A Seamy Trifecta

Extending from our post on Arthur Levitt’s non-binding vote of shareholders, we stumbled across three issues today from which we can draw some interesting parallels between corporations, financial services, and governments.

Levitt’s preferred method of dealing with executive compensation–through direct, non-binding shareholder approval–raised the issues of governance and agency risk, a topic that is close to our hearts. It is possible in corporations for executives and directors (agents) to enrich themselves at the expense of shareholders (principals), and it can be very difficult to detect this kind of malfeasance. Our qualified objection to Levitt’s recommendation was based on a recognition that non-binding shareholder votes and tightly controlled director elections do not provide shareholders with adequate control over their agents. It’s clear that much of the principal-agency risk in publicly traded firms arises from the fact that shareholder’s assets are almost continuously at the disposal of executives and directors. It’s also clear that a relatively closed network of executives and directors–ie, a network where shareholders are largely absent from the relevant conversations–amplifies the risk of misconduct.

An announcement that Vanguard was issuing some new exchange traded funds with an annual expense ratio of .11% reminded us that in the realm of financial services, many investors incur ongoing costs that they may not understand or be aware of. Vanguard has played a key role in creating awareness around this issue and forcing the industry to improve its overall value proposition. Nonetheless, in segments of the financial industry where the value proposition is still tilted away from the customer, it seems clear to us that much of the principal-agency risk in these segments arises from the fact that customer/investor assets are continuously under the control (to varying degrees) of brokers, advisors, money managers, etc., and that a relatively closed and traditional culture–where customers/investors have little or no control over price setting and are not typically involved in relevant conversations around value–lessens the impetus for adding greater value relative to costs incurred.

Finally, this Sen. Tom Coburn interview in the current issue of GQ (which we learned of from Don Luskin) inspired the observation at hand. Quoting from the article:

[Senator Coburn] wants you to know how it works in Washington, how the machine keeps itself running, and the favors get traded, and the deals get struck, and the bridges to nowhere are going up every day. He wants you to know that the United States Congress simply cannot stop itself—that both parties are in on the fix, backing each other and looking the other way, and that in the spirit of bipartisan waste, they manage to blow $500 billion more than they collect in taxes every single year. He wants you to see where that money is going: the 10,000 personal projects and earmarks that senators and congressmen are sneaking into the federal budget every year…

To put it in terms of the two examples above, the federal government is a hotbed of principal-agent risk because of its near continuous control over public assets*, a culture where agents enable mutual self-dealing, and the exclusion of taxpayers/voters from the most relevant conversations around policy and appropriations.

[Two side notes to the Coburn article: (1) We are skeptical of those who decry our public debt based solely on its level--it's very difficult, perhaps impossible, to quantify, but U.S. debt must be assessed like any other--how does it compare to total U.S. assets, some measure of equity, or expected cash flows? And is said debt invested productively, that is, in ways that will add marginally to U.S. assets, equity, and cash flows in the future? (2) We disagree that the USD's position on forex markets is a de facto measure of overextension of federal budget deficits; Senator Coburn would have to reconcile the USD slide with current long term interest rates to make his case; in our view, the exchange value of the USD is driven primarily by Federal Reserve behavior.]

Getting back to the thrust of this post, we have illustrated two key factors that indicate the level of risk in any principal-agent relationship: the degree of agent control over principal assets, and the degree of self-reinforcing behavior among agents. That said, we have to wonder which of the three examples cited above poses the highest level and degree of agency risk overall, and how the three compare at present. Private actors like Vanguard have done wonders for improving the ‘terms of trade’ in the financial services industry; activist investors are increasingly flexing their muscle in publicly held corporations, and executives are subject to rules and penalties imposed by Sarbanes-Oxley; meanwhile, Senator Coburn considers himself something of a lone voice in the wilderness.

There’s a governance revolution afoot in the world. Beltway and other capital denizens should be careful to take notice.

*Imagine if, instead of having access to the cash flowing through the Treasury from debt issuance, payroll tax withholding, quarterly tax filings, and other sources, our Congressional representatives had to present their constitutents with strategic investment plans, detailed budgets, and compensation and benefit plans for approval, and then request the required tax contributions.