- The REIT industry is rife with conflicts between management and shareholders.
- Management usually wins.
- I dug through the SEC filings on HLSS to look for the dirt. I was shocked.
Home Loan Servicing Solutions, Ltd. (NASDAQ:HLSS) has an interesting governance structure. The chairman of the board is really the driving force. Mr. William Erby is not only the chairman of multiple companies. He is Harvard educated (a fact pointed out in the statements), and the financial statements for his firm were brilliantly designed. Remarkably the firm managed to compile both the 10-k and the other definitive proxy statements without using the term "arm's-length" (or arm's length) once. Given that the chairman would appear to face numerous conflicts, it is an interesting reporting choice.
Anyone who has seen my previous REIT articles knows that I can be pretty harsh on companies that design their corporate structure to disadvantage the shareholders. I find the practice morally objectionable and completely incongruent with efficient markets. Simply designing a structure that disadvantages shareholders is a betrayal of the trust shareholders put in the board. I've found that REITs are more prone to problems than the general market.
When I started digging into the financial statements, I expected to find severe problems. The chairman is at the chair of several companies, and he has the perfect position to steal from the shareholders. The company is incorporated in the Cayman Islands, which made me suspicious. If he wanted to, he could have put in place a system that would let him regularly transfer shareholder wealth to himself. Ironically, I didn't find problems. The chairman has recused himself from ALL negotiations in which there is even the appearance of a conflict of interest. The other employees, anyone that is not solely serving on the board, face extremely strict employment guidelines.
So basically, he had the legal option to plunder the company, and instead created rules to say that neither he nor anyone else would be allowed to plunder. He even established a rule that he wouldn't be allowed to participate if it even appeared that he might have a nefarious intent. The following chart breaks down all the problems I was searching for:
Your chart has numbers and letters and colors. What does it all mean?
Green means I found strong evidence that the potential conflicts were not present or effectively mitigated.
Yellow means the evidence was insufficient for me to declare that there was no potential problem there.
Red means I found strong evidence that the potential for conflicts of interest was present.
Yes, I'm aware there is NO red in this chart. That is NOT normal. It is extremely rare to find a REIT where there isn't a single red bar.
Numbers indicate the page number on which I found evidence. There may be evidence on multiple pages. If the evidence on a single page is sufficient to make a decision, I only list that page. Sometimes it takes multiple pages viewed as a whole to reach the required level of evidence.
The letter K or the word Proxy is listed to let you know if I was looking at the 10-K or the Proxy statement when I found the conflict and recorded the page number.
With that cleared up, I'll move on to the individual findings.
Mr. Erby is the chairman, but he isn't the CEO. I don't want the chairman to be the CEO. How much power should the CEO have over the board of directors? I think the answer is near zero. I don't believe in hiring the fox to guard the hen house. They didn't believe in doing that either.
External manager structures
This structure stinks for shareholders. It reduces the companies reporting requirements and allows them to designate systems that are unfair to shareholders without the shareholders having any say. It's a terrible structure. They avoided it.
Not arm's length
Many REITs engage in transactions where the head of the company signs on the dotted line for a transaction between two companies which are both compensating him to negotiate in their best interest. These documents suspiciously avoided the term. Judging from the requirements for the chairman to excuse himself, I think it is highly unlikely to be a problem. It stays yellow instead of green because the evidence isn't strong enough, but it is very close to strong enough.
The parachute payments are a mere pittance compared to the extravagant amount thrown at most executives. This proved beyond the shadow of a doubt that such parachute payments are NOT required in order to attract talent.
Equity based compensation
Given the structure in place, it is unlikely that this is a problem, but their disclosures didn't address it directly enough to give the green light.
Adjusted "Equity" definition
Many REITs that create external manager structures provide themselves a payment based on the book value of the equity. At first, that might seem okay. The executives would have an incentive to grow the equity so they could be paid more in later years, and they wouldn't get paid for taking on excessive leverage. Sounds good, right? Most REITs redefine the term "Equity". They don't all use the exact same definition, but most definitions include that Equity will not include adjustments for changes in AOCI (Accumulated Other Comprehensive Income) or Retained Earnings or Loss.
In practice, that means the best way to increase their compensation is to continue issuing shares. To give an extreme example:
Company Imagination earns 0 dollars in net income. They pay out 1 million dollars in dividends. They issue stock for 1 million dollars. Under the "Adjusted Equity" definition, their value of equity has increased by 1 million dollars and they will proceed to pay themselves a percentage of those one million dollars every year.
Does it really happen? In the real world, it isn't that simple, but I have found one company using that definition that pumped out tons of new stock at a massive discount to book value. The shareholders that bought before the act were completely screwed as book value per share tanked. Management wanted those extra shares out as soon as possible because they were paying themselves a percentage of the "adjusted equity". I'll be exposing that company in a later article. There was no evidence that HLSS participated in that type of behavior, but no green bar because they didn't explicitly say they wouldn't.
Usually it is easy to find out if management has indemnified themselves on behalf of the shareholders. It's very common, and frequently the indemnifications are visibly stated. On rare occasions the company neither states if the managers were indemnified nor includes in the exhibits any statements of indemnification.
Other employment / No meaningful restrictions / Competing employment
Surprisingly this is fairly common in the industry. Often the CEO will be paid several million dollars a year and permitted to have another job at the same time. Occasionally it is even stated that he does have another job, and that he has no obligation to spend any minimum amount of time working for the company you might invest in. Sometimes his other job involves investing in the same securities. Shareholders just get to trust that he'll do right by them and not give them whichever deals are not panning out as well. That's a pretty bad bet, seeing as he usually has a legal contract that says he can't be held responsible for anything he does to harm the shareholders. That's the normal situation, but isn't the case at HLSS. In the case of HLSS, the company requires all top level employees (and maybe the lower ones) to sign contracts saying they are not allowed to perform work for any other company. They are not permitted to engage in any transaction or hold any equity that could cause the appearance of a conflict of interest. For shareholders, this is great. This is the way it should be done.
HLSS is a morally sound company that went out of its way to ensure that no one would even start to think about stealing from the shareholders. Shareholders may be concerned about the business risks of investing in a REIT, and those certainly exist. Shareholders shouldn't have to be concerned about the manager legally plundering their equity in the company. For shareholders of HLSS, that isn't a concern. I'm rating their ethical systems as top notch. When I invest in REITs, I want a company that is ethically sound and undervalued. If I take on risk of unethical management, I want a large discount to reward me for that risk. Based on HLSS's ethical controls, they should be trading at a premium to their less ethical peers.
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