Lloyd Blankfein Won't Run Goldman Forever

Also Martin Shkreli, fake news, pay ratios, passive investors and continuing-director puts.

Lloyd Blankfein, chairman for now.

Photographer: Andrew Harrer/Bloomberg


Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein will retire one day, presumably to be succeeded by one of his two designated potential successors. Those are not very controversial claims: Blankfein told Bloomberg Television last year that he's "not planning to die at my desk," and the likely successors, Harvey Schwartz and David Solomon, were named co-presidents of the firm in late 2016 so that everyone would know they were next in line. But on Friday the Wall Street Journal reported that Blankfein "is preparing to step down as Goldman Sachs Group Inc.’s chief executive as soon as the end of the year," or perhaps in 2019, which caused a flurry of concern and reminiscence until Blankfein tweeted that it was a false alarm.

Goldman Sachs' Succession Story and the Path Forward

Or I mean he tweeted that "It's the @WSJ's announcement ... not mine." Might he retire this year or next? Sure, why not? He has to retire eventually, and as banking gets more boring -- Goldman is making consumer loans now! -- there is less reason for him to stay. And when he does go there will no doubt be another flurry of reminiscence. Blankfein is one of the longest-tenured investment bank CEOs, pretty successfully steered the most famous U.S. investment bank through one of the most difficult and consequential periods in modern financial history, and is surely the big bank CEO with the most finely developed Borscht-Belt comedy skills. He will be missed. After last week's discussion of other comings and goings at Goldman, I look forward to reading a roundup of what people think Blankfein should do next. James Tisch suggested that former Goldman President Gary Cohn "could head a financial institution, be the front man for a venture firm, or own a local restaurant" after leaving his current job in the White House, and while the first two options are probably off the table for Blankfein, perhaps he will go in on a restaurant with Cohn? I would certainly eat at Lloyd & Gary's House of Nosh. 

When Blankfein does retire, there will be extreme continuity of bald men, since the board "isn’t looking beyond Goldman’s two co-presidents, Harvey Schwartz and David Solomon, to replace him," the Journal reported. Here is a joint profile of the two presidents from last November, which involves both knife-sharpening and karate, giving you some sense of the succession intrigue. Here is a story from Friday about how Schwartz was the favorite:

“Harvey has promised a lot of things to a lot of people,” one person familiar with Goldman’s inner workings told The Post, adding there’s already talk of a reorganization. “I think Harvey’s getting it.”

But those promises will go unfulfilled, because Goldman announced this morning that Schwartz will retire next month and that Solomon will be the sole president, chief operating officer, and -- though this was not spelled out -- surely heir presumptive. One lesson here may be that (1) Goldman's partners don't actually get together to elect the next CEO but (2) they sure talk like they do. Another lesson is presumably that there's something to the Blankfein retirement talk: Why would the firm end the succession battle and declare Solomon the winner unless that decision has some near-term relevance?

Disclosure: I used to work at Goldman, where Solomon sat at some impossible distance above me in the hierarchy. 

How's Martin Shkreli doing?

Real bad: On Friday, he was sentenced to seven years in prison for his dumb fraud, which seems too long, though if you are going to shed any tears for a victim of America's fanatical over-reliance on incarceration, there are thousands of more worthy candidates than Martin Shkreli. Seven years in prison for what Shkreli did is a wildly cruel and disproportionate punishment, but he is Martin Shkreli, so at least there is that. Plenty of people get wildly cruel and disproportionate prison sentences without even being Martin Shkreli!

Elsewhere here is some speculation about the U.S. Marshals' auction of Shkreli's one-of-a-kind Wu-Tang Clan album that is apparently inevitable. I once joked about that album that "perhaps it is cursed and brings an indictment for securities fraud to whoever possesses it," but now I am pretty sure that is true. The winning bidder for that album is not going to be a modest fan of classic hip-hop; it's going to be someone who (1) admires Martin Shkreli and (2) has a lot of money. I feel like that combination suggests someone with a lot of ill-begotten money. If you are doing some dumb fraud with great success, and you want to draw the government's attention to you, be sure to bid on Shkreli's album. 

Elsewhere in financial crime and punishment, "a 25-year-old man who invented a bogus buyer to manipulate the price of Fitbit stock and cash in was sentenced Friday to two years in prison." This seems unduly harsh to me -- he only made about $3,000 from his scheme -- but I am doubly biased insofar as (1) my wife's law firm represented him in his criminal case and (2) he apparently reads my work, or at least, prosecutors noted that he read my article about a fake Avon tender offer before launching his own fake tender offer. So I am sorry to have had a hand in leading him astray.

Incidentally, while we're talking about fake tender offers, here is a draft paper on "Fake News in Financial Markets," by Shimon Kogan of MIT and Tobias Moskowitz and Marina Niessner of Yale:

Small firm prices rise on fake news, which is predominantly positive, by 8% upon its release, which subsequently gets fully reversed over the course of a year. Hence, for small firms the market appears fooled by these articles initially, overpricing small firms with fake news by 8% on average, but then eventually corrects the mispricing. For mid-size firms, the price impact is negative immediately, and there is a permanent 4% discount associated with fake articles written about the firm, suggesting that mid-size firms having fake articles is a bad signal about the firm. For large firms, there is no price impact – initially or long-term – from fake articles written about the firm. These results suggest that the market is efficient with respect to large firms and appears inefficient for small firms, consistent with intuition suggesting that the cost of information (direct and indirect/psychological) is larger for small firms. The evidence for mid-cap firms, however, may be consistent or inconsistent with market efficiency.

The small- and large-firm effects are kind of what you'd expect -- though I guess I'd have expected a momentary dumb blip even for large firms -- but the medium-firm effect is a delight. It really should be embarrassing if people are going around putting out fake press releases about you, and it is pleasing to learn that it has a negative effect on the stock.

People are worried about non-GAAP pay-ratio disclosures.

I mean, not really, but here is an article about how companies are starting to comply with Securities and Exchange Commission rules requiring them to disclose the ratio between their chief executive officers' pay and their median workers' pay. "Critics call the pay ratio a blunt instrument that offers little meaningful insight," which certainly seems true, but on the other hand if you think it's too blunt you can always sharpen it up in the commentary:

One of the biggest contrasts so far is at Marathon Petroleum Corp. The company’s median worker made $21,034 last year. The oil refiner paid CEO Gary Heminger 935 times as much, or $19.7 million.

Marathon Petroleum, of Findlay, Ohio, notes in its filing that 32,000 of its 44,000 employees work in the convenience stores and gas stations of its Speedway unit, many of them part-time. Excluding those workers would bring the firm’s median pay closer to $126,000 and lower the ratio to 156 to 1.

"Median pay" may not be an especially meaningful number at a company that has very different sorts of workers, but nothing stops a company from providing more meaningful comparators. If the ultimate result of the pay-ratio rule is to push companies to give more nuanced pictures of their pay structures for different lines of work and different regions, then that does not seem like an especially bad thing?

Should index funds be illegal, are they Marxist, etc.

The Bank for International Settlement's Quarterly Review is out and it hits on a number of our favorite themes. The headline is "Volatility is back," and there's a discussion of the return of volatility generally and the rise of exchange-traded volatility-based products in particular. ("Overall, market developments on 5 February were another illustration of how synthetic leveraged structures can create and amplify market jumps, even if the core players themselves are relatively small.")

Even more useful though is the section on "the implications of passive investing for securities markets," which doesn't exactly contain any big surprises but which is a good overview of the standard issues involved in the rise of passive investing:

Passive portfolio managers have scant interest in the idiosyncratic attributes of individual securities in an index. They do not devote resources to seeking out and using security-specific information relevant for valuing individual securities. In effect, they free-ride on the efforts of active investors in this regard. Hence, an increase in the share of passive portfolios might reduce the amount of information embedded in prices, and contribute to pricing inefficiency and the misallocation of capital.

An increase in passively managed portfolios could also affect the pricing of securities through greater portfolio-wide trading in the market. Passive managers buy and sell the entire basket of index constituents in response to fund inflows and outflows. This trading pattern can induce higher co-movement in the prices of the constituents of the index.

That sort of thing. Here's one fun bit that has gotten some attention:

By design, passive funds invest in all securities included in the index they track. Unlike active investors, they cannot express their disagreement with the decisions of individual issuers by selling their holdings. A higher share of passive investors could therefore weaken market discipline and alter the incentives of corporate and sovereign issuers to act in the interest of investors.

Growth of passive bond funds, specifically, might encourage leverage by borrowers. Because inclusion in bond indices is based on the market value of outstanding bonds (that is, the face value of bond debt times its price), the largest issuers tend to more heavily represented in bond indices. As passive bond funds mechanically replicate the index weights in their portfolios, their growth will generate demand for the debt of the larger, and potentially more leveraged, issuers. From a financial stability perspective, there is a concern that this can act procyclically and encourage aggregate leverage.

Passive investing is a simple algorithm in which you buy more of the biggest companies. In equities this is pretty intuitive, but it's a little weird in debt markets: The algorithm tells you to buy more debt of the most indebted companies, which is arguably the opposite of what credit analysis would tell you. 

Incidentally, there is a parallel argument in equities, though I guess it is less troubling. There, the point is that inclusion in indexes is based on bigness, and the rise of indexing encourages companies to defer going public. If you were the 2,000th biggest company in America, 20 years ago, you would quite naturally have gone public: That's a big company, and public markets were where the money was. But now there is more money in private markets than there used to be, while the money in public markets is increasingly index-dominated. Now if you're the 2,000th biggest company you might wait a few more years, raise some more big venture rounds, tap SoftBank a bit, and wait to go public until you're in the top 500 and have a quick path to inclusion in the S&P 500 Index.

Continuing-director puts.

A lot of bonds have a provision saying that, if there is a "Change of Control" at the issuer, then it has to immediately offer to pay back the bonds. This makes sense, from a bondholder perspective: You bought bonds of XYZ Corp., you analyzed the credit of XYZ Corp., you liked XYZ Corp.'s steady cash flows and conservative management, and if it is suddenly taken over by the fly-by-night yahoos at PQR Corp. then you want your money back.

Exactly what a "Change of Control" is is debatable, though. Obviously if PQR acquires XYZ in a cash merger or tender offer, then that is a change of control. But what if XYZ's management loses a proxy fight, its board is replaced by insurgents, and those insurgents put in place a new fly-by-night management that is very different from the one its bondholders signed up for? That is not as obviously troubling as a merger: The corporate structure is the same; it's just under new management. But it is still worrying enough that bondholders might want a chance to get their money back. And many bonds allow them to do so; this is usually called a "continuing directors" change-of-control put.

There is a problem with that, though, or rather two problems that interact interestingly. One problem is the dumb simple one of how to write it, which lawyers mostly solved not by writing "if we lose a proxy fight then that is a change of control" but rather something to the effect of "if a majority of our board is replaced by new directors who were not approved by the previous directors then that is a change of control." The other problem is that, if your bonds all have to be paid back immediately at a premium when you lose a proxy fight, then that rather discourages shareholders from exercising their right to vote in a proxy fight. Shareholders may think incumbent management is bad and that the insurgents would be better, but nonetheless feel forced to vote for the incumbents because the company just can't afford to have all its debt come due. What seems to bondholders like a sensible protection of their investment might seem to shareholders like a cynical measure to limit the shareholder franchise and entrench incumbent management.

But the courts in Delaware, where most big U.S. public companies are incorporated, have solved this problem fairly simply, by saying basically: Well, if you lose a proxy fight, then your existing board had better "approve" the new directors. If the incumbent board "approves" the new directors, then that neuters the change-of-control put; if it doesn't, and makes the debt immediately payable, then it violates its fiduciary duties to its shareholders. Perhaps there are some exceptions where the new directors are so beyond the pale as to be un-approvable, but in general, "absent any determination by the incumbents that the rival slate has suspect integrity or specific plans that would endanger the corporation’s ability to repay its creditors," the board ought to approve them. 

Anyway here is Alexandra Scaggs on a proxy fight at Newell Brands Inc., which has one of these change-of-control/"continuing-directors" puts, and which has put a risk factor into its Form 10-K explaining that "absent amendment, consent, or other action," it may have to offer to pay back all of its debt at 101 percent if (1) it loses the proxy fight and (2) its credit ratings are cut. (Newell's change-of-control put is limited to changes of control that bring its rating below investment grade.) Scaggs quotes Covenant Review arguing that this risk factor is a little overblown -- "we think that the Risk Factor with respect to a Change of Control under its indentures should not have been included, and can be considered potentially wrong, misleading, or incomplete" -- because realistically speaking if Newell does lose its proxy fight it will probably have to approve the new directors and avoid the change-of-control put. Wellllllllll. The risk factor isn't wrong. "Absent amendment, consent, or other action," there is a risk of a change-of-control put. Sure the board probably would give consent, but it can go ahead and talk tough now. Part of the purpose of the continuing-directors put is to protect bondholders, part of it is to protect incumbent directors, and part of it is to allow those incumbent directors to gesture menacingly towards it even if it won't ultimately protect them. 

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