MASTERING THE PROXY STATEMENT PART IV: PAY FOR PERFORMANCE…?

In part III of this series, we explained how you can find out who really owns a publicly traded corporation. In this part, we will discover where you can find the detailed pay packages of the top executives who work for ownership, and why this information should matter to a shareholder. 

Read part I here.

Read part II here.

Read part III here.

By The Sick Economist

Another area of the proxy statement where “anything goes,” is executive compensation. Of course, large, publicly traded corporations are notorious for large pay packages. So it would be wrong to look at the bulk compensation packages just to gawk at their size. Rather, we just want to make sure, roughly, that the corporate compensation plan makes sense, for all shareholders. In other words, it’s advisable to review the compensation discussion in the Proxy Statement not to scrutinize every penny, but rather, just to make sure there are no obvious red flags. Remember, an executive pay package can consist of anything as long as the information is disclosed. And most investors have no idea where that information is disclosed, and if so, they have no idea what it all means. 

Again, this is an area that seems complicated at first, but in reality, is quite simple. About halfway through the Proxy Statement, there will typically be a section entitled, “certain matters related to executive compensation.”  There can be many pages of flowery discussion, accompanied by charts that would make a Harvard Business School professor blush.

But there is always, ALWAYS, a one page chart that discloses the total compensation of each executive and member of the board of directors. Furthermore, the chart will typically break down what form that compensation takes, adding up each column, until on the far right of the chart, the total number is disclosed. 

Great news. You don’t need to be an expert in corporate compensation or a PhD in finance to be a successful investor in a publicly traded company. Rather, you are just simply going to review this ONE PAGE document to see if any anomalies stick out. As the page is mandated to be displayed in a standardized format, anomalies are usually easy to identify. 

What would be an example of a “red flag” on the compensation chart?

-If the CEO makes much much more than the rest of the “Named Executive Officers” 

-If too much of the pay comes in the form of cash, or cash up front, as opposed to  compensation that vests over time. 

-If someone else in the C-Suite seems to make much more than everybody else. 

-If the compensation package seems unbalanced. In most cases, your “Named Executive Officers” receive a mix of cash salary, cash bonus, stock, and stock options. There can be variation in the proportions, but if all of the compensation falls into one column or another, this would bear more investigation.

-If the total compensation of all of the “Named Executive Officers” seems out of proportion for the size of the company. There is never ending media hype as to how much top corporate executives get paid these days. And, on a gross basis, they do make an awful lot. But, the general rule of thumb is, the entire executive team, together, takes home less than 2% of the total profit of the company. And the bigger the company, the lower the percentage. So, for example, If your company earned $10,000,000,000 last year (Not uncommon for giant publicly traded corporations) all of your named executive officers, together, should be taking home $100 million or less. Geez, that is a lot of money. But it’s just 1% of the corporation’s total profit, so no problem. But if you are looking at a corporation that made “just” $500,000,000, and the executive team is still taking home one hundred million, then something is not kosher. The proportions are out of whack. 

Other Items of Note

There are few other items that are worth checking on the Proxy Statement before you decide whether or not you want to become an owner in this corporation.

Along with discussions about ownership and executive compensation, the proxy statement will also describe the members of the board of directors. Now remember, the Board are, theoretically, the ultimate bosses of a publicly traded corporation. The Board is elected directly by shareholders to represent the broad interests of ownership. They theoretically hire and fire the CEO, and they conduct very high level supervision. 

But why do I use the term “theoretically?”   Because there have been notorious abusive cases where a board can be “packed.”  This is when an abusive or manipulative CEO finds ways to “stock” the board with his friends or even relatives so that who is actually supervising the CEO is … .nobody. In cases like Meta, it doesn’t matter who is on the Board, because as we discussed above, former boy genius Zuck owns everything anyhow. However, it is much more common for CEO’s who do not own controlling shares to use their considerable powers of persuasion and strategy to rig the system in their own favor. Notorious examples are the board of General Electric who did nothing while CEO Jeffery Immelt drove the company into the ground, or the absurd shenanigans at Disney related to a non-existent CEO succession plan. 

Legendary investor Warren Buffett has quite a few colorful comments related to public companies and their boards. Ultimately, a certain amount of drama is inevitable when big money is at stake. But there are a few simple questions to ask when reviewing your Board of Directors in the Proxy Statement

Firstly, and mostly obviously, are these people directly related to the CEO, either by blood, or through some obvious connection? A surprising number of public companies are actually just jumbo sized family run companies, meaning that one, or several family members are on the board of directors (Walmart and Ford come to mind). That might be just fine, but it’s a decision you would have to make as an investor. Do you want to invest in a family business ?

Secondly, just on a basic level, do these people seem qualified to supervise this company?  No, you do not have to be an expert in corporate governance, or any other arcane subject. But do these directors, as presented, pass the “common sense” test? For example, if you are looking to invest in a biotech company, do the board members at least have a background in science and technology? Do any have advanced science or medical degrees? Have they run science based businesses before? 

You might be surprised by what you find. Another common way of “packing” a board is to hire individuals who have big names, but really don’t know anything about the relevant business. One notorious example was erstwhile blood testing company Theranos, which hired George Schulz to act as a corporate director on its board. 

Schulz had a very accomplished career in Federal Government, holding prestigious positions such as Secretary of the Treasury and even Secretary of State under various Republican presidents. But Schulz was almost 90 years old at the time of his appointment to the Theranos board, and he had no background in medicine or biology. 

Unfortunately, it was later revealed that Theranos was a total fraud; investors lost millions and millions and several Theranos ex-executives went to jail. 

The point here is not to pick on a poor old man, who himself may very well have been a victim of fraudsters. But rather to simply point out that you want to  make sure that your company’s directors are roughly appropriate for the job. Do they have relevant qualifications, and are they physically and mentally fit to supervise a multi-billion dollar corporation? The information is all right there in the Proxy Statement; 95% of inventors never bother to look. 

The last major “item of interest” would be to look out of disguised ownership. Again, there is no one particular ownership arrangement that is an automatic red flag, but you want full information before making the decision to invest, or not. 

One thing to look out for is misdirection in terms of ownership. The proxy statement must list all major owners in the corporation….but what if some of the owners aren’t even….people? 

That is right, some major corporations are not even owned by individual people. Rather they are owned by legal entities, typically LLC’s. This is somewhat rare, but not unheard of. If this is the case, the LLC will be listed right there on the proxy right along with other individuals who own a meaningful percentage of the corporation. 

Even this is not necessarily a “red flag,” but rather just something to be further investigated. There are lots of potential reasons why a person, or people, might want to hold their corporate ownership interest through an LLC. But this complex ownership structure often obscures the true control of a corporation, and you want to know who you are in business with. 

If this feels like another splitting investment headache, don’t worry! What is the law? Disclose, Disclose, Disclose. Very often, when an LLC is listed as a major shareholder in a corporation, you will see a tiny little footnote attached to the listing. The tiny, little footnote will often refer to an explanation of the arrangement, often in tiny, little letters at the bottom of the page. It’s right there for you to read, if you make the effort. 95% of investors don’t! Even in the rare case where there is no explanatory footnote, typically you can Google the name of the LLC and ample public records will pop up. You usually don’t have to be Sherlock Holmes to understand the ownership and control structure of a publicly traded corporation. If you do feel like you need a detective’s cap and a 19th century pipe, then simply don’t invest. 

By now, you should feel very well armed to scour a Proxy statement and ask the questions that need to be answered before you choose to buy into a publicly traded firm. But perhaps a few of the concepts still feel vague or fuzzy? In part five of this post, we will tie all of our learning together in a real world example. We will look at two companies that look very similar on the surface, but are quite different when we review the Proxy Statements.