I have been reading with great interest William Caferro's biography John Hawkwood: An English Mercenary in Fourteenth-Century Italy. It interests me both because of my longstanding interest in military history and because, as Caferro notes:
Mercenary bands were corporate in structure. The captain stood at the head of his brigade in a manner similar to the way a modern CEO stands at the head of his firm. When the captain decided to leave, the company did not disband but retained its name and elected another man. (Kindle Locations 1511-1513).
And here's a really interesting fact about those companies: the most famous and successful condottieri got paid a very substantial multiple of what the common soldiers made.
The famous Italian mercenary Giovanni d’Azzo deli Ubaldini earned an impressive salary of 500 florins a month in Sienese service in 1381. But his cavalrymen earned only 6 florins a month .... (Kindle Locations 1665-1667).
Granted, a multiple of 83 to 1 is lower than the multiple earned by many of today's top CEOs. But it's still a very dramatic difference.
What's going on here? There are two basic theories of executive compensation: managerial power and arms'-length bargaining:
The so-called principal-agent problem arises because agents who shirk do not internalize all of the costs thereby created; the principal reaps part of the value of hard work by the agent, but the agent receives all of the value of shirking.
Although agents thus have strong ex post incentives to shirk, they have equally strong ex ante incentives to agree to contractual arrangements designed to prevent shirking.Wherever a principal-agent problem is found, we thus expect to see a mixture of carrots and sticks designed to constrain shirking. The sticks include ex post sanctions, up to and including dismissal. The carrots include incentives that align the agent's interests with those of the principal.
In theory, these divergences in interest can be ameliorated by executive compensation schemes that realign the interests of corporate managers with those of the shareholders.
Stephen M. Bainbridge, Book Review Essay Executive Compensation: Who Decides?, 83 Tex. L. Rev. 1615, 1620 (2005), reviewing: Pay without Performance: The Unfulfilled Promise of Executive Compensation, Cambridge, Ma: Harvard University Press, 2004. Pp. Xii, 278. $24.95. (Draft available here.)
In the arms'-length model, "compensation schemes are claimed to be 'the product of arm's-length bargaining' between managers 'attempting to get the best possible deal for themselves and boards seeking to get the best possible deal for shareholders.' As a result, financial economists loyal to the arm's-length-bargaining model assume compensation schemes are generally efficient, while courts generally defer to decisions by the board of directors." Id. at 1623.
In contrast, the managerial power model claims that:
... boards of directors--even those nominally independent of management--have strong incentives to acquiesce in executive compensation that pays managers rents (i.e., amounts in excess of the compensation that management would receive if the board had bargained with them at arm's length). The first of these incentives flows from the fact that directors often are chosen de facto by the CEO. Once a director is on the board, pay and other incentives give the director a strong interest in being reelected; in turn, due to the CEO's considerable influence over selection of the board slate, directors have an incentive to stay on the CEO's good side. Second, Bebchuk and Fried argue that directors who work closely with top management develop feelings of loyalty and affection for those managers, and they become inculcated with norms of collegiality and team spirit that induce directors to go along with bloated pay packages. (Id. at 1624-25)
The net effect of managerial power is that CEO pay packets are higher than would obtain under arm's-length bargaining and less sensitive to performance. (Id. at 1626.)
A condottieri's pay ought to be the product of arms'-length bargaining rather than managerial power. In the first instance, the condottieri's pay is set in the condatta (the contract between the city-state employer and the condottieri), which presumably is negotiated more or less at arms' length (of course, the condottieri has a considerable degree of bargaining power in the form of the military band at his disposal).
In the second, unlike public corporations where the owners of the business are dispersed and relatively powerless, the condottieri is elected by his employees. In theory, employee ownership should obviate the agency cost problem that drives up CEO pay.
Interestingly, however, the modern evidence suggests that employee owned enterprises should have much lower ratios of CEO to worker pay. In the famous Mondragon cooperative, the permissible ratio of the highest paid to lowest paid employee has gradually risen but only to 8.91 to 1. (Jones, D. C. 2013. The Ombudsman: Employee Ownership as a Mechanism to Enhance Corporate Governance and Moderate Executive Pay Levels. Interfaces, 43(6): 599-601.)
Why then did the condottieri's pay so greatly exceed that of the common soldier? One likely explanation is the tournament theory of executive compensation.
As the story goes, tournaments are a mechanism for reducing agency costs by providing incentives through “comparative performance evaluation.” In a promotion tournament, the principal ranks its agents by their performance relative to one another. The best performing agents are promoted to positions with higher pay and/or status.
Stephen M. Bainbridge, The Tournament at the Intersection of Business and Legal Ethics, 1 U. St. Thomas L.J. 909, 911 (2004). (Draft available here.)
Caferro's book offers some support for this hypothesis:
The pay structure provided obvious financial incentive for cavalrymen and officers to seek advancement to the leadership of companies. (Kindle Locations 1673-1674).
But why would the common soldier tolerate the vast disparity in pay? What did the common soldier get out of working for a condottieri who made more than 80 times what he did? Interestingly, Caferro informs us that:
There was surprisingly little connection between the wages of cavalrymen and those of the captains for whom they worked. Service for a renowned mercenary did not result in higher pay. The famous Italian mercenary Giovanni d’Azzo degli Ubaldini earned an impressive salary of 500 florins a month in Sienese service in 1381. But his cavalrymen earned only 6 florins a month, the same as those in the employ of the obscure mercenary Riccardo Dovadola, whose own monthly stipend was 24 florins.
But it turns out that soldiers in the mercenary companies were not paid by salary alone:
The appeal of working for a well-known captain lay in his ability, through victories, to bring earnings beyond salaries in the form of spoils of war and, perhaps, through his reputation, to increase the likelihood that an employer would pay wages he promised. (Kindle Locations 1664-1669).
So it turns out that the winner of the tournament does have coattail effects on those below him in the hierarchy.
I'm not sure if this has anything to do with modern corporation CEO pay, but it does suggest new ways of thinking about CEO pay in workers cooperatives, employee-owned corporations, and maybe even law firms.
As the once proudly classically liberal Economist morphs into progressive liberalism, we are seeing more of this sort of nonsense:
A paper in the January issue of the Accounting Review suggests ... that the companies which do the most CSR also make the most strenuous efforts to avoid paying tax—and that those with a high CSR score also spend more lobbying on tax.
Surely CSR depends on the idea that firms have an obligation to society, not just to shareholders? And surely the most basic obligation to society is to pay the taxes that support the poor and vulnerable?
Piffle. Since they say a picture is worth 1000 words, suffice it to say that:
This is interesting:
Political activism positively affects firm innovation. Firms that support more politicians, politicians on Congressional committees with jurisdictional authority over the firms’ industries and politicians who join those committees innovate more. We employ instrumental variables estimation and a natural experiment to show a causal effect of political activism on innovation. The results are consistent with the hypothesis that political activism is valuable because it helps reduce political uncertainty, which, in turn, fosters firm innovation. Also consistent with this hypothesis, we show that politically active firms successfully time future legislation and set their innovation strategies in expectation of future legislative changes.
Reza, Syed Walid and Ovtchinnikov, Alexei V. and Wu, Yanhui, Political Activism and Firm Innovation (December 14, 2015). Available at SSRN: http://ssrn.com/abstract=2703365
Eric Rasmussen notes that:
I just read about Freedman v. Adams, 2012 Del. Ch. LEXIS 74, at *45-46 (Del. Ch. Mar. 30, 2012) at Taxprof and the original discussion by Prof. Hemel at the Chicago Law blog. It's a good example of a corporate law case, the kind of situation good for an exam, perhaps. Part of it is about whether the shareholder plaintiff should get a million dollars in "legal fees" (quantum meruit would be vastly smaller, another issue) because the directors paid unnecessary taxes by using a thoughtless compensation plan.
I wrote a long post on this issue back in 2012.
Anne Tucker Anne Lipton writes:
The Pep Boys – Manny, Moe & Jack (NYSE: PBY) merger triangle with Bridgestone Retail Operations LLC and Icahn Enterprises LP is proving to be an exciting bidding war. The price and the pace of competing bids has been escalating since the proposed Pep Boys/Bridgestone agreement was announced on October 16, 2015. Pep Boys stock had been trading around $12/share. Pursuant to the agreement, Bridgestone commenced a tender offer in November for all outstanding shares at $15.
Icahn Enterprises controls Auto Plus, a competitor of Pep Boys, the nation's leading automotive aftermarket service and retail chain. Icahn disclosed an approximately 12% stake in Pep Boys earlier in December and entered into a bidding war with Bridgestone over Pep Boys. The price climbed to $15.50 on December 11th, then $17.00 on December 24th. Icahn Enterprises holds the current winning bid at $18.50/share, which the Pep Boys Board of Directors determined is a superior offer. In the SEC filings, Icahn Enterprises indicated a willingness to increase the bid, but not if Pep Boys agreed to Bridgestone's increased termination fee (from $35M to 39.5M) triggered by actions such as perior proposals by third parties. Icahn challenged such a fee as a serious threat to the auction process.
Regardless of which company ends up claiming control over Pep Boys, this is a excellent example of Revlon principles in action and also shows the effect of merger announcements (and the promised control premiums) have on stock price.
Which raises the question: If Icahn sued, would Pep Boys' increased termination fee (standing alone) violate Revlon? I don't think so. Pp Boys has 55 million shares outstanding. At $18.50 per share, the deal currently has a value of $1,017,500,000. A $39.5M termination fee thus is only 3.88% of the deal value, which is well within the range courts have approved.
In the corporate world, termination fees are a common and generally accepted method to “reimburse the prospective purchaser for expenditures incurred in pursuing the transaction.” Gray v. Zondervan Corp., 712 F.Supp. 1275, 1276-77 n. 1 (W.D.Mich.1988).Cancellation fee provisions typically require the [seller] to pay the bidder a specified dollar amount. * * * [T]he fee ordinarily ranges from one to five percent of the proposed acquisition price. A cancellation fee reduces the risk of entering a negotiated merger by guaranteeing the initial bidder reimbursement for the out of pocket costs associated with making the offer and, in some instances, for the bidder's lost time and opportunities. Accordingly, they are increasingly common in negotiated acquisitions.Stephen M. Bainbridge, Exclusive Merger Agreements and Lock-Ups in Negotiated Corporate Acquisitions, 75 Minn.L.Rev. 239, 246 (1990).
St. Jude Med., Inc. v. Medtronic, Inc., 536 N.W.2d 24, 27 (Minn. Ct. App. 1995).
To be sure, while Delaware courts have "upheld termination fees of greater than three percent of total deal value," the courts have also made clear that "[t]hough a '3% rule' for termination fees might be convenient for transaction planners, it is simply too blunt an instrument, too subject to abuse, for this Court to bless as a blanket rule." Louisiana Mun. Police Employees' Ret. Sys. v. Crawford, 918 A.2d 1172, 1181 n.10 (Del. Ch. 2007). Instead, "plaintiffs must specifically demonstrate how a given set of deal protections operate in an unreasonable, preclusive, or coercive manner, under the standards of this Court's Unocaljurisprudence, to inequitably harm shareholders." But it's hard to see how a termination fee of less than 4% is going to be deemed preclusive or coercive if it's the only deal protection device in play.
Under Unitrin, a defensive measure is disproportionate and unreasonable per se if it is draconian by being either coercive or preclusive. A coercive response is one that is “aimed at ‘cramming down’ on its shareholders a management-sponsored alternative.”A defensive measure is preclusive where it “makes a bidder's ability to wage a successful proxy contest and gain control either ‘mathematically impossible’ or ‘realistically unattainable.’ ”
A rider in the omnibus spending bill bans the SEC from using any funds “to finalize, issue, or implement” rules “regarding the disclosure of political contributions, contributions to tax exempt organizations, or dues paid to trade associations.” But 94 Democrat Senators and Congressmen--but no Republicans--have petitioned the SEC to go forward with "discussing, planning, investigating, or developing plans or possible proposals for a rule or regulation relating to the disclosure of political contributions.” If that doesn't violate the letter of the omnibus bill, it certainly violates its spirit. But when has that stopped Democrats?
Once again, we see the intensely partisan nature of the campaign disclosure fight. So the next time some academic tries telling you that this debate is just about good public policy and sound disclosure rules, tell them to stuff it. It's about politics.
Todd Zywicki posts an essay carrying the above title:
This is congressional testimony provided to the United States House of Representative Committee on Financial Services at a hearing entitled, “The Dodd-Frank Act Five Years Later: Are We Freer?” Although much has been said on the impact of Dodd-Frank on the economic and financial system, little has been observed on the impact of Dodd-Frank on individual liberty. Yet the freedom of the financial system is intertwined with the ability of individuals to pursue their goals in life: to gain access to capital to start and grow a business, freedom to buy a home and provide for your family’s financial security, freedom to choose those whom you entrust with your hard-earned money provide the means for pursuing the American dream.
The massive bank bailouts taken in 2008 shredded the rule of law and replaced the system of market competition with a system of crony capitalism in the banking industry. Instead of reversing and resolving those issues of arbitrary government discretion and political favoritism on behalf of well-connected special interests, however, Dodd-Frank reinforces the system of crony capitalism and entrenches those movements away from the rule of law. The result has been to further entrench the concept of “Too Big to Fail” in the American financial system, to increase the arbitrary discretion of government regulators (such as the Consumer Financial Safety Bureau), and to disadvantage community and other smaller financial institutions in the competitive marketplace.
In short, Dodd-Frank entrenches the system of picking winners and losers in the financial system and reinforces the market power of large banks that are of sufficient size and influence to deal with the cost and uncertainty of the current financial regulatory regime.
Here's what I think is the money quote:
The freedom to plan your financial future, buy a home, or open a bank account, is being crushed under an avalanche of costly and arbitrary rules and a regulatory system so complex that only well- lawyered multi-billion dollar banks can survive. On issues ranging from which financial insitutions are considered “Too-Big-To-Fail” to the loan terms of your new car, a handful of unelected Washington bureaucrats are prying into your wallet and bank account to make those decisions for you.
If you want to understand why everything Liz Warren says about financial regulation is wrong, you need to read this essay.
Yvan Allaire and François Dauphin cogently analyze the costs and risks of proxy access, arguing that "Anyone believing that this process is likely to produce stronger boards in the long run needs to consider anew the calculus of current and prospective board members, the actions, likely dysfunctional, of people facing the humiliation (and economic loss) of an electoral rejection."
Here's a great essay on how Ethan Allen stood up to the hedge fund activists. It will probably become a leading case study.
What struck me was the way hedge fund activists tried to undermine Ethan Allen in their effort to impose their own model on the company and all its other investors:
In our case, it was primarily the activist investor and Institutional Shareholder Services, and those shareholders who outsource their proxy governance voting to them, who supported financial engineering to fund large share buybacks and so fuel short-term financial returns.
While we were talking to our shareholders, the activist hedge fund pressure on Ethan Allen and its people was coordinated, personal, local and immense. For our CEO and CFO, in a very flat management operating company structure, responding to the hedge fund activist diverted more management time and resources than our prior initial public offering or managing through the early years of the great recession. The activist publicity campaign against Ethan Allen was intended to create business uncertainty and inevitably created questions from our key business relationships and associates in considering whether to continue making long-term commitments to our company. These typical activist tactics risk our Ethan Allen business and so our shareholder values. It’s very difficult to see how this disruption improves Ethan Allen now or in the long term for the benefit of our shareholders. Some of our investors acknowledged the typical immense Wall Street advisor costs and how they might be isolated and reported as an unusual expense, and more generally acknowledged to us, that it’s not worth it in the long term, you should exit the U.S. public stock markets, just as almost half of U.S. public companies have done so in the recent decade.
This is a significant source of costs that you never hear hedge fund academic apologists acknowledging. It's why I believe limits on shareholder power have become essential.
For Christmas dinner this year it was just Helen and I, so I wanted a meal that would not generate a lot of leftovers. I ordered a couple of Wagyu ribeye steaks from D'Artagnan, which I prepared using Alton Brown's recipe. I served them with honey-glazed carrot coins and potatoes au gratin.
I poured a 1995 Ridge Monte Bello, which is a blend of 69% Cabernet Sauvignon, 18% Merlot, 10% Petit Verdot, and 3% Cabernet Franc, and for which I provided a detailed note on my blog in December 2013.
The cork on this bottle disintegrated upon opening and I ultimately had to push the remnants through the neck into the wine, which necessitated decanting through an unbleached coffee filter in a funnel. In short, an even worse mess than the 2013 bottle.
In 2013, I thought this wine was still too young. Tonight, however, it was drinking very well. To be sure, it's still very youthful in appearance--a deep ruby. The intense bouquet suggests cassis, blackberries, and blueberries. On the palate, the tannins have softened quite a lot, making it much more pleasant to drink. There are still a lot of red and black fruit associations, but there are now also maturity markers like leather and tobacco. I think it has at least another decade of potential improvement, but I would not blame you if you opened it tonight. Grade: 95
For Christmas Eve dinner, I made roast chicken with root vegetables from the latest edition of Cook's Illustrated (still my favorite food magazine). I sprung for an air cooled, free range, organic bird. I used baby Yukon Gold potatoes, baby golden beets, and heritage multi-color carrots as the root veggie mixture. I tweaked the brine by adding 1 tablespoon each of garlic powder, onion powder, and paprika, as well as 1 lemon (quartered), 10 black peppercorns, and a couple of sprigs each of fresh rosemary and thyme. I also tripled the brine time to 3 hours. Finally, I reserved some of the liquid as an au jus for the chicken. Highly recommended.
With it I poured a 2006 Domaine Lignier-Michelot Morey St. Denis Premier Cru Les Chenevery. This red Burgundy was a perfect match for the roast chicken. Medium ruby with a small amount of light sediment. Huge bouquet. The first thing you notice on both the nose and the palate is a blast of cherry cola followed by earthy and leafy notes, some vanilla-ish oak, and roses. Grade: 91
Great column. Go read the whole thing but here's a taste:
Racial and ethnic diversity, it is said, helps students learn about different points of view and prepares them to live and lead in a multiracial and multicultural society. This new orthodoxy creates a relentless focus on race and ethnicity in admissions, and at times even more so in faculty hiring.
... Ezra Klein of Vox amassed data suggesting that the greatest cleavages society were not between racial and ethnic groups, but between members of different political parties. A high percentage of members of both parties, for instance, expressed horror at thought of a daughter or son marrying outside the faith. Large majorities of both parties would be likely to hire a member of their party over that of another. As Ilya Somin has noted, such partisanship has troubling implications for democracy. Partisans will be more likely to dismiss opposing views reflexively, making beneficial decision making far less likely.
Thus, assuming we accept diversity as essential in higher education, it would seem that we need at least as much political diversity as diversity with respect to race and ethnicity. Students would learn about different political and ideological viewpoints if exposed to those espoused by Republican as well as Democrats, by conservatives as well as liberals. Indeed, political diversity provides a more direct way of gaining access to different viewpoints than relying on race and ethnicity, which are at best proxies for viewpoints. Society as whole would benefit because citizens would learn not to reflexively dismiss viewpoints. .
Yet higher education has largely shown no interest in political or ideological diversity.
High education: Hoist by its own petard.
Hadiye Aslan and Praveen Kumar's analysis of industry-wide effects of hedge fund activism ends with an interesting conclusion about the long-term sustainability of the phenomenon:
The analysis of the product market effects of HFA also generates some interesting hypotheses on the future of activist investor intervention. If firms become more efficient through pro-active responses to the threat of intervention, and if the number of activist investors keeps increasing, then the returns to HFA should come down over time. Furthermore, there can be a backlash to HFA from a variety of directions. Access to hedge funds is limited because the average individual investor does not have the financial wherewithal to invest in them. If HFA reduces the returns of the competitors to HFA targets (as shown by our analysis), then HFA is likely to adversely affect average investors, who are more likely to hold equity in the competitors than the target. That is, HFA is not a positive-sum game in terms of generating higher equity returns for all investors. In that case, there will be increasing pressure on mutual and pension funds (which is how most individual investors participate in stock markets) to put pressure on the management of firms they own. In this case, again, activist investors could lose their edge in return performance and could even become redundant.
Is this likely to result in industry-wide improvements? They also suggest some reasons to doubt it:
... we do not find support for the view that activist investors have industry-wide benefits, for example, through the introduction of best practices that are emulated by industry firms. Indeed, our analysis indicates that the post-HFA economic pressure on industry competitors lowers their capital investment and productivity on average, which may hasten the exit of weaker peers from the industry. And in ongoing research, we find that target firms improve profits by extracting price concessions from their suppliers. Of course, exit by economically inefficient firms is central to a dynamically efficient economy. Consistent with this, we find that the threat of activist investor intervention remains a potent incentive for firms to make pro-active improvements; such firms are generally able to compete effectively with target firms. Nevertheless, we have little knowledge today of long run economic effects of HFA on industry competition and innovation. For example, if HFA encourages “industry consolidation,” such as seen recently in the pharmaceutical industry, then there may be long run detrimental effects on R&D investment and innovation. In light of the positive industry- and economy-level externalities of R&D spending, such reductions in corporate research spending could have long run negative consequences for an economy built on continuous technological advancement. In a similar vein, there may be social costs from reduced employment if the pressured competitors and suppliers of HFA target firms are forced to lay off workers.