions

The Center for Political Accountability reports that mutual funds are increasing their support for shareholder resolutions calling for companies to disclose information about their political contributions.

Support by mutual funds for the Center for Political Accountability’s corporate political disclosure resolution jumped significantly in 2017, to 48 percent from 43 percent in 2016, according to an analysis by Fund Votes.

The analysis also found that abstentions decreased from five percent to three percent, indicating a shift toward more active support for political
transparency in the first year of Donald Trump’s presidency….Among 20 of the 23 largest asset managers globally, average support for the CPA model
resolution was 37.3 percent, based on 22 resolutions filed. This represents an increase of more than six percentage points from 2016 when average support was 31.1 percent, based on 27 resolutions filed. In addition, more fund groups participated in voting on the resolutions with abstentions decreasing by an average of eight percentage points from 11.5 to 3.4 percent.

As has been the case in previous years, the biggest fund groups remained the biggest laggards. Vanguard, Fidelity, BlackRock and American Funds continued a nearly unbroken record of voting against or abstaining on corporate election spending disclosure resolutions. Average shareholder support also dropped slightly from 33 percent in 2016 to 30 percent in 2017.

Report: Conflicts of Interest on the FINRA Board

Ann Marsh of Financial Planning says that a new report documents conflicts of interest on the FINRA board, the self-regulatory body with jurisdiction over financial services.

A new report by a group of securities arbitration attorneys calls into question FINRA’s ability to protect investors given alleged conflicts of interests on its board.

The report was issued Wednesday morning by the Public Investors Arbitration Bar Association, whose members represent investors in legal disputes with FINRA member firms. The group raises concerns about five of FINRA’s 13 public governors and one recently departed governor who now sits on the Federal Reserve’s Board of Governors.

FINRA’s board is comprised of 24 members. Among them, 10 have open industry ties consistent with the nonprofit’s public-private status as a self-regulator of the financial industry. Another 13 seats are designated to public members, intended to represent investors. The remaining seat is for FINRA’s CEO.

VEA Vice Chair Nell Minow was quoted:

“It’s just a disgrace,” says corporate and nonprofit governance expert Nell Minow. “These conflicts of interest are a monstrous issue. It destroys any credibility that the organization has at all.”

Minow, who is vice chairman of ValueEdge Advisors in Portland, Maine, was not involved in PIABA’s report. “This is exactly the reason that we don’t like to see industries regulate themselves,” she says. “Normally it takes a government agency at least a generation to become completely captive to industry. But in a self regulatory system, it takes five minutes….”This is not the fox guarding the henhouse,” she says of FINRA’s governance issues. “This is the fox eating all the hens.”

Performance-Based Compensation May “Die” Under the Tax Cut Legislation

An amusing but telling “obituary” for performance-based compensation by Dan Walter outlines the consequences of doing away with the tax benefits for pay linked to stock price increases.

The proposed tax reform bill of 2017 would eliminate many of the time-tested and successful components of equity compensation, effectively removing one of the three legs of many companies’ three-legged stool of compensation philosophy.

Under the proposed rules:

Appreciation vehicles such as stock options and SARs would be taxed at vesting, instead of at the time of exercise. This would effectively shorten their useful lives from potentially 10 years to perhaps 4 or 5 years. It would also make the use of these tools for pre-IPO or other illiquid companies too risky to be a recommended practice.

Full value vehicles like RSUs, would be taxed much as they are today, but with far less flexibility in deferring income or linking vesting to performance conditions.

Performance vested awards would be taxed immediately, instead of at the time of performance achievement and associated vesting. While these are currently investors’ preferred tool for executive long-term incentives, the change in taxation would make them a punitive form of pay beginning in 2018.

It appears that all outstanding equity would be subject to these rules as of January 1, 2018. This would result in changes for both companies and employees that would include the death of long-term motivation and retention tools, immediate taxation for employees, acceleration of expense associated with all equity-based incentives and much, much more.

Presumably, cash bonuses tied to financial metrics or other performance goals would still be available.

Judge Allows Shareholder Suit Against Wells Fargo Directors to Go Forward

A shareholder suit against the directors of Wells Fargo for negligence and complicity in the creation of millions of fake accounts for the fees has survived an effort at dismissal, raising the possibility of a very rare ruling of liability for board members.

[Judge John Tigar] found the complaint properly laid out evidence showing executives and directors made false statements about the scheme in the bank’s filings to the U.S. Securities and Exchange Commission…Tigar found the bank’s board members and managers knew about the illicit account-creation scheme by 2014 and also knew they’d made false statements in securities filings about the program, designed to bump up bonuses for Wells Fargo employees.

“Just as it is implausible that the director defendants were unaware of the account-creation scheme given the extent of the alleged fraud and the number of red flags, it is implausible that Wells Fargo’s senior management, involved in the day-to-day operations of the bank” weren’t aware of the effort, the judge said.

See full article on Bloomberg

Gretchen Morgenson: 20 Years of Corporate Governance

In her last column for the New York Times, Gretchen Morgenson summarizes the best and worst and most improved of the corporate governance issues she has reported on, quoting VEA Vice Chair Nell Minow:

Nell Minow is a corporate governance expert and vice chairwoman at ValueEdge Advisors, a firm that guides institutional shareholders on reducing risk in their portfolios. She has been rattling cages in the governance field since the mid-1980s and says she’s seen a definite improvement in boardroom makeup and practices.

“When I started in this field, O. J. Simpson was on five boards, including the audit committee of Infinity Broadcasting,” she recalled in an interview. “And at another company, the C.E.O.’s father was on the compensation committee. We’ve come a long way.”

That’s not to say that problems arising from sleepy and clubby boards have been eradicated. “Exhibit A is executive compensation,” Ms. Minow said. “The first C.E.O. pay package I ever complained about was $11 million. The very fact that that has gone completely berserk shows that boards are still a long way from where they should be.”

Cardinal Health Agrees to Shareholder Proposals

With Cardinal Health’s surprise announcement early Monday that it will separate the roles of chairman and CEO and fill the chairman position with an independent director, the Teamsters claimed victory in their push to get the company to do that.

“Cardinal Health’s announcement of leadership changes ahead of Wednesday’s shareholder meeting demonstrates the strength of a growing investor movement led by the Teamsters to hold America’s largest drug distributors accountable for their role in fueling the opioid epidemic,” said Ken Hall, general secretary-treasurer of the Teamsters, in a statement Monday.

“The bar has been set — no more business as usual. Cardinal’s decision to appoint a new CEO and transition to an independent board chair, as demanded by the Teamsters, signals that our message for strengthening corporate governance and setting a new tone at the top is getting through.”

Teamster-led Group Persuades Cardinal Health to Make Governance Changes