Crowdfunding Loses its Appeal after the Facebook IPO

As Facebook’s shares continue to slump, recriminations over its busted IPO continue with no end in sight.  It might also prompt fresh concern about the JOBS Act, which loosens the rules on capital raising.

Regulators and plaintiffs’ attorneys are circling Facebook and its advisors.  Bankers, company officials, early stage investors and Nasdaq are all coming in for criticism. Even the glassy eyed retail investor is being blamed for assuming Facebook was a risk free way to be a hedge-fund titan for a day and make a quick killing.

But here’s the thing: For all the finger pointing, it’s likely that the Facebook and its bankers complied with the IPO rules. Yes, Facebook’s disclosures weren’t all that clear, and the underwriting banks’ analysts kept their earnings downgrades away from the public, but all this was acceptable under the rules.

The rules are set to change, and in ways that don’t favor retail investors.  So if small investors are feeling burned Facebook, just wait until bankers start crowdfunding growth companies under the provisions of the new JOBS Act.

Under the law, enacted just weeks ago, companies with under $1 billion in revenue will be able to tap the public markets without many of the restrictions that govern IPOs today. They’ll be exempt from disclosure and corporate governance requirements. Small companies will also be able to crowdsource their funding – soliciting investors via the Internet – without filing a registration statement. The information disadvantage for retail investors looks likely to grow worse under the new law.

Many of the protections put in place in 2003 after the collapse of high flying tech companies are also eliminated. (Ironically, the JOBS Act would permit underwriters to publish research on companies before an IPO, which some have argued would have been useful for retail investors eyeing a flyer on Facebook.)

The SEC is not very enthusiastic about the JOBS Act, and it has begun to gather public comments as it develops rules to implement the law. Facebook’s disappointed shareholders should be writing to Mary Schapiro.



Disclosure is an Attitude

I recently had lunch with a senior executive from a big accounting firm who complained about the criticism his firm was facing over audits it conducted at big companies that later were found to have big problems.

In all these cases, the executive said, there was a “well established body of accounting practice” that permitted the company to forestall disclosure or keep certain items off the balance sheet or bury an important fact in a fine-print footnote.

As it turned out, the things these companies obscured were pretty important to investors.  Once the off-balance-sheet liabilities were known, the company’s valuation tumbled, executives were fired and lawsuits and recriminations ensued – for the board and its auditor.

The accountants’ defense that “we were just following the rules” just doesn’t fly.  For one thing, the so-called “rules” on disclosure don’t exist.  The SEC does not provide a strict threshold for disclosure, choosing instead to let companies determine what should be released.  The burden is, appropriately, on the company’s board to make the right judgment, consistent with its fiduciary obligation to shareholders.

More than that, auditors ought to stand up as professionals and insist on disclosure when important issues are involved.  Sadly, there are few examples when they’ve done so.

It’s not all the fault of the auditors.  Ultimately, it’s up to the board.  Disclosure isn’t a matter of meeting a test or ticking a box.  Disclosure is an attitude.  A company decides it is going to keep investors informed or not.

Disclosure failures have been at the heart of spectacular corporate failures, from Enron nearly a decade ago, to Lehman Brothers in 2008, and it’s again in focus in the aftermath of Facebook’s bungled IPO.  There, Facebook filed a revised prospectus with a vague statement about user growth was outpacing advertising – an oblique way of saying its revenue growth was slowing.

Did the SEC filing by Facebook meet the legal requirement to disclose a material fact? Probably. (Although that question seems headed for the courts.) Was the statement sufficient to inform investors about the true state of Facebook’s profit outlook?  No, it wasn’t.

The adequacy of J.P. Morgan’s disclosures has also been questioned following its $2 billion trading loss from a complex hedging strategy.

Ultimately, the decision to make a disclosure comes down to management and the board and whether they want to state the facts openly or hide behind obscure accounting practices.

I know in which company I’d want to invest.

I’m Starting to Worry about Goldman Sachs

The outlines of Goldman’s new public relations strategy are becoming clearer.  It involves more television appearances by CEO Lloyd Blankfein, investments in trendy green-tech companies and a new twitter account, unveiled at yesterday’s annual shareholder meeting.

It is part of an effort to create a “more open and friendly” firm, according to news reports.

Lloyd Blankfein in a Zuckerberg-style hoodie surely is next on the agenda.

This looks a little like the time your uncle tried to look cool by wearing skinny jeans.  He was still the same fat guy, just a lot more uncomfortable.  And that’s the risk for Goldman or any other company that tries on a new style without really changing.  The new image will be superficial and short-lived.

Unless Goldman addresses tough issues like executive compensation, business conflicts and financial disclosure, perceptions about the firm won’t really change.  Achieving a lasting shift in public perception takes a lot of work, and it starts with making real changes in the institution itself.  If it were as simple as television interviews and tweets, no firm on Wall Street would have an image problem.

There’s another risk at play here, too.  I suspect that clients don’t really want Goldman to change too much.  For clients, anything that distracts the firm’s management from its core focus is bad.  Making markets, clinching merger deals and raising capital are things Goldman does very, very well, and clients keep returning for more. Goldman’s franchise remains strong, despite the endless negative media coverage the firm has suffered these past few years.  So perhaps Goldman shouldn’t stray too far from the image that has made it so successful.


The Facebook IPO Trainwreck

No one is covering themselves in glory in the aftermath of the Facebook IPO.

Lead underwriter Morgan Stanley is battling allegations that it priced the deal too richly.

Facebook insiders are being called greedy for the last-minute increase in the number of shares they sold in the offering.

Facebook’s management is being criticized for signaling analysts to lower their revenue estimates just days before the deal priced – a move that could be a violation of securities laws.  It also appears some institutional investors were informed of the analysts’ downgrade but retail investors were not.

If all that wasn’t enough, Nasdaq has endured a barrage of complaints for breakdowns in its system on the first day of trading that left investors in the dark about the status of their orders.

Predictably, regulators are launching investigations, legislators are scheduling hearings and plaintiff attorneys are filing lawsuits.

This is hardly the place Facebook wanted to be after completing its IPO.  Nor is it encouraging to other firms that are thinking about going public.

Morgan Stanley is clearly in the hot seat. The firm issued a statement late Tuesday defending its actions, but it is standing on narrow ground, asserting that its procedures were “in compliance with all applicable regulations” and that it handled Facebook in the same manner as every IPO.   That’s not enormously reassuring but it may be all it can say right now as it gathers the facts.

Nasdaq also has a lot to answer for.  Its systems are meant to handle high transaction volumes, and its people are expected to test and monitor the infrastructure to prevent these kinds of problems.  It’s not reassuring to hear Nasdaq executives admit they underestimated the scale of the technical problems.  Nasdaq needs to give guidance quickly on how it will address investor losses and repair the weaknesses in its systems.

Even if Facebook shares recover, the events of the past few days will linger in the minds of investors.  It’s too early to know if it will lead to changes in the IPO book-building process, which hasn’t changed much in the past half-century.  If it does, Facebook in its own way will disrupt Wall Street, just as it upended the media and technology sector.

What’s Next for the FX Lawsuits Against State Street and Bank of New York?

Although it didn’t make the headlines last week, State Street suffered a setback in its long-running legal dispute over the fees it charges clients for foreign exchange services when a District Court judge in Boston denied its motion to dismiss the suit.

State pension funds in Arkansas and California have sued State Street, alleging that they were for years systematically overcharged by the bank for foreign exchange transactions.

State Street has not set aside a reserve against potential claims in these cases, according to a regulatory filing, and its public statements indicate it will contest the lawsuits.  It also has said that the outcome of these suits could have a “material adverse effect” on its future financial results.

This issue also dogs Bank of New York Mellon Corp., which is facing similar suits from state pension funds in Virginia and Florida.  It reported a decline in first-quarter foreign exchange revenue of 21% versus a year ago, and in January settled with federal prosecutors, agreeing to amend its marketing material by eliminating the reference to providing “best execution” in foreign exchange.

Both banks are in a very tough spot.  The outcome of a court trial is risky and would present sensitive bank documents for everyone to see.  There are bound to be embarrassing emails and other material that the banks would not want revealed.  Bank of New York in particular could face some very juicy evidence gathered by a whistle-blower.

But a settlement is also difficult without opening the door to further claims from clients or regulators, who, as State Street notes in its 10-K, are already taking a look at the matter:

“Since the commencement of the litigation in California, attorneys general and other governmental authorities from a number of jurisdictions, as well as U.S. Attorney’s offices, the U.S. Department of Labor and the Securities and Exchange Commission, have requested information or issued subpoenas in connection with inquiries into the pricing of our foreign exchange services.  We continue to respond to such inquires and subpoenas.”

For both banks, the best way to end the litigation – and the uncertainty it creates for its clients and shareholders – is to reach a global settlement that addresses changes in business practices and monetary restitution.  That will take leadership by their CEOs, but the alternative is months, perhaps years, of costly legal skirmishes in courtrooms around the country, while clients take their business elsewhere.

An aggressive settlement strategy, coupled with a credible communication plan, could bring this unpleasant story to a close.

Misreporting CEO Pay

This is the season for tallying CEO compensation, and for shaming those who profited while shareholders suffered.

I’m no defender of high CEO pay, but much of the reporting on it is inconsistent at best, and in many cases it’s highly misleading.  The problem arises from combining two things that should be separate: pay granted by the board and stock gains taken by the executive.

Most analyses look at the CEO’s annual compensation award – salary, cash bonus, perqs, and the present value of equity grants that typically vest over several years.  So far, so good.  But then they add on the amount of equity gains that were realized by the CEO.

And that’s where the problem begins.

When you bundle annual pay and equity gains in a single amount and treat it as if the CEO “earned” it in that year, you get a picture of how much pre-tax cash the CEO took home – not a measure whether the CEO’s pay was aligned with shareholder returns.

For that, you really need to look at the annual award alone, separate from any realized stock gains, and focus on whether the compensation was in line with the company’s performance.

Yet many of the compensation and governance experts assess CEO pay by including gains from stock options and restricted shares that were awarded years earlier.

Governance research group GMI just reported its ranking of top-paid CEOs, singling out Herbalife CEO Michael Johnson for the equity gains he harvested.   Of Johnson’s nearly $89 million in 2011 “pay” cited by GMI, $77 million – 87 percent – came from options gains.

A big number makes headlines, but it distorts the picture.  Johnson’s options were awarded years earlier, and their rise in value over time was a benefit enjoyed by all shareholders.  Some reports point that out, but it’s usually buried deep. Here’s what the Guardian said – seven paragraphs into its story:

“…some might say that Johnson deserved the profits he made on exercising his stock options. Most of the options that were exercised in 2011 were awarded between 2003 and 2005, when Herbalife’s shares traded below $10. Since then, the stock price has done well. Total shareholder return, for example, rose by nearly 292% over the last five years. During 2011, it was mostly trading in the $50-plus range.

Realized stock gains simply shouldn’t be included in the annual compensation tally.  It’s only “annual compensation” in the sense that it all occurred in the same year as the rest of the CEO’s pay.

Let’s look at an example, using a couple of fictitious companies:

John Bounty is CEO of Megacorp, which had a bad year and a stock price that fell by 15 percent.  The Megacorp board trimmed Mr. Bounty’s pay, awarding him no cash bonus and stock options valued at just $2 million – a smaller grant than he received in prior years when Megacorp performed well.  Yet despite the sag in the Megacorp shares over the past year, Mr. Bounty still had substantial unrealized gains in the Megacorp shares he’d received in prior years.  So he decided to reap some of those gains, realizing $40 million (pre-tax).

Across town, Vikram Plunkett also presided over a mediocre year at his company, Giantbank, where the shares also fell by 15 percent.  He, too, received no cash bonus but his board awarded him a whopping number of stock options, with an estimated present value of $11 million.  By cutting back on dinners out and private jet travel, Mr. Plunkett figures he can get by on his salary and decides not to realize any of his long-term gains in Giantbank stock.

Now, most governance experts would say the Megacorp board acted responsibly by lowering Mr. Bounty’s annual pay award, while the Giantbank board was careless in doling out a pile of options to Mr. Plunkett after a poor year.

But because Mr. Bounty realized $40 million in stock gains, most reports will say he was “paid” this amount plus his salary and new stock options, and the Megacorp board will be singled out for scorn for “giving” Mr. Bounty a bounty when shareholders saw their wealth tumble.  Meanwhile, Mr. Plunkett, who didn’t take any cash off the table and got a juicy $11 million equity award, will escape notice.

The CEO’s annual salary, bonus and equity award are based on a board-level decision.  But harvesting equity gains is the CEO’s decision, and one that’s often driven by tax and estate-planning needs.  Boards can – and should – impose minimum stock-ownership and holding-period requirements, but the decision to take gains ultimately is up to the CEO.

What matters most is the board’s decision on current-year pay.  And there’s plenty to criticize when it comes to boards making overly generous annual comp awards, including outsized stock and option grants.  But if we’re going to have a reasoned discussion about CEO pay, we should start by communicating the facts clearly.

At Barclays, Inaction Speaks Louder than Words

The Barclays annual shareholder meeting last week was a loud and lively affair, with howls of protest directed at CEO Bob Diamond and Chairman Marcus Agius over the bank’s pay practices.  Here’s how it was reported by the New York Times:

“The atmosphere at the meeting was hostile from the start, and the speeches were repeatedly interrupted by hecklers. Mr. Diamond was booed as soon as he stepped on the stage to take his seat, and when Mr. Agius said Barclays had “made progress” over the last two years in accepting that “remuneration levels across the industry have to adjust to the new reality,” the audience burst into laughter.”

Shaken by the ordeal, Mr. Agius said poor communication was the root of the problem:

Mr. Agius said Friday that he was sorry that some shareholders felt their views on executive pay had not been taken into consideration. “What we’ve not done well this year — and I admit it and I apologize for it — is handle communication,” he said.

If only that were true.  Mr. Agius has spoken about compensation in a clear and consistent manner.  Here is what he said about it in the 2011 annual report (emphasis added):

Remuneration continues to be the subject of considerable discussion. It remains our policy that we only pay for performance, not failure, and that we only pay the minimum necessary to be competitive. Historically, there has been intense competition for talent, particularly in the investment banking industry. The difficult economic environment and the impact of regulation on the profitability of investment banking lessened this competition in 2011 and, as a consequence, performance related pay across the Group reduced significantly. We recognise that compensation has to adjust to the new reality of lower returns for the sector and we will continue to ensure that our remuneration policies and practices are aligned with the long-term interests of our shareholders.

Those are fine, brave words; they are music to shareholders’ ears.  Except when you realize the pay reduction to which Mr. Agius refers was only in the aggregate and that Mr. Diamond was exempt from it.

A year ago, in the 2010 annual report, Mr. Agius gave shareholders similar assurances about pay restraint (again, emphasis added):

“As Chairman, I am acutely aware of the public disquiet over remuneration in the industry. Barclays is committed to acting responsibly in this area. We are fully compliant with all regulatory requirements and our remuneration systems are designed to reward success, not failure.”

In fact, you can look back at Mr. Agius’s remarks on pay in any year and see strong, purposeful words, carefully crafted and oozing sincerity.  Here’s the 2008 vintage (once again, emphasis added):

“As a Board, we very much regret what has happened to the banking sector in general and to Barclays share price in particular. We fully recognise that banks must review their internal governance systems and remuneration structures to ensure there can be no repeat of the turmoil that has impacted the industry, and the wider economy, over the last 18 months. The Board HR and Remuneration Committee is reviewing compensation policy and structures across the Group to ensure maximum alignment both with the interests of our shareholders and with best practice. The Board is also committed to ensuring that Barclays plays its full part in contributing to the restoration of the health of the global economy and, with that, the reputation of the industry.

Saying the right thing hasn’t been Mr. Agius’s problem.  But effective communication involves actions, not words, and that’s where Agius and the Board have failed.  That is why shareholders – and the public – are so irate.   Despite all of the nice language about “aligning shareholder interests,” pay for Mr. Diamond and other senior executives went up while shareholder returns went down.

No amount of communication can change those facts.

Five years of lovely, meaningless words.  No wonder shareholders are in revolt.