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Local Restaurateur Steve Hartnett Is Trying To Save Capitalism

By Nancy Nichols |

Steve Hartnett, the man behind many local restaurants (Cool River, Fox & Hound, Flip’s, Bob’s Steak & Chop House in Grapevine, to name just a few), is also an astute futures trader. He’s a rich man and he is on a rabid campaign to make a difference. Hear him out:

Dear Friends and business associates,
About a month ago we sent out 1000 copies of the below letter to all the Senators, House members, administration folks, relevant government servants, along with hundreds to the media.  My/our goal is to support capitalism and reign in excessive pay packages.  We are receiving encouraging written response from government officials (SEC), senators and house members.  The most treasured hand written response came from billionaire John Bogle–founder of Vanguard.  To address the problems outlined in our letter he volunteered to serve with Warren Buffett in advisory capacity to our government.  He also offered his warm encouragement–advocating we “press on.”

We are noticing much of our terminology and argument has made it’s way into both the media and government.  This of course is rewarding and highly encouraging.  It is a great motivator to see one can make a difference on issues that are important.  What starts with a “butter fly effect” can become a stampede of elephants.

Unless you notify me otherwise, I will include you in our ever growing email contingent of concerned citizens.

Below is a copy of the letter.

Ps: no offense to the CEO’s on my list, as I am not suggesting you are overpaid, but I think you will agree the system is being abused.

March 6, 2009

Dear Dr. Bernanke,

This is a cry for help.  A message in a bottle, corked and set adrift in a sea of people who can make a difference.

As a late stage cancer patient my motivation for writing this letter is selfishly simple; gain favor with our capitalistic maker through a humble effort to help “thy neighbor.”  Our capitalistic system mimics the creator’s brilliant, “tough love,” self improving system of natural selection; reward strength and success and discourage weakness and failure (anyone want to take a shot at improving His plan?).

Parasite Found

Our divinely endorsed free market capitalistic system is under attack from within.  The assault was initiated by executive betrayal of duty regarding their compensation.  This was followed by a misdirected and counter-productive government response; raise marginal tax rates.   As a result, we find ourselves in what might be called, The Great Repression.

Today in corporate board rooms there are parasites, cloaked in Armani suits, gorging themselves on the muscle of wealth creation; they are killing both the working class and risk taking investors.  While costly middlemen — gluttonous carried interests and overpriced investment managers — are extracting the icing off an otherwise mediocre cake, an even more sinister misappropriation is playing out in corporate board rooms where corporate insiders cut themselves bigger pieces of a finite wage cake.  Our great country was built when fortunes of “old money” were created by investors taking great personal risk to grow the economy.  Much of today’s “new money” feeds on the risk and labor of others; they act as leeches, extracting vital economic energy from the system.  In desultory response, searching for equalizing justice, an angered and confused government raises taxes on all the most successful, impeding the natural selection process that is crucial to economic growth.

I am a 60 year old investor, academically trained in finance and entrusted with funds from 150 family members and friends.  This duty I take very seriously.  Also, I am the founder of a restaurant company that was taken public in 1994.  As chairman of our fledgling company I had a front row seat (and was a reluctant beneficiary) to the sleazy, self-fueling dynamics of insider compensation.

Thou Shall Not Tempt

We are all guilty, we are all suckers.  We deserve punishment when we negligently provide insiders the “ATTRACTIVE NUISANCE” of writing their own checks.  The resulting value drainage from savings and retirement accounts is relentless and will eventually be forced on the tax payers.  The trillion dollar problem is hiding in plain sight.

It is no big surprise that the genesis of our current meltdown is rooted firmly in the overreaching behavior of corporate decision makers.  Why do they risk their company with ever increasing no house limit bets? (Subtle hint: their compensation package encouraged recklessness).  Two inequities are prominent with executive pay.  Firstly, the outrageous, ever expanding size of these compensation packages and secondly, their stealth, hard to value structure.  We all want to hire the best and brightest to steward the companies we invest in, but our total disregard for cost when attracting talent is akin to a drunk tearing up the room looking for a bottle.

While scrutiny is currently being applied to executives in the banking system, the problem goes well beyond banking.  Common sense whispers…“something is rotten in Denmark” regarding the compensation programs in all industries across the nation.  Consider that the compensation of the average CEO has grown from about 40 times the average employee–in just 1985–to upwards of 450 times today (not counting personal perks like private jets and sinful golden parachutes).  Executives are not 10 times more valuable today than they were in the past but they have found 10 times more ways to game the system.  The collateral damage from this inequity could destroy capitalism.

The Endless Loop

Scientists understand the runaway greenhouse effect on Venus is caused by an ever increasing carbon dioxide canopy which traps heat; this releases more carbon dioxide which further thickens the canopy.  As the canopy metastasizes less heat can escape, causing surface temperatures of 700+ degrees (only a convenient analogy and not meant as a position on climate change).    Corporate insider compensation is trapped in this same sort of self destructive ever increasing loop.

As chairman at board meetings, I quickly found an uncomfortable dynamic at work.  WE WERE IN CHARGE OF OUR OWN COMPENSATION (smell that?).  This created an obscene conflict of interest because we represented both the shareholders and ourselves!–Guess who was the favorite in that conflict?

When we discussed compensation for executives – which was the same time we would discuss board compensation – they would roll out reams of facts and statistics supporting how well upper management was being paid at other companies of similar size[i] (we must keep up with the ever increasing wealth of the corporate Jones’s).  Companies of below average compensation were conveniently omitted from the data base — after all, we were better than average.  The CEO, or possibly a board member who was a golfing buddy of the CEO, would present data supporting a large pay increase for our amazingly talented executive.  After a wink and nod, the shamefully biased voting board, in quid pro quo collusion with the incestuous compensation committee (hired and fired by the board), would approve these increases, hiding behind “comparables” from other companies.  Just like Venus, the ever expanding salary loop reinforces itself with no end in sight.

With everyone in the room looking for ways to break new “justifiable” ground for higher pay the problem starts working its way down the high end of the corporate ladder.  After all, it is hard to justify an astronomical CEO package without giving a huge package to other executives.  Soon, the entire upper management team’s compensation becomes bloated–in  2006 CEO’s of America gave themselves a 38% raise at the expense of those doing the heavy lifting!.  How do you like them apples?

Weapons of Wealth Destruction

Ever wonder why executive ‘group think’ loves risky leverage?  THINK OPTIONS.  Here is why options are the number one problem with compensation packages and inappropriate for executives (don’t forget to hold your nose):

(1)     A general lack of understanding of options encourages doling them out like candy, when they are truly “weapons of wealth destruction.”

(2)    Options create risk management vertigo by encouraging executives to take unreasonable business risk.  THE PRINCIPLE DRIVER OF OPTION VALUE IS VOLATILITY.  The more the better.

(3)    Options destroy fiduciary impartiality regarding dividend policy.  Dividend payout always has a negative impact on option value giving executives an incentive to limit appropriate payout.

(4)    Academics have continually proven that most of a company’s change in value is driven by GDP and industry prospects. Options often pay off for a general rise in GDP, not for exceptional CEO performance.

(5)    In bull markets, options pay off like winning lottery tickets.  In bad times, a dark and deadly comedy plays; featuring the threat of abandoning ship by the very executives who set the course.  They scream out the need to re-price their options, blaming the economy for the falling share price (but never giving GDP credit during the expansion phase).  RE-PRICING IS THE ULTIMATE RIP-OFF and we are about to see a wave of option re-pricing the likes of which will defy imagination[ii].

A Possible Solution

As a trader of financial futures, I was stunned to learn that financial institutions levered 50:1 were unwilling to take defensive action when the market started falling.  Their leverage ratio only allowed a 2% fall in value before going underwater; unforgiveable.  Worse still, the instruments to hedge this over exposure were liquid and readily available.  But imagine the $100’s of millions they make on their options if things go just right–with no downside if they don’t.

In 2006, as a small investor I learned that insurance against mortgage default was available and I purchased a large chunk to protect my overall portfolio against economic collapse; we were repaid 7 to 1.  Questions:  Why didn’t the CEO’s of over exposed entities do the same?  Where was the board?  Short answer:  Watching how it all played out on their compensation packages.

Although I am not a fan of big government, I recognize the good and the necessity of intervention on certain issues.  Just like the government must limit highway speed to protect the innocent, so to they must limit runaway executive compensation.  Below is a four part solution:

(1)    The first, though simple, is the most critical… outlaw stock options as compensation.  Substitute restricted stock, eliminating risk management vertigo.

(2)    Roll back CEO pay, and require shareholder approval beyond a “reasonable” number.  If insiders want to make a democratic run at shareholder generosity, fine, but shareholder approval must be requested on a separate instrument from the dense legal information sent out by companies.  It should be requested in bold print with emphasis on the importance of insider conflicts, golden parachutes, and include warnings about runaway compensation.

(3)    Incorporate this new legislation all at once to prevent brain drain between industries.

(4)    Appoint the venerable John C. Bogle and Warren Buffet – who are proven risk takers and guardians of shareholder value – to review these suggestions and edit/add their own.

In conclusion, executive pay is inequitable and destructive due to both size and structure.  Executives will continue to take excessive risk in a quest to justify excessive pay.  Eventually the outrage mayl be remediated but the hour glass of capitalism is low on sand.  There is no democracy in our current methodology.   It is a hidden dictatorship riddled with quid pro quo[iii] .  The quiet majority does not like it one bit, but we only have ourselves to blame.  We allow the foxes to guard the shareholder hen house.

Most sincerely,
Steve Hartnett
United States citizen

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