One of the favorite theories of economists is that people respond to incentives. Ask an economist about how to change a person’s behavior and they will respond that if you put into place the proper incentives, people will alter the way they do things. Of course, there always seems to be unintended consequences, but that gives people like me something to write about.
Looking at incentives has a number of applications with respect to investor relations. For example, if you really want to understand why corporate managements are doing what they’re doing, look at the compensation programs their companies have in place. For example, if a company has as a key component of its incentive plan Return on Equity, investors need to consider the consequences. In itself, ROE as a measure used in compensation bonuses is not a bad thing, because it rewards efficient use of corporate capital and causes corporate managers to think twice before undertaking risky projects. However, the unintended consequence of using ROE may well be that instead of expanding the company through new projects, management will figure out that it is safer for their bonuses to buy back stock in order to lower the equity denominator in the ROE equation. As a result, the company may shift away from expanding its core business and focus instead on buying back stock, in essence becoming more driven by financial measures than operating measures.
Or consider how a company’s bonus plan is constructed. If management’s bonus is calculated off actual results, the focus will be on achieving that particular target, whether it is improvement in EPS or operating profit or something more exotic. However, if a compensation plan is constructed to measure against management’s plan for the coming year, then there is every incentive for management to sandbag the plan, thereby setting up easily achieved bonus goals. In such a case, investors need to ask “What’s the plan?” because if management exhibits a low opinion of its ability to hit operating goals, investors shouldn’t be expected to build in large gains into their stock performance expectations.
What caught my eye and started me thinking about incentives actually comes form the opposite side of the equation. As you may recall, the Dodd-Frank Financial Reform Act of 2010 contained language regarding payments to whistleblowers in fraud actions. In short, if a whistleblower provides independent information of fraud to the SEC that results in a successful enforcement action that recovers at least $1 million in sanctions, the whistleblower is entitled to recover at least 10% and up to 30% of the recovered funds. For more on the law, see my blog post “Whistle While You Work” dated February 28, 2011.
Now, a little over a year after the law went into effect, The Wall Street Journal through its Marketwatch web site reported on October 18, 2012 that the SEC is averaging 8 tips about fraud per day, for a total of 2,820 to date. It seems as if the incentive part of the law is working. Of course, receiving a tip and conducting a successful prosecution are two separate things, as the same article reports that to date, only one whistleblower has received a payout under the provisions of Dodd-Frank. The unintended consequence here may be that the SEC simply doesn’t have the resources to sift through all the information to determine the best cases to prosecute.