Indict Mozilo, but indict American corporate governance too
Yesterday afternoon I was on my way to a studio to appear on CNBC's Closing Bell when I got a call from the producer telling me that at 4 pm the SEC would announce an indictment of former Countrywide CEO Angelo Mozilo on an insider trading rap. While I am not sure the SEC has a solid case, I believe there's a better case to be made against the corporate governance principles that enabled Mozilo to make so much money selling Countrywide stock.
The SEC alleged that Mozilo made $140 million in personal profit selling Countrywide stock which he promoted publicly even as Mozilo's emails called many of its loans "poison." (I'd imagine that Mozilo's lawyers will use Countrywide's 2006 10K, which clearly shows rising delinquencies among its 'non-prime' mortgages to suggest that it was disclosing its problems -- including a 36 percent increase in its provision for credit losses.)
Before getting into why Mozilo's alleged insider trading indicts American corporate governance, there's an interesting connection between the topic I discussed and the Mozilo indictment. My CNBC topic was Variable Prepaid Forward Contracts (VPFCs) -- a way for CEOs who hold a big stock position in their companies to lock in profits, limit their losses to as little as 10 percent, while delaying and lowering their tax payments on the gains.
VPFCs are contracts between the CEOs and brokerage firms. The CEOs get cash upfront equal to between 75 percent and 90 percent of the stock they commit to the plan and the brokerages get a promise that the CEOs will give them a certain number of their shares at a specific price in three to five years.
The IRS is investigating whether VPFCs are a tax dodge and a study of 474 VPFCs has found that their stock prices decline eight percent more than a control group. The potential tax dodge happens because the executive pays the taxes on the stock when he or she actually turns over the shares to the bank, typically many years after he receives cash from the brokerage with which he does the deal. And since the executive does this through a partnership, he or she pays less than the 35 percent ordinary income rate. Billions in tax dollars could be at stake here.
What does all this have to do with Mozilo? First and foremost CEOs have much more information about their company's prospects and both insider trading and VPFCs enable them to profit from that information through their stock holdings. While Mozilo's alleged insider trading is clearly illegal, VPFCs are legal but they still enable CEOs to profit from insider information.
How so? As I mentioned, research indicates that after companies take on VPFCs, their stock prices decline by 8 percent more than a control group of stocks. Why?
- Bad news predictor. CEOs tend to adopt these plans right before bad news comes out about the company. As Carr Bettis, a Gradient Analytics executive who co-authored a study on VPFCs said, "they [VPFCs] are followed on average by a share decline and unusual levels of negative corporate events."
- Increased short position in the stock. The other reason is that VPFCs boost short interest in the stocks. To hedge their holdings, brokerage firms borrow shares from the CEOs and sell them short -- betting on a decline.
VPFCs and Mozilo's alleged insider trading are birds of the same feather. They both allow CEOs to use their privileged access to information about what is really happening inside their companies to make a profit which depends on a high stock price. That in turn depends on creating the illusion that they believe in the future of the companies they lead.
Fortunately for them and unfortunately for the common shareholders, CEOs write their own report cards. In academia, teachers grade students, students don't grade themselves. This is one principle that ought to make its way from the ivory tower into the real world.
That means companies that let CEOs execute VPFCs should at a minimum be required to disclose those details to shareholders -- like what proportion of their holdings they are betting -- through the VPFCs -- will decline. But to really get at the root of the problem, we should remove the financial accounting function from public companies and give it to an independent government body.
If not, why should anyone buy common stock?
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and is the author of You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.