- MTGE has several conflicts of interest, but they are properly disclosed.
- RWT and MFA are not only mitigating conflicts of interest, they are eliminating them.
- TWO has serious conflicts of interest that should concern any shareholder.
- RSO has limited their conflicts better than TWO, but not by much.
This is part 3 in a multi-part series on conflicts of interest in the REIT industry.
Conflicts of interest are a constant problem that prevent the market from efficient operations. Most economic textbooks focus on an environment that rarely occurs in the market. The textbooks are geared toward real free markets and assume that owners are managers. With those two assumptions the textbooks move away from the reality and create the potential for investors be misled.
The stock market can distort the connection between ownership and management. The normally difficulties of keeping a manager working in the owners' best interest are dramatically increased when ownership is distributed across thousands of people. The owners may have enough power to force management's hand, but it requires the collective effort of many informed owners. Management on the other hand is not distributed.
If management can increase their compensation at the cost of shareholders, they will gain all the benefits. Shareholders will diversify the losses, so it isn't worth the time and effort for individual shareholders to hold management accountable. Collectively, it would be worthwhile, but the shareholder may not be able to internalize enough of the gain.
Rather than attempt to fix every company suffering from a conflict of interest, it may be more efficient to find out which companies are already being responsible. That is where we come in. We review the financial statements looking for some of the most common conflicts of interest. We prepare a graph to quickly convey the most relevant information and the sources to anyone that is interested. A company could be a great investment even if it had conflicts of interest. The goal isn't to stop people from buying companies that have conflicts. The goal is to allow shareholders to be informed.
Each report on conflicts of interest will have 5 or 6 companies. The discussion that follows the chart will bring up the most interesting things we learned about the company.
The general format of this report:
- Discussions of the companies
This report contains a chart that may be difficult to read without the description "How to read this chart". The explanation is part 1. To keep the analysis at a reasonable length, the description has not been restated. If you have not seen the directions in part one, please read them.
Link to the 10-K/A: RSO
Link to Code of Ethics document (PDF): MFA
Link to Code of Ethics page: MFA
Other companies may also have a code of ethics. I use them to supplement as needed, not as a primary method of collecting information. The information acquired there could not be found in their 10-K or Proxy statement.
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.
Discussion of the companies
MTGE did a fairly good job of disclosing the conflicts of interest. Unfortunately, there were several of them. The CEO and Chairman of the board is also the CEO of the management company. Unfortunately, the management company also has a parent company, which can convolute disclosures and requirements. Unfortunately, it feels like every sentence about this company has to start with unfortunately. That could result in a great deal of yellow on some stocks, but for MTGE they always laid out enough clear evidence for a solid red.
The highlight of their financial statements, in my opinion, is this sentence from page 34 of the 10-K: "Mr. Kain is also the President and Chief Investment Officer of American Capital Agency Corp. and the President of its manager. Thus, he has, and may in the future have, significant responsibilities for other funds that are managed by the parent company of our Manager or entities affiliated therewith."
RWT is looking very solid. The CEO and Chairman positions are occupied by different people. Previously that was not the case. The board has amended the bylaws to state that the Chairman of the Board does not automatically serve as the CEO. That's better than nothing, but it would be better if the roles were separated by rule. The board has endorsed this separation of powers, which says good things about their performance.
All severance packages are contingent upon the executive signing a statement releasing all claims against RWT. That's a great sign. The severance packages do exist, but they are less than the industry norm and require the executive to sign off. The 250% comes from base salary, rather than including all bonuses. That is an enormous difference.
The highlight of their financial statements is this line from page 59 of the Proxy statement: "Our Board of Directors monitors and reviews issues involving potential conflicts of interest and related party transactions. In this regard, the Board of Directors applies Redwood's Code of Ethics, which provides that directors, officers, and all other employees are prohibited from taking actions, having interests, or having relationships that would cause a conflict of interest, and our directors, officers, and all other employees are expected to refrain from taking actions, having interests, or having relationships that would even appear to cause a conflict of interest. Except as described below, there were no relationships or related party transactions between Redwood and any affiliated parties that are required to be reported in this Proxy Statement."
Most REITs are structured to create the very conflict that RWT is explicitly preventing. Well done to RWT.
MFA has also caught my eye. Their financial statements were very limited in their reference to conflicts of interest, but did include directions to view the company's code of ethics. Lacking enough information to fill in several of the cells, I searched the company code of ethics. It is wonderful. I would recommend it to any REIT, or any corporation for that matter, that wanted to take shareholder rights seriously.
They currently separate CEO and Chairman, with the Chairman position held by a "non-executive independent director." That's how it should be. The roles were previously combined, but during that time, powers that were traditionally granted to the chairman of the board were instead reserved to a fully independent Lead Director.
Parachutes were set in dollar amounts rather than relative to salary. They appeared to be low to moderate compared to industry norms.
Other employment is strictly prohibited. No arrangement which would limit the employee's ability to function solely in the best interest of the company is permitted. MFA gets the nod for the best ethical controls so far in this series.
TWO deserves to be all red. The only yellow square is the separation of CEO and Chairman, however, the people work together closely and share ownership in the management company. The CEO and Chairman are technically different but the conflict has not been effectively mitigated. The CIO is also a part owner of the manager.
In a nutshell, this disclosure (found on page 28 of the 10-K) sums up the problem with being a shareholder in TWO:
"We are subject to conflicts of interest arising out of our relationship with Pine River and its affiliates, including PRCM Advisers. PRCM Advisers is wholly-owned by Pine River. Each of Brian Taylor (the Chairman of our board of directors), Thomas Siering (a director, and our Chief Executive Officer and President), and Bill Roth (our Chief Investment Officer) is a partner and owner of equity interests in Pine River. All of our other executive officers are employees or partners of Pine River. In addition, Mark D. Ein (the non-executive Vice Chairman of our board of directors) owns an interest in CLA Founders LLC, which, in consideration for services to be provided to PRCM Advisers under a sub-management agreement, is entitled to receive a percentage of the management fee earned by PRCM Advisers, and an affiliate of his is an investor in a private fund."
RSO filed an amended return, so the 10K and 10K/A have been linked. Our report used the 10K, rather than the amended form, because the 10K/A was uploaded without page numbers. If looking for our original source material, please use the link to the 10K. Without page numbers, it would have been much more difficult to provide easy access to the original material and relevant passages. Since the focus of these articles is to increase transparency and bring conflicts of interest to light, providing clear links to our research is crucial.
The CEO and Chairman positions are occupied by different people, but they explicitly do not have a policy about it. Page 182 of the 10-K does contain some provisions to limit conflicts of interest, but in my opinion, they are insufficient.
Note: This series usually focuses on Real Estate Investment Trusts that invest primarily in Mortgages on residential properties. RSO is a REIT, but would not fall under such a narrow definition. This series will be expanding to include more diversity in the REITs it examines.
This analysis contained companies that were remarkably free of conflicts and companies that were the polar opposites. Based on the results of this ethical screening, I am unlikely to conduct deep research into MTGE, TWO, or RSO. However, I may do some deeper digging into RWT and MFA. If the companies perform well on the financial metrics, I may invest in either or both of the companies. Upon completing an investigation of those REITs, I may also publish articles referencing both their financial performance and mitigation of conflicts of interest. At this time, that research into financial metrics has not been completed.