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By Lynn Parramore, Senior Research Analyst, Institute for New Economic Thinking. Originally published at the Institute for New Economic Thinking website
ust about everyone wants to hold Wells Fargo accountable for a scheme in which sales quotas drove employees to set up phony credit card and bank accounts without customer knowledge. A Donald Trump advisor declared the behavior “stupid” and “greedy,” while Hillary Clinton proposes to make it easier for consumers to take companies to court for such behavior. So far, over 5,000 regular workers have been fired at Wells Fargo, and the Consumer Financial Protection Bureau has fined the bank $185 million. “Hold Wells Fargo Accountable” even has its own Facebook page.
Will it make any difference? Not much, warns William Lazonick, a leading expert on American corporations and co-author of a new study on CEO pay sponsored by the Institute for New Economic Thinking. Until critics truly understand why companies have strong incentives to create such schemes in the first place, they will go on doing so, hurting workers, customers, and taxpayers. The entire economy will be dragged down and economic inequality will continue to rise.
As Lazonick explains, the Wells Fargo cross-selling scandal and other scams that ripple across the headlines are born in a business culture in which executives are focused on jacking up stock prices in the short term so that they can cash in on stock options and awards. As long as this continues, the urge to cheat will be too tempting for most to resist.
Here are three things anyone wanting to hold Wells Fargo accountable needs to know.
1) American businesses have become stock manipulation machines
When a company does a stock buyback, it purchases its own outstanding shares, a financial trick that reduces the number of shares on the open market and boosts the price per share. As Lazonick points out, the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012 used over half their earnings to buy back their own stock, almost all through purchases on the open market. Buybacks continue apace.
When companies do this, profits that could have been used to develop new products, pay workers fairly, and invest in the long-term health of the firm are diverted to prop up share prices. Executives love buybacks, because they often get paid in stock-based instruments. They can time stock price-boosting activity and cash in at the optimal moment to line their pockets.
Before 1982, the Securities and Exchange Commission (SEC) considered stock buybacks to be a potentially unlawful form of stock price manipulation. But that year, under the sway of Reagan-era enthusiasm for unfettered markets, the SEC loosened its rules. This change, plus a shift toward stock-based compensation for top executives, has exacerbated economic inequality by pushing pay at the top into the stratosphere while shortchanging workers. Instead of growing companies in the long term and paying workers what they deserve, executives have focused on boosting stock prices in the short term for their own benefit. Stock buybacks drain trillions of dollars from the real economy and produce nothing of value.
2) Focusing on short-term stock prices leads to corruption
As long as companies are incentivized to boost stock prices in the short term, executives will be tempted to do that by any means necessary. The problem is not just buybacks, Lazonick emphasizes. They will also engage in all sorts of misconduct and even outright fraud, whether it’s Wells Fargo setting up fake credit card accounts or pharmaceutical firms resorting to price gouging, as Mylan has done with its EpiPen.
Lazonick points out that even the most vocal critics of such shady business practices often don’t understand what’s behind them. “When Mylan raises the EpiPen price,” he explains, “they use a million phony arguments to justify why they are doing it, but the truth is that they are doing it to boost the stock price so that executives can gain.”
Simply stopping a particular shady activity will not solve the problem, says Lazonick. As long as the incentives for stock price manipulation are there, companies caught in one scam will just move onto another. “It’s totally corrupting,” he observes. “There may be some ethical constraints going on in some companies, but the scams still continue. Price gouging has been going on in pharmaceutical companies for thirty years. No one should be surprised about Mylan. Or the next Mylan.”
Lazonick notes that even if an executive doesn’t want to engage in unethical behavior to boost stock prices, the pressure to do so from, say, an activist investor may be too great. Her job may depend on it. “CEOs who resist may be gone pretty quickly,” he notes.
3) Punishment means little until executive pay is understood
Big fines, clawbacks, and withholding executive pay may sound great in terms of punishing wrongdoing, but they don’t mean much when they are based on fiction.
The Wells Fargo board announced that CEO John Stumpf would lose unvested stock awards and would not be paid his annual salary while the investigation into the cross-selling scam was going on. But how much does he actually get paid? How much are his stock awards really worth?
Turns out, hardly anybody really knows.
Lazonick’s research with Matt Hopkins shows that for decades, corporate executives have been making far more money than anybody reports, because the metric used to estimate what they take home is wrong.
When people talk about how much a CEO like Stumpf makes, they are usually basing the number on something called ” estimated fair value” (EFV) of his or her stock options and stock awards. But that doesn’t represent what Stumpf puts in his bank account and reports on his tax return. In the case of stock options, that estimate derives from a celebrated economic theorem, often referred to as the “Black-Scholes” model after the two economists who formulated it. But the real numbers require looking at “actual realized gains” (ARG) — that’s how much stock-based pay is worth at the time executives actually cash in.
When you use the EFV metric, Stumpf’s compensation numbers from 2006-2015, for example, add up to add up to $179 million. That’s a lot of money, to be sure, but if you use the correct ARG numbers, you see that Stumpf’s taxable, take-home pay for those years was actually $259 million. That’s 1.45 times more than the vast majority of reports indicate.
Even the most progressive organizations have been incorrectly stating CEO pay, says Lazonick. The AFL-CIO, for example, has long decried a ratio of CEO-to-average-worker pay of about 350:1. The actual figure, according to Lazonick’s research, is more like 700:1. He warns that people need to realize that they have been given false information.
Reporters and others who are questioning executives on these things just quote the wrong numbers. The executives must be laughing all the way to the bank. The ones who are doing all the buybacks and the price gouging and the scams to get their stock prices up are the same ones for whom the actual realized gains are far out-pacing this phony metric of estimated fair value. The public is being mislead.
The actual numbers that determine what executives take home reflect stock price volatility — the kind of volatility that happens, for example, when a buyback or cross-selling scam jacks up the price.
No wonder executives are happy that nobody understands it. There’s no accountability if there’s faulty accounting.
Lazonick and his colleagues were surprised when they found out how far off reported estimates of actual CEO pay have been:
Once we really took a deep dive into how to estimate executive compensation, we realized how complicated it is to understand. We knew there was a problem of measurement, but we didn’t know how systemic it was or the extent of it. The reality is astonishing.
Lazonick points out that while understanding the CEO pay numbers is important, even more important is realizing what’s driving those numbers. Executives engage in stock price manipulations schemes because they expect to time the market and take home giant piles of money when those prices rise temporarily.
Stock buybacks that shortchange workers and scams that defraud customers drive the numbers. They fatten the banks accounts of executives and leave everyone else high and dry.
It would be helpful, of course, if regulators would catch misconduct and fraudulent activity earlier, but ultimately, says Lazonick, the solution must come from taking on the corrupt culture of self-centered stock manipulation behind these activities.
The fix, he says, is a relatively simple one.
The rule that was changed in 1982 has become a big problem. The SEC should not allow stock buybacks that encourage corporate executives to benefit from stock-price manipulation and to engage in unethical behavior. It’s time that we recognize how corrupting to business and how damaging to our economy this has become.
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A very succinct and on-target summary there from Lynn — as usual.
The rewards for those who are not even at the top of the greasy pole in corporate life but are sufficiently near it for distorted incentives to apply are so huge, it’s like putting children in charge of stock control at the sweet shop. At my TBTF, direct-reports of direct-reports to the C-level are on — minimum, absolute minimum — £250k p.a. packages. Bonuses and stock options can add another 20 to 50% on top of that.
So just getting a few years at that echelon, which isn’t as I mention the top or even especially near it, makes you, if not an overnight millionaire, a millionaire just so long as you can stay in position for a few years grabbing what you can until the roof falls in. No wonder there’s no shortage of fall guys and fall gals to enable the real looting (or, maybe even more accurately but dispiritingly, wanton fraud and theft from the company and from customers just for fun — this sounds crazy but when you get up close to the personalities involve and their existing levels of personal wealth, the psychology of why they do it does seem to me to boil down to just something to amuse themselves with) by the C-level and CEO.
In Japanese companies, certainly when I had experience a decade or so ago, the package for the equivalent level topped out at the £100k sort of range. And it wasn’t the money which mattered, it was the status and the respect from society which those positions brought rather than the money. Surprising there was a lot less overt wrongdoing. Where there was illegal conduct — and there was a lot of it, don’t misunderstand, Japanese large companies are not innocent — it was aligned to the long-term prosperity of the company such as payments to officials to win important contracts or oil the wheels of the bureaucracy to get things passed more speedily. Featherbedding yourself within the company just didn’t happen. Politicians used the graft system to reward themselves and their parties, but rarely did company employees.
A fitting epilogue to this post–or prequel to the public Strumpfscandal–is OrangeCat’s comment on yesterday’s Water Cooler, informing us that Strumpf sold lots of his Wells Fargo shares right before this scandal hit.
That should be investigated by SEC as insider trading. And the Wells Fargo Board should do more.
Another NC commenter / post observed that the only effective disincentive in the industry will be prison time.
“Another NC commenter / post observed that the only effective disincentive in the industry will be prison time.”
And pull Wells Fargo’s charter. Poof! No more corporation. Don’t forget that part.
There are other far more radical and perhaps far more effective disincentives that may include among other things lynch mobs and guillotines. Let’s hope it doesn’t come to that.
Another item that may be used to justify higher executive compensation is the reporting of pro forma earnings by corporations.
This is also known by some as “earnings before bad stuff”.
Per this link: http://archives.cpajournal.com/2003/0203/dept/d026403.htm
“Many critics argue that pro forma earnings reports are simply an attempt by management to cast the company’s earnings in a more positive light or to excuse poor financial performance. They cite that such reports seem especially handy at turning a GAAP loss into a pro forma profit. A review of 185 quarterly earnings announcements found in the Wall Street Journal for a recent three-month period (November 2001 through January 2002) shows that when pro forma earnings were reported, they were almost always (88% of the time) higher than GAAP earnings.”
If the pro forma measure were unbiased and simply an attempt to average earnings over a longer time frame than one year, then one might expect GAAP corporate earnings to be higher/lower than pro-forma about half the time as GAAP and pro forma earnings converge to the same long term number when each is summed over a 5 year/10 year time period.
Instead, management touts Pro-forma earnings to the press, helping to justify their compensation packages, while reporting GAAP earnings to the USA tax authorities as the “real” earnings that the corporation pays taxes on.
Then it is on to a new year, with a new pro forma earnings to report.
We need to bring back the quaint ethical constructs “Conflict of Interest” and “Self-Dealing” that were banned from public culture at some point — probably during the 1980’s when Southern California wheeler-dealer culture invaded the rest of the country through Reaganism and Encino Man Michael Milken. No corporate executive should legally be allowed to control stock in a company where he or she works. No corporate executive should legally be allowed to be compensated with stock in a company where he or she works. Period.
However the pervasive graft, fostered by thirty years of looting by shameless wanna-be rock-star Baby-boomer executives who should have been acting as fiduciaries for shareholders, has comprehensively corrupted government and the legal profession, who now serve the looters. Because it’s so cheap to buy senators from fly-over states, it is unlikely that ethical standards will ever be restored through legislation, no matter how obvious the problem is as so clearly described by Lynn Parramore above.
Who are these “shareholders” you speak of, which corporate executives (holding large blocks of shares and share-equivalents are supposed to be fiduciaries to? Warren Buffett? The Walton decadents? The Kochs? The Central States Pension Fund? And spare please the noise about retired school teachers in Keokuk, who “hold” only through great big “Funds” often managed by “activist investors” seeking alpha, and the other players. Everyone that matters (that is a big enough player) is in on the game, when the game is looting and bubble-blowing and the rest of the Faux Economy.
Wishful thinking at best, that somehow “someone with authority” will change the rules, like SEC regulations, federal legislation, the Delaware corporation act, the rules of accounting, the Federal Rules of Civil Procedure governing class actions and shareholder derivative actions. Let alone somehow extirpate the part of apparently innate and pretty universal human conduct that revolves around stimulating one’s pleasure centers and getting into position to pay other people to stimulate them too…”Soylent Green” is a business model, not just a scary sci-fi tale…
I completely agree that there is no way to put the Genie back in the bottle. See my second paragraph and read my comments elsewhere about the comprehensive corruption of the staff at CalPERS, the pension fund that is the biggest shareholder of all. We still need to bring back the constructs of honor and ethical behavior. It’s just not going to happen in the United States of America as currently constituted.
“Corporations are people;” Soylent Green is People…
I would add, very importantly, is the pay of the people surrounding the CEO. Most corporate structures are very hierarchical and the gradient of the commands is very steep from the top down. Those in the top tier are usually reimbursed according to how close they are to the very top; for example the term Sr. Vice president usually means the CEO will spend a good part of his year’s work with say, (in a middle to large structure) fifty or sixty people. The rest of the people in the organization get little if any time with the CEO, Sr. managers in turn spend most of their time with a group of junior vice presidents who in turn are focused on area managers.
The reason I am going into all of this is that I feel it’s important to realize that top senior officials at many large corporate structures (private corporations not government) are also highly compensated and if the CEO is collecting $30 million/yr the person sitting to the right hand is collecting a comparable salary and bonuses. Where I work, in 2015, the CEO collected an official salary of $1.3 million (against $26 billion annual revenue) but received a bonus of $8 million. His right hand man’s official salary was about $850k not sure what the bonus was but I’m certain you could do the math on the ratio and come (about six times) to about $4 million.
Again my point is that there is a cloud effect here and it rains money on all of the people at the top not just the CEO. I have to keep this anonymous so as to not have someone walk up behind me one day at work.
Slightly off topic but related I think.
We are in the process of looking for office furniture. Consistently, the best quality and design is happening outside of the United States. That’s a direct reflection on the shift in focus to money and away from product.
So it’s not just manufacturing that’s taken a hit in the United States. It’s the entire business pipeline from research, to concept, to development, to design to prototyping, to manufacturing, to marketing, to consumer. The over emphasis on short term profit has lead to cheap, poorly made, poorly conceived products. Crap as far as the eye can see…
“Buy American, its cheap!”
Stumpf is just one of thousands.
Modeled and repeated in the entire chain of “military” procurement and rank. I keep wondering when somebody (other than the cops, aiming at unarmed mopes) is going to start shooting…
Far as I can see, “we,” the mopes who become aware of and see the general danger of stuff like this, can blow off all the steam we want, in our relatively safe spaces like this-her blog, but there ain’t gonna be any hope of change. the Beast is too big, too pervasive, too well entrenched, too completely in control of the whole ecology/political economy…
Wonderful synopsis.
IMVHO, exec pay needs to be understood so that there is more consensus about the problems with corporate governance and economic structures in contemporary capitalism, which in cases like WF are choking the lifeblood out of the economy.
+1
I used to be a retail store “sales associate” and eventually assistant manager for West Marine Corporation — seller of boating supplies and related lifestyle crap. The founder, a sailing nut who built a pretty good brand and a healthy workplace (the text for manager training was “Zapp! The Lightning of Empowerment,” http://www.jfdperfsolutions.com/modules/news/organizational_excellence-book_summary~3A_~26quot~3Bzapp~21_the_lightning_of_empowerment~26quot~3B_by_william_c._byham.html). He aged, attracted the corporate blowflies in an effort to keep Groaf!ing, and eventually dished off the corp to “management experts” and went sailing away. The model that replaced that text was straight management-by-intimidation.
These “experts” did a neat stock price manipulation. The analysts and greed heads of Wall Street were then rewarding, as I recall, corporate management with good “fill rates” at the time, something about anticipating chain profitability from how fast particularly a retail operation could push product from warehouses out to the stores. For my stores, and I worked at several, that included, among other sutpidities, shoving fresh-water fishing tackle with ridiculous markups into store inventories where the market was solely to salt-water fishermen. For those who know about fishing, that is a hugely different set of gear. The stuff never sold, and the corp rulers would not even allow honest discounting to move the stuff out of inventory, to avoid having to recognize and take responsibility for evil decisions (kick it down the road-ism).
The analysts and the “market” rewarded this scam with a run up from something like $9 a share to well over $30, at which point the Fokkers exercised their options and flew off into the misty watercolored sunset. Check out WMAR, which has shrunk and demolished the brand, while new ranks of flailers move in to repeat the game, under slightly different parameters…
One more remark: West Marnie used to carry mostly quality stuff. But to try to drive sales, in come a bunch of loss leaders like “rechargeable searchlights” from China with cheap plated-steel switch contacts and lead-acid batteries that would not charge and leaked, and crappy bulbs and chintzy plastic cases in “West MArine Blue” with the Proud West MArine Label on the side. Heavily promoted products, associates fresh out of “sales training” with new metrics hanging over them, beaten up to try to force customers to buy. Most of these lights failed within days, especially in salt water (advertised as “waterproof:” NOT) and returned by angry customers. A team of Watsonville Wizards came through our district to do their managerial magic, seeking profit from new stores idiotically competing with existing ones. I happened to ask one of the marketing VPs what West was peddling these crappy products, noting that they get returned quickly with a cost in reputation. His response was: “Who cares? We have the use of their money between the time they buy and the time they return them. And because these are so inexpensive, a lot of people will just throw them away. Net-net good for us.”
Cannot be fixed.
JT McPhee, You are spot on (except allusion to the four-letter word). I, as you seem to, use Federal Rule of Civil Procedure 23 much, Delaware Corporation law some, and West Marine occasionally. I noted both the slide in quality of the merchandise and the proliferation of stores competing with each other. As to “Futilization”, you are also spot on. I don’t let that get me down. Example, the Sanders campaign appeared like a flower in the desert, activating an eighth of the demoralized electorate, who rallied to its glorious themes and leader. I was thrilled and trepidatious, anxious to see if Sanders and his unidentified close advisors intended to build a grass-roots organization, hopefully in the Democratic Party (my, not everyone’s choice), for the long run. The big issue and tell-tale sign for me was who would control the mailing list after the campaign? I don’t think they intended to build a movement, a grass-roots organization. Instead it seems his advisors, after jettisoning the Young Turks with a plan, carving them off from the Sanders campaign mailing list, intend to live off donations from the list, much like Howard Dean and his brother do their list from the 2004 campaign. Think political annuities and annuitants. The annuitants, having spent 15 months flat out on the campaign with little pay and no retirement plan, believe they deserve it — and the celebrity. They need their “product symbol”, Bernie. But Bernie, never an organization man nor theorist, is going along. The fans, err, the base, dispirited, await the next leader. Nodes will be left here and there, reading Naked Capitalism. Then it will spring again. With me in tow.
Gyrations abound. But all we need is to do is restore the rule of law where lawbreaking results in prison time again. Not tarmac meetings on private jets, or irrelevant arguments on the existential importance of a certain industry or company. If lawbreaking by an institution must be ignored for the ongoing function of the economy then the regulator must act.
Yah, that’s all “we” need to do, all right…