Lukomnik named to Directorship 100 for Second Consecutive Year

For the second consecutive year, the National Association of Corporate Directors has selected Jon Lukomnik, Sinclair Capital’s Managing Partner, as one of the 100 most influential people in corporate governance in America. Mr. Lukomnik’s selection in the NACD’s 2012 Directorship 100 is related to his work as Executive Director of the IRRC Institute as well as his work at Sinclair Capital.

In 2011, the NACD’s Directorship publication, in revealing the Directorship 100, wrote that “Sinclair Capital Managing Partner and ICGN cofounder Jon Lukomnik is executive director of (IRRC Institute), noted for managing both a top–ten pension fund and being a managing director of a top-ten hedge fund. His knowledge is so extensive that he was the only non-lawyer invited to join the Bar Association of the City of New York’s Committee on Corporate Law.”

To view the full list of 2011 NACD Directorship 100 honorees, please visit http://www.nacdonline.org/directorship100/2012honorees.cfm

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Can the SEC fine itself?

Can the SEC fine itself for facilitating differential market access – in effect encouraging insider trading?

Perhaps it’s time for the SEC’s enforcement division to take a look inside the rabbit warren that is the SEC headquarters. Someone should point Robert Khuzami, the SEC’s head of enforcement, to the office of the Division of Trading and Markets. That division just approved allowing the New York Stock Exchange to profit by charging high frequency traders to “co-locate” their flash-crash causing computers at the NYSE’s data center. That, in turns, allows some investors to get price data before others.

Wait! Before you stop reading this post because it has mind-glazing words like “co-locate” and “latency”, just know this: The NYSE is rigging the market, giving some market participants preferred access to price data before the rest of us – for a large fee. Effectively, the NYSE is setting up a two-tiered exchange: Slide a fistful of money to the maitre d’ and be allowed past the velvet rope into a private room that virtually guarantees you making money. For the rest of us, it’s play by the rules and take your chances.

Most embarassingly, one part of the SEC is blessing that flaunting of the fair access rules, even while the enforcement division fines the NYSE for the same sale of preferred access in a different form. The SEC — or at least part of the SEC — requires the NYSE to maintain fair market access – a fancy way of saying that all buyers and sellers should have an even playing field. Less than a month ago, the SEC fined the NYSE $5 million for sending out price information to some customers in advance of others. “Improper early access to market data, even measured in milliseconds, can in today’s markets be a real and substantial advantage that disproportionately disadvantages retail and long-term investors,” stated Khuzami.

However, less than a month before that, the Division of Trading and Markets approved the NYSE’s request to charge thousands of dollars a month to high frequency traders to “co-locate” computers at the NYSE’s Mahwah, New Jersey data cents. (see http://www.sec.gov/rules/sro/nysemkt/2012/34-67665.pdf) High frequency traders (HFTs) use pre-programmed computers to effectively micro-front-run everyone else’s buy and sell requests. To do this, their computers need to be able to read, process, and understand everyone else’s orders in thousandths of a second. In other words, they need to know the price you’re willing to pay – and the price at which someone else will sell to you or buy from you – before everyone else. And, when you are dealing in thousandths of a second, the distance from the information source to your computer matters; even electrons take some amount of time to travel. The time it takes for information to move through wires is called “latency.” For HFTs, the less latency the better. So, if you are trying to front-run everyone else’s orders, it helps to have your computers adjacent to the NYSE’s, rather than in your own offices, which might be miles away. The NYSE understands this: It has created a thriving business selling co-location. Indeed, the opening line of its sales flyer states the bald-faced unfair market access basis of its co-location business: “High frequency and proprietary trading firms, hedge funds and others who need high-speed market access for a competitive edge.”

But isn’t that exactly what the fine was trying to correct? Selling market access that’s unavailable to the rest of us?

It’s past time for Mr. Khuzami to pay a visit to the Division of Trading and Markets.

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Sinclair Managing Partner Honored by National Association of Directors

The National Association of Corporate Directors has selected Jon Lukomnik, Sinclair Capital’s Managing Partner, as one of the 100 most influential people in corporate governance in America. Mr. Lukomnik’s selection in the NACD’s 2011 Directorship 100 is related to his work as Executive Director of the IRRC Institute as well as his work at Sinclair Capital.

“The NACD D100 honorees have displayed their ability to apply their own individual attributes in raising the standards of boardrooms throughout the country,” said Kenneth Daly, president and CEO of NACD. “They have demonstrated core values in advancing corporate governance while also weathering the economic and regulatory uncertainties that have defined this past year.”

The NACD’s Directorship publication, in revealing the Directorship 100, wrote that “Sinclair Capital Managing Partner and ICGN cofounder Jon Lukomnik is executive director of (IRRC Institute), noted for managing both a top–ten pension fund and being a managing director of a top-ten hedge fund. His knowledge is so extensive that he was the only non-lawyer invited to join the Bar Association of the City of New York’s Committee on Corporate Law.”

Mr. Lukomnik and the other honorees will be recognized at a dinner in New York City on November 8, 2011. To view the full list of 2011 NACD Directorship 100 honorees, please visit www.nacdonline.org/2011-D11-Honorees.

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Water: The medium is the message

Nearly 20 years ago, when derivatives were still relatively new and exotic, I was an honored guest at an asset management conference. It was one of those events where you worked tremendously hard from about 7 am until after lunch, and were then free to relax. If I remember correctly, it was in Carmel, California and many people went to play golf or shop; two sports I don’t play. So, instead, I worked out in the gym and then, around 5 pm, went to the hot tub to relax some aching muscles. I was joined there by the head of the company’s London swap desk. We engaged in a spirited discussion and that was that. Or so I thought.

The next morning, she was the first speaker. Remember, derivatives were unfamiliar and scary to most people. She walked to the podium and began by saying “I learned something important about derivatives from Jon Lukomnik last night.” Sitting in the audience, I immediately puffed up, cartoonishly proud that I could teach the expert something. “What I learned,” she then deadpanned, “was that any conversation about derivatives is much more pleasant in a hot tub.” Of course, I immediately deflated. But the lesson she taught has stayed with me two decades later: When and how you have a conversation matters.

I was reminded of that last week. Together with other institutional investors, we were in a floor-through glass fishbowl of a conference facility, some 42 stories up in the iconic HSBC building, overlooking the Hong Kong harbor. After three days in Bejing, we had already heard about the development of the Chinese asset management market, regulatory reform, macroeconomics, private equity, dim sum bonds, etc. The afternoon at HSBC promised more of the same – presentations that were high quality and thought provoking. We heard about current global market conditions, Chinese economics and even a presentation about gambling in Macau. Then something unforeseen happened. Debra Tan, a former accountant, stepped to the podium and began speaking about water risk in China. Slowly, with an auditor’s precision, she detailed how a lack of water was threatening China’s economic rise, how the most at-risk provinces were the most productive agricultural and industrial areas, how China was already at work on a $62 billion project to divert water from the South to the North (a stopgap even if it works), how some manufacturers had to halt production in a particular city when the power company couldn’t provide power because of a lack of water, etc.

The statistics were powerful: People in Bejing have less water per capita than Palestinians in the West Bank. 40% of China’s food production comes from water-stressed areas. Nearly 53% of China’s industrial output is produced by water scarce regions. The average person throughout china has about one-fifth the fresh water availability of an American. Water input costs for manufacturing are expected to rise by a factor of three to five times in just a few years.

If the facts were startling, the implications were frightening, not just for China, but for the global economy and, potentially, for the geo-political situation. The World Bank predicts 30 million internal Chinese “water refugees,” fleeing water stress in China within this decade. China itself said that extreme weather, including water issues, killed nearly 5,000 people last year and low water levels cause the Yangtze River (China’s major waterway) to close to shipping once already this year.

The American institutional investors who filled the room were as silent as they had been all day. These were not dedicated socially responsible investing types, but mainstream mutual fund and insurance professionals. The potential extreme implications slowly dawned on us. China’s size and scale is vast. It is the world’s largest agricultural producer; to use one small agricultural example, it produces more potatoes than the US, Russia and Germany, combined. If it has agricultural problems caused by water issues, world food prices are heading up. It is the world’s second largest economy. If it can’t produce or consume because of freshwater scarcity, the world economy will suffer. In the worst case, we could see a new set of global security issues arise from “water wars”, as rivers that flow from China are major sources of freshwater from India, Pakistan, Laos, Thailand, Cambodia, Vietnam, Bangladesh and Myanmar.

OK, Ms. Tan’s purpose was to shock us out of our complacency. She succeeded. But I, for one, think that what was most shocking was the site of the presentation. This wasn’t a meeting of environmentalists or even one of the many groups that try to link investors to climate issues, such as the UNEP FI or the CERES coalition. It was an HSBC presentation. And, as if to emphasize that fact, the very next day the same group heard a presentation from a competing firm, CLSA, which included a slide on water worries and Chinese agriculture.

In the end then, the most impressive fact might not be any of those presented by Ms. Tan. It might be that both HSBC and CLSA included water as a major risk factor – one generally ignored by most institutional investors – in mainstream presentations to mainstream investors. Where, and how, you have a conversation does matter. Perhaps it’s time to start worrying.

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U-Turn For Exec Comp?

Paris, September 13 – Just yesterday, 23 people gathered in a windowless conference room at a convention hotel in Paris. The ostensible reason was to comment on the work of the International Corporate Governance Network’s remuneration (executive compensation) committee The conversation took a quick and sharp turn, however. 

It began normally enough, with a discussion of alignment of interests between executives and shareowners, role of a Board’s compensation committee, disclosure of compensation, etc.   However, I decided to ask what I thought was going to be an ineffectual verbal challenge.

Why, I asked, do institutional investors keep preaching alignment?  We’ve been doing that for two generations and it has not worked. Perhaps it’s time to admit the obvious: Shareowners’ interests and executives’ are not perfectly aligned and cannot be made to be perfectly aligned. Perhaps it’s time to admit that fact and return to an old idea: Management, even senior management, are employees. They ought to be fairly – and I’d say even generously compensated – but they are employees of the corporation not suppliers of capital. Is it simply time to stop trying for alignment and deal with them as highly-compensated employees for whom the board must make a compensation decision, whether in cash, shares, options or whatever.  But that means the Board must consider what has become know in Europe as “quantum,” which is shorthand for both “what do all the various compensation schemes add up to” and “how much is enough”.  It does not include, however whether options or restricted shares or phantom shares or time-vested grants or performance-grants or deferred comp or three-year vesting rights or any of the other “comp speak” we’ve all come to know far too well over the years.  In some ways, by considering the mechanisms of pay, and trying to make them aligned, we’ve emphasized form over substance, and the amount has become a fall-out, rather than a decision.

Surprisingly, I received an amazing amount of support.  The comments came quickly, as if a dam had been broken. “We’ve become too complex,” “Even boards don’t know what they’re paying,” etc. Later, in a plenary session, a banker basically admitted as much, saying that for senior bank executives, compensation had become a slot machine: They pull a lever and three years later out comes a trickle of coins or a fountain of folding money.

To be sure, the shareowner community is not about to consign alignment to the scrap heap of history. Nor should we.  The fact that alignment is not perfect is to make the best the enemy of the better. But to admit that alignment can never be perfect means that we must insist that the Board use judgment about quantum as well as instruments that align compensation as best it can.  And that has been a taboo topic for institutional investors (including me) for too long.

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Debunking Myths About ISS

Together with my frequent collaborator Stephen Davis, Executive Director of the Millstein Center at Yale, I write a monthly column for Compliance Week. The most recent debunked some myths about ISS and Glass Lewis, the leading American proxy advisory services. (Quotes indicate a direct excerpt from the Compliance Week column, available at http://www.complianceweek.com/three-myths-about-iss/article/209119/ .)

 Myth 1: Shareowners Blindly Follow ISS’s Recommendations.

“People… generally cite two facts to support the all-powerful ISS theory, one substantive and one related to timing and process.

“The substantive fact is that all companies failing to receive a majority on their say-on-pay resolutions had negative recommendations from ISS. That is true. As of this writing, ISS has recommended against 279 say-on-pay resolutions at companies in the Russell 3000 universe, according to Patrick McGurn, special counsel at ISS. Of those, 37 have failed to achieve majorities. What type of super-villain is ISS when it can only get its way about 13 percent of the time?

“More damning, almost as many companies (30) received support from more than 90 percent of the shares cast. In other words, a company that received a “no” recommendation from ISS was almost equally likely to get a positive vote (of 90 percent or more) as it was to get a negative vote….

“The timing and process explanation also confuses correlation with causation. More than one CFO has told us he “knows” investors are blindly following ISS because it was immediately after ISS issued its negative recommendation that negative votes were cast. This shows two basic misunderstandings of how institutional investors vote. First, about 75 percent of ISS’s clients use ISS as a voting platform. This is a ministerial function where ISS provides an electronic voting mechanism… ISS is hired to analyze the proxy proposal, but the decision on how to vote depends on the investor’s own guidelines. They cannot cast the votes until ISS’s analysis is released. Even for those “research only” clients of ISS… wait until after ISS (and other proxy advisers, if they have subscriptions) release their analyses to vote, because they use those analyses as inputs to their own analysis.”

That’s not to say that all institutional investors are careful proxy voters. About 700 of ISS’s 1200 clients do not customize their votes (though they tend to be the smaller clients by assets under management). Those lemming-like proxy voters are doing no one any favor. They are the kernel of truth in the web of conspiracy-theory falsehoods about ISS controlling corporate governance in the United States. But the best academic studies we have seen suggest that they amount to less than 15% of the votes cast in most cases. To be sure, that’s far too many. But don’t elevate them to a threat to American capitalism.

The second major myth exploded by the column concerns ISS’s supposed role as the de facto corporate governance standard setter in the United States. As we point out, ISS is as much standard taker as setter, serving as a vessel for receiving and amalgamating market views from its clients. It starts reviewing its proxy voting guidelines for the next year in the summer and solicits responses to a proxy voting survey. It hosts roundtables and even has an open comment period, open to the public, every fall. That comment period is announced on the ISS website, and is usually in September or October.

Finally, we examined whether or not ISS listens to companies, and noted that it held more than 200 in person meetings with companies last year, as well as thousands of telephone conversations and e-mail communications. ISS even staffs a dedicated help line for companies seeking to understand or challenge its recommendations, and has an entire sector of its web site explaining how companies can communicate with ISS.

On a personal basis, it feels strange being cast as a defender of ISS. As we wrote in the column: “We know that debunking these myths makes us sound like unabashed apologists for ISS. We’re not. We have continuously criticized ISS for maintaining a consulting service to issuers even while rating and recommending votes for them on the other side. In fact, our public criticism resulted in a former CEO of ISS threatening one of us in writing with a libel suit. We still maintain that having both practices is unseemly, despite the “wall” ISS has created and the independent counsel opinion it has received. We have also crossed swords with ISS professionally. We were two of the four original founders of GovernanceMetrics International. Though we have no affiliation with GMI today, the firms were, and are, rivals.

“So we have reasons to be critical of ISS. But criticism does not ignore reality. We are in the midst of difficult changes to America’s corporate governance system, changes that affect power relationships, changes some people believe to be destructive. Let’s discuss them with one another, engage with one another, and even disagree with one another. In other words, let’s argue about the real issues. But let’s not demonize one market participant to the point that we lose sight of what’s important. It’s time to stop mythologizing, stop blaming ISS, and just get on with the hard business of governing our companies.”


___

Sinclair Capital wishes to thank Compliance Week for allowing extensive excerpts from “Three Myths About ISS”.

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Irrational Short-Termism in Investing

We have long maintained that time frame mismatches contribute to many of the thornier investing and corporate governance problems. We recently contributed an article on irrational short-termism to the International Corporate Governance Network annual review that will be published at its annual conference in Paris next month. We thought it worth excerpting a small portion of it here.

In “The Short Long,” two Bank of England officials examined how investors discounted future cash flows when valuing some 624 large capitalization companies listed in the UK and US from 1986-2009. Overall, they find that cash flows that are five years in the future are valued as if they are eight years away; cash flows 10 years in the future are valued as if they will not occur for 16 years, and cash flows more than 30 years away are “scarcely valued at all.”.

In 13 of the 20 years examined investors overestimated the discount rate, or, to put it another way, investors were irrationally short term in their analysis. In nine of those 13 years, the irrationality was statistically valid, as it was over the entire period. However, perhaps the most disturbing finding is that eight of those nine statistically significant years were in the second half of the time period examined, indicating that short-termism is getting worse. Or, as the authors state: “Myopia is mounting”.

Indeed myopia appears to be endemic according to the findings. Investors were irrationally short term, in a statistically significant way, across the following economic sectors: materials, information technology, industrials, energy and utilities, consumer, health, and financials. Overall, they estimate “excess discounting of between 5% and 10% per year.”

While a 5-10% error may not seem like much, the fact that it is a yearly factor means it, too, compounds over time. They cite example upon example of investments which should have positive net present values, and, should, therefore, be made, but will not with such excessive discounting. “This I a market failure,” they write. “It would tend to result in … long-duration projects suffering disproportionately… including infrastructure and high-tech investments… often felt to yield the highest long-term (private and social) returns and hence offer the biggest boost to future growth.”

The Bank of England study is available at www.bankofengland.co.uk/publications/speeches/2011/speech495.pdf. The full ICGN article also discusses an IRRC Institute/Mercer study showing excess unexpected turnover in the public equity portfolios of institutional investors. That study is available at www.irrcinstitute.org/pdf/IRRCMercerInvestmentHorizonsReport_Feb2010.pdf.

–August 14, 2011

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