- WMC and ARR suffer from serious conflicts of interest. In the case of WMC, behavior of management has led to fines and compensation to other parties.
- DX is raising the bar for the industry. They mitigate conflicts and disclose clearly.
- NLY's financial statements could have really used a page from CIM's 10-K. Literally, they should have addressed a conflict in their company that CIM addressed for them.
This is Part 2 in a multi-part series on conflicts of interest in the REIT industry. Part 1 can be seen here.
Conflicts of interest are everywhere. It is the nature of agency that conflicts of interest will arise. It is the duty of the board of directors to eliminate and mitigate those conflicts of interest to the best of their ability. Occasionally, the board of directors must decide between curing a conflict of interest and profiting from it. As investors, we do not have the same conflicts of interest. We want to invest in companies that provide a return on our money. Investors are stuck facing a situation of "Caveat emptor," which is Latin for "Let the buyer beware." To help investors with their research, we are developing a series investigating and uncovering some of the most common conflicts of interest. These conflicts are NOT unique to the Real Estate Investment Trust (REIT) industry, but they are present in sufficient number to merit research.
The general format of this report:
- Discussions of the companies
To make time and room for a discussion of the companies, the description of each "conflict of interest" is omitted. Similarly, the description of how to read the chart is found in Part 1.
Please use the link at the top of the article to "Part 1" if you have not seen it.
There is no link to the proxy statement of CIM. The statement was not available from the Securities and Exchange Commission filing. Further information is available in the discussion of companies.
Link to: Form 10.7 for WMC
Below, you will see a chart showing several of the most common conflicts of interest, in shorthand, on the Y axis. Above the X-axis will be the ticker symbol for several REITs. This list is far from exhaustive.
You may notice from the chart that this batch of six REITs collectively scored much better on Golden Parachutes.
Discussions of the companies:
WMC: This is an unusual situation. The majority of the evidence came up red, but four areas were inconclusive. Inconclusive is more common in companies with effective stockholder protection. When a conflict does not occur, there is often no reference to it. It is my professional opinion that the bottom 3 conflicts, which are yellow are probably occurring. Nothing conclusive could be found, so it is only an educated guess.
On the upside, WMC does limit the expenses that can be passed on to them by the manager. On the downside, page 35 of the 10-K states: "Our manager maintains a contractual as opposed to a fiduciary relationship with us." That small line is redefining the obligations of the manager in a legal sense. Going deeper would require a legal education that we do not have.
Page 36 of the 10-K has deeply unsettling information. In January 2014 settlements of two separate and unrelated regulatory matters were announced. These matters involved the manager. In both cases the manager "solved" the problem by paying millions in both compensation and fines. It is my experience that these amounts are generally paid from the company's equity, rather than from the pockets of the person that decided to perform the action. In both cases they did not admit or deny the charges. For comparison, even Richard Nixon declared he was not a crook. It's something special when a company does not bother to admit or deny charges while paying out a combined amount of over $20 million.
CYS: In an unusual event, CYS internalized their management functions on September 1st, 2011. Though the employees were changing their status, no termination fees were triggered. That shouldn't have to be said, but given the state of the industry, it needed to be checked.
The CEO/Chairman dual role can create some serious problems in compensation. By having internalized management, rather than an external manager, some of those problems can be mitigated. The compensation committee does not include CEO in any role, and in 2013 the independent directors met 11 times without management. Page 27 of their proxy statement does a great job detailing the executive compensation.
Equity based compensation is probably in the clear, but the information was not quite conclusive enough to color it green. Mr. Grant, the CEO and Chairman of the Board, had a golden parachute equal to 2.5 times annual pay. The rest of the executives were limited to 1 times annual pay. While this is clearly a golden parachute, it is so vastly below the level of golden parachutes in most REITs that a red square felt inappropriate. Page 35 of the proxy statement really lays out precisely what is included in the golden parachute.
Unfortunately, there are some problems not included in the chart. For instance, in addition to the parachute paying out for termination "without cause," it also pays out if the executive leaves for "good cause." The definition of "good cause" includes a reduction in responsibilities or pay. This ties the board's hands when it comes to negotiating pay.
DX: This REIT is setting the bar for mitigating conflicts of interest. There are a couple of conflicts that merit attention though. While CEO and Chairman are currently not the same position, it wasn't always that way. As recently as 2013 Mr. Akin was serving in both roles. He is now the "Executive Chairman" and Mr. Boston is the CEO.
The arm's length transaction has an asterisk because of the way the compensation committee works. They have the authority to hire outside consultants, but historically did not do so prior to June 2013. Historically, they did not use the option. Instead, they considered the compensation practices of similar public companies based on information compiled by management at the committee's request. That is one of the worst possible methods for a compensation committee.
Golden parachutes are in effect, but are clearly explained in pages 29 to 32 of the proxy statement. The performance bonus program was available to the following individuals: Mr. Benedetti, Mr. Boston, and Mr. Akin. The troubling bit there is that Mr. Akin is the Executive Chairman. I do not know any of these people, but I frequently jot down the names of people in key positions while researching a company. It helps find oddities like this.
My professional opinion is that it is more likely than not that there is no competing employment. There is not sufficient evidence to be certain though.
ARR: The competing employment situation is bad. Read pages 24 and 34 of the 10-K if you are considering investing. One example they give of this conflict of interest is to state: "For example, each of our executive officers is also an executive officer of JAVELIN and an employee of ARRM." They go on to state that these executives may "cause us to enter" into contracts that are not at arm's length and may not be favorable.
Golden parachutes definitely exist, but the specifics are not provided. Requirements to provide such information are handled by stating that the information is another report. I was unable to locate that other report. It probably exists and is probably on file with the SEC, but I did not find it. If anyone has a link to it, I'd be happy to have it posted in the comments.
There is one section that references a sub-management agreement with a termination fee equal to 6.16 times the annual payment. If that contract were terminated, the payment would have been $35.4 million. There might or might not be other termination fees.
NLY: On July 1, 2013, employees were moved to an external manager. Page F-35 of the 10-K details the move. There are restrictions on outside employment, but the restrictions are placed on the management company rather than the individuals working for it. The problem with those restrictions is the management company could, to the best of my knowledge, create a parent company that owns them and move their agreement to the parent company. The parent company would not be bound by the restrictions on competition and the human beings would be effectively free of the restrictions. From a shareholder's perspective, this is a poorly designed restriction.
If you simply read page 6 of the 10-K, you'd think there was no conflict of interest. That's the worst part. When you read the statements for CIM, you'll find disclosures that indicate a conflict of interest is occurring. Yes, you read that correctly. The financial statements for CIM name their management company and reference a conflict of interest that involves NLY. If you only read NLY's statements, this is very difficult or impossible to uncover. The disclosures you may want as an NLY shareholder are found on page 16 of the 10-K report for CIM.
There are non-compete agreements for three of the employees, but the non-compete is based on them leaving the manager company. Further, these non-compete clauses do not come into effect unless they are terminated for cause or quit without "Good Reason." I do not consider these non-compete clauses to be worth the paper they are printed on. Based on the wording in the financial statement, it appears they are free to act in ways that would benefit competitors while working in their current position.
The only benefit to the ethics section is that there is no termination fee on the management contract. I sourced two pages because I was so surprised and wanted to make sure it was real. The language appears to be quiet clear.
CIM: The manager's function under very broad guidelines. Or in other words, they are free to do as they please. The board of directors has not seen fit to protect shareholders. According to page 17 of that 10-K, management can change the strategy without stockholder consent. To be clear, at this point we are only assuming that they are still an mREIT. They might be something else. We wouldn't know until statements were published after the change.
The good news is that the management fee is only .75% of equity annually. Normally it would be 1.5%, but not now. The management fee will stay at 0.75% until management is current on all filings required under applicable securities laws.
Perhaps the best thing about the disclosures is that most of the conflicts were clearly admitted and relatively easy to find.
Conclusion: A decision to buy or sell a stock should involve more than a review of the ethics, even though that is an important part. However, the situation in WMC and ARR was so alarming that I would be incapable of providing a buy recommendation in any reasonable circumstance. I'm refraining from issuing "sell" recommendations when the research is strictly into conflicts of interest. I would be feeling very nervous if I held shares in either of those companies.
Similarly, I do not issue buy ratings without a more complete analysis. From an ethical standpoint, DX is raising the standards. There are still issues, but compared to other securities DX has done a far better job at eliminating and mitigating conflicts of interest.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.