Monday, May 13, 2013

What's Wrong with the "S" in "TSR"

Fred Whittlesey
Compensation Venture Group, Inc.

We are caught in a zeitgeist that promotes Total Shareholder Return – the increase in a company’s stock price plus dividend payments over a defined period of time – as the most important, and perhaps only important, measure of a company’s success.  This, in turn, is applied by external observers of and advisers on assessments of executive compensation and corporate governance as the ultimate measure of a CEO’s performance. This is where the problems begin.

On June 21, I will have the privilege of participating on a panel presentation at the NASPP Silicon Valley Chapter All-Day Conference with James Clark of Yahoo! and Madori Playford of Equinix.  Our topic is “Revisiting TSR – Solutions and Problems.” We will discuss a number of strategic and tactical issues with Total Shareholder Return as a performance measure in executive and employee compensation plans. It will be a highly technical session, as there are plenty of problems cropping up from the "solution" offered by TSR. 

In our panel discussion, for example, we will discuss that  Institutional Shareholder Services views TSR over fixed 1-year, 3-year, and 5-year periods, believing that his is how shareholders view their return on investment.  I’ll note the absurdity of this given that the average period of ownership by shareholders has shrunk from over three years to less than three months, and 70% of trading volume in US equity markets results from “high frequency trading” – firms holding shares from periods ranging from a few minutes to fractions of a second.  In these markets, CEO's and other executives have very little impact on TSR over any period of time. Stock price manipulation by traders and mutual funds is rampant. Some analysts have noted that 75% of stock price movement is driven by broad macroeconomic factors and industry-specific factors.

Moreover,  the focus on short-term results (yes, 3 to 5 years is short-term when life expectancies are 80+ years, and combined with our children’s life expectancies are probably approaching 200 years) is a recipe for disaster.  We have seen those disasters repeatedly over the past fifteen years.  But we repeat the behavior over and over.  The dot-com bust, Enron, global financial crisis, London whale, LIBOR – the latter few occurring since TSR became a prevalent measure and was supposed to "fix" this.

More important than these technical issues, however, is a point of view that has not yet been discussed in equity compensation circles, but is rapidly emerging in broader corporate governance conversations:  The need to consider all stakeholders, not just shareholders, in corporate governance and performance measurement.

So here’s what’s really wrong with the “S” in “TSR”:
  • To dispel the first argument we typically hear, the notion that Boards of Directors are legally bound to put the interests of shareholders above all others is false.  While legislation is being passed in many states to allow the formation of Social Purpose Corporations, current corporate law does not prohibit Boards from suboptimizing the interests of shareholders to balance the interests of other stakeholders.  Don’t take my word for it, read a compelling and clear legal analysis by Lynn Stout, in The Shareholder Value Myth (summary here).
  • The multi-stakeholder model, and the premise of Conscious Compensation©, highlights that maximizing the outcome for one stakeholder group – shareholders, in the case of TSR – at the expense of other stakeholder groups – debt holders, employees, customers, suppliers, the environment, and the community – is a poor way to do business and not in the interest of shareholders.  This theme permeates the concept of Conscious CapitalismResearch shows that conscious companies outperform the S&P 500 index by a factor of 10x...over a 15-year period.
  • Europe and the UK – which are far ahead of the US in progressive corporate governance practices – were early adopters of TSR as a basis for executive pay, early realizers of its flaws, and early innovators of a broader view of corporate performance.  This broader view has many labels – ESG, triple bottom line, CSR, B Corporations, Shared Value Capitalism.  The world has shifted its view of who “owns” a corporation and its outcomes, and it is not just shareholders. The US is behind on this.
  • ISS, the purveyor of TSR obsession, gives lip service in its 2013 Proxy Voting Policy about linking ESG – Environmental, Social and Governance measures – to executive compensation, stating they will “Vote CASE-BY-CASE on proposals to link, or report on linking, executive compensation to sustainability (environmental and social) criteria.”  Yet the same policy document has twelve pages of detail on how ISS intends to vote on thirty-one “social/environmental issues” including sustainability reporting, recycling, and animal testing.  Yet another example of ISS’s extreme inconsistency in its views, but perhaps a harbinger of their future view of compensation, because...
  • Gary Retelny, President of ISS, said at the ESG Risks and Financial Implications Roundtable in April 2013 "ESG issues and their financial impact on investing are very important timely topics that continue to grow in importance around the world for our clients.  They are on a par (sic) with corporate governance..."
Conscious Compensation© references the work of thought leaders including R. Edward Freeman on multi-stakeholder models of business.  It is directly tied to the framework of Conscious Capitalism. It is being introduced to our portfolio companies at Fledge, the conscious company incubator, as well as a number of clients of Compensation Venture Group with social impact missions and sustainability strategies. And it is wholly incompatible with a focus on short-term Total Shareholder Return and equally destructive measures like EPS.

Stay tuned and watch the “S” in TSR turn from "Shareholder" to "Stakeholder" and turn performance measurement in compensation upside down as Conscious Capitalism turns the business world upside down.  And don't worry, actuaries and valuation consultants - accountants will need to accrue for incentive plans that reward stakeholder value, too.

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