The proxy statements filed by public companies prior to their annual meetings are not always interesting to read. But Coca-Cola’s (KO) has caught my attention, thanks to some diligent work by David Winters of Wintergreen Advisers, LLC. Like many companies, KO is putting its compensation plan up for a non-binding shareholder vote. However, it turns out that when you wade through the various elements of Annual Incentive Compensation, stock options, Performance Share Units and Restricted Stock, the company has estimated that as much as 500 million shares of KO could transfer from the owners to management depending on meeting various performance metrics. The potential dilution could be as much as 14.2% according to KO’s own documents, some $24BN of value based on its current market capitalization. In 2013, 6,400 employees received some type of long term equity compensation, so this amounts to just under $3.8 million per eligible employee.

What makes this even more staggering is that Berkshire Hathaway (BRK) is the largest shareholder in KO and one would imagine that Warren Buffett’s support of owner-oriented corporate governance would have been more fully reflected in this plan. Perhaps he was unaware of the details, but it looks like a shocking attempt to unreasonably enrich KO’s management.

The details listed above are not prominently featured; KO’s proxy statement that was mailed to shareholders omits the pertinent facts listed above. For those you have to go to the electronic filing and read the supplemental information, something I was only prompted to do by Mr. Winters raising the issue.

An interesting sidebar from my perspective is that the Compensation Committee is chaired by Maria Elena Lagomasino, fondly known as “Mel” (her initials) when she ran the Private Bank catering to Chase Manhattan’s wealthy clients (prior to its merger with JPMorgan). I didn’t work closely with Mel, but she was generally well liked and respected by those that knew her. Sadly, Mel’s judgment in overseeing the development of this plan has come up short. Perhaps she’s trying to create a whole new class of high net worth clients among the ranks of KO’s senior management. 

We are shareholders in KO and BRK (as is Wintergreen Advisers). My faith in the judgment of KO’s management is somewhat shaken by this plan. They note that only 77% of shareholders voted in favor of the 2013 compensation plan last year, and incredibly this 2014 plan was drawn up as a shareholder-oriented response to last year’s low approval rating. We find the 2014 plan an egregious and unnecessary transfer of shareholder wealth to management, and shall be voting against its adoption. We’re interested to hear what Warren Buffett thinks.

Today’s Wall Street Journal has an article that analyzes the transactions costs, or commissions, faced by retail investors in municipal bonds. They find that the cost of buying a typical muni is about twice that of a high grade corporate bond. I wrote about this in my book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. The SEC published a 2012 Report on the Municipal Bond Market in which they also identified relatively high transactions costs.

The problem isn’t necessarily the high costs faced by investors; it’s the effort the industry makes to avoid full disclosure. Finance routinely benefits from opaque pricing of its products, from brokers knowing more about pricing than clients. There’s a basic conflict of interest between a municipal bond broker, who wants to sell bonds at a high price, and a retail client who wants to buy them at a low price. The type of price transparency that exists for equities would clearly benefit the clients, but not the brokers since it would impede their ability to charge such a high commission. The industry is generally against improved price disclosure, for obvious reasons.

If brokers had to invest in what they push on their clients, such as overpriced municipal bonds, the problem would probably solve itself quite quickly. But that’s unlikely to happen anytime soon, so in the meantime retail investors in municipal bonds should approach the market with a healthy level of skepticism and recognize that their is no alignment of interests between the retail bond buyer and their broker.

Unlisted, registered REITs (Real Estate Investment Trusts) deserve a worse reputation than they apparently have. Yield-seeking investors continue to plow cash into them, and  the brokers that market them clearly won’t let a bad idea get in the way of a commission. This is a curious animal; registered, meaning the security has to meet all the disclosure, reporting and other requirements of public securities, but not listed meaning there’s limited or no liquidity. The registration feature no doubt gives comfort to the retail investor, but the absence of liquidity represents a substantial drawback.

You’d think that if you’ve gone to all the trouble of registering a security you’d want it to be publicly traded. However, these unlisted securities can charge underwriting fees of up to 15%, leading to an immediate 15% loss of value for the client. A public market quote that reveals this loss would be quite an inconvenience for the underwriter and issuer. Furthermore, the absence of a public market dissuades any sell-side research from covering the company, because there are no commissions to be earned on secondary trading activity. Inland American Realty is one such security, and in September Massachusetts announced a settlement with five brokers over improper sales of unlisted registered REITs including Inland American Realty. I wrote about this in June. Five firms, including Ameriprise, had been stuffing unwitting clients with a bad investment because of the high fees it generated. At least regulators are on the case. The Federal securities regulator, FINRA, also has a website that warns investors about this type of security. The warnings are out there. Why would any firm that truly puts its clients’ interests first continue to push such poor investments?

Yesterday, I was at a conference and I picked up a brochure from one firm titled, “The Case For Investing in Non-Traded REITs”. Among the supposed advantages are, “Illiquidity that favors the long term investor.” Are they serious? How does illiquidity favor any kind of investor, short term or long term?? It favors the issuer, because there’s no public market to expose how poorly their securities are valued. Another related benefit is that they are, “Not subject to public market volatility.” But again, public markets allow you to exit your investment. It’s your choice, you can always decide to ignore the information public markets give you, but as with most information it’s better to have it than not.

If your broker markets unlisted, registered REITs, they’re not wholly focused on investment products that are designed with your best interests in mind. You should draw the appropriate conclusion.

Aubrey McLendon is the former CEO of Chesapeake Energy (CHK). He’s a swing-for-the-fences kind of CEO; he almost bankrupted himself with leveraged holdings of his company’s stock when it plunged in 2008. In 2011 Forbes named him America’s most reckless billionaire. He famously negotiated a sweetheart deal allowing him  to personally invest in individual wells drilled by the company. Earlier this year he was forced out by Carl Icahn. McLendon no doubt has many talents, but a strong sense of fiduciary duty is not among them.

American Energy Capital Partners, LP is McLendon’s new venture. It recently filed for a $2 billion IPO. American Energy is sponsored by American Realty Capital, run by Nicholas Schorsh. Schorsh is also the backer of Inland American Realty, an unlisted, registered REIT. We wrote about Inland American in June. It’s not clear why a company would be registered but not listed. Being registered allows sales to the general public, while not being listed means there is no public market to allow investors liquidity to sell. No public market liquidity means there is little incentive for sell-side form to provide research – which in the case of Inland American was a good thing because their IPO included numerous conflicts and up to 15% of your invested capital as fees. Their REIT has performed miserably since then.

McLendon and Schorsh have both demonstrated a facility for placing their own interests ahead of their investors. It seems especially appropriate that they have joined forces in this new partnership.

A year ago Corvex, a hedge fund run by Keith Meister, published a detailed analysis of why ADT was a cheap security. ADT is the largest market leader in home security monitoring in North America. They were spun out from Tyco earlier in 2012. Meister identified an underleveraged balance sheet supporting a business model with highly recurring revenues well positioned to grow through accretive acquisitions of smaller players. In addition, increasing ADT’s leverage and using the funds to buy back stock looked like a good way to return value to shareholders.

Corvex took a 5% position in ADT and Meister joined the board. It took a while, but by the Summer ADT seemed to have taken Meister’s advice to heart since they increased their stock buybacks and in September issued $1 billion in debt in part to fund their buyback program. But evidently Meister’s view from his position on the company’s board was no longer as positive as it had been in late 2012, when he assessed a Downside Case for the stock at $43 and an Upside Case of $63. At the time of his presentation in October 2012 it was trading at around $38. Last Friday it closed at $44.01.

On the weekend ADT announced that it had agreed to buy Corvex’s 5% position back at Friday’s closing price, and that Meister was resigning from the board. There’s no way of knowing why Corvex suddenly exited its position, but in the poker game that took place between ADT’s CEO Naren Gursahaney and Corvex’s Keith Meister over the pricing of this trade, there’s little doubt that Gursahaney’s naivete was fully exposed. Clearly a sale of 10.24 million shares of ADT, particularly when combined with the resignation of a director who was up until then clearly focused on shareholder value, should have taken place at a steep concession to the closing price. Meister understood this. Gursahaney did not. The consequent 5.8% drop in ADT’s stock price was in response to this news. A more shareholder-oriented CEO, or a better negotiator, would have been less desperate to rid the board of Meister, but ADT instead destroyed at least $26 million of value for the company by overpaying for its shares.

We owned ADT ourselves and would have at least liked the opportunity to make the same sale as Corvex with the same information, but equal treatment was not afforded to all the other shareholders. Activists are most definitely a two-edged sword in financial markets. They are by nature short term in orientation, so their claims to represent the interests of shareholders against intransigent management may not always be genuine. Some CEOs can add value to a company by resigning (such as Steve Ballmer from MSFT). In some cases, an activist investor can reduce the value of a security through its presence. Since Corvex can so quickly turn from pro-shareholder activist to opportunistic short term value extractor, the Corvex Discount might now reasonably exist on any security in which they have an interest. Just another hedge fund seeking a quick profit. He was a fiduciary to ADT’s shareholders until he suddenly wasn’t. His hedge fund clients might take note.

Summer has finally arrived in the north east United States. Cycling to work provides a pleasant reminder that commuting can be enjoyable, accompanied for now by the curious background chorus of billions of buzzing cicadas emerging from their 17 year subterranean slumber. It certainly beats getting on a train.

The question of the day is, when a company tells you how badly you might expect to be treated as an investor, does that absolve them of any responsibility when they subsequently do what they promised? Well, at least in the Commonwealth of Massachusetts, it turns out that a company’s disclosure doesn’t eliminate the obligation of a financial advisor to steer their clients away from really bad deals no matter how much the advisor may earn in additional fees.

Inland American Realty is a registered, unlisted REIT (Real Estate Investment Trust). Registered securities are available to the general public (unlike, say, hedge funds which are generally not registered and are therefore limited to investors with income and investable assets above a certain threshold). Registered securities must conform to more onerous reporting and disclosure requirements, but have a far larger pool of potential investors as a result. Unlisted securities cannot be bought and sold on an exchange (which is true of hedge funds as well as many other private, unregistered securities). Inland American is therefore a curious hybrid – available to anyone who wishes to invest, but with no obvious means of getting your money out. Being unlisted eliminates the interest of Wall Street research analysts to cover such a company, which given management’s operating history is just as well.

To start with, Inland American’s original prospectus in 2005 disclosed that, of $5 billion in estimated proceeds from their initial offering, $550 million was going to be used to pay “Selling Commissions”, a “Marketing Contribution” and “due diligence expense allowance”. Unashamed of this immediate 10.5% payout of their investors’ money, the company further disclosed that “actual organization and offering expenses may total 15% of the gross offering proceeds.” So your $10,000 initial investment was instantly worth $8,950 and possibly less (assuming, that is, that you could sell it, which you could not).

No doubt on the basis that, if a 15% fee hasn’t put you off many other highly unfavorable features are unlikely to, management went on to disclose additional gems including the complete absence of any prior operating history, conflicts of interest between management and a key service provider, the expected payment of big fees to affiliates of management and the fact that no market would exist in the securities. Full disclosure of anticipated investor-unfriendly acts was evidently an important part of their business model. The 5% dividend has seduced many investors in search of steady income. However, since the company isn’t profitable, paying any dividend simply amounts to giving you back some of your own money (i.e. a return OF capital rather than a return ON capital). Among their real estate assets are, appropriately, hotels in California. The Eagles warned investors how hard it could be to leave.

Perhaps not surprisingly, the investments chosen by this management team didn’t turn out that well either. Evidently skill at fleecing the buyers of your stock in broad daylight doesn’t correlate that well with real estate acumen. The company’s NAV (Net Asset Value) per share duly sank from its IPO price of $10 and was at $4.84 based on their most recent regulatory filing. Of course you can’t sell it there because no public market exists. The company will buy shares back from investors, but only under fairly onerous circumstances such as death. Most would no doubt prefer somewhat better liquidity.

Since 2005 real estate investors have endured some gyrations to say the least. However, the Vanguard REIT Index ETF (VNQ) has risen 35% during this time, so holders of Inland have reason to feel that there were better places to put their money.

In 2012 the company disclosed that the SEC was investigating several issues including fees paid to affiliates, dividends paid to investors, and valuations. Inland American maintained a mysteriously stable NAV through the 2008 financial crisis which possibly helped them sell additional shares at too high a level. This is, in sum, not a story that reflects well on anybody involved in recommending the investment.

Which brings us back to Massachusetts, whose securities regulator recently reached a financial settlement with five brokerage firms who had been improperly selling Inland American and other non-traded REITS to investors in that state. The regulator found, “…a pattern of impropriety on the sales of these popular but risky investments.” The complaint cited high commissions, conflicts of interest, sporadic valuation and the absence of a public market as sources of additional risk for investors. Evidently a few firms in Massachusetts were not overly burdened by the inconvenience of considering client suitability for their recommendations. One of the firms claimed in its defense that its compliance manuals and training materials included appropriate safeguards throughout the time they were inappropriately selling the securities. They obviously have bigger problems.

One would think that the features listed above would render Inland American and other similar securities (apparently unlisted REITS are a $10 billion per year industry) unsuitable for the clients of any brokerage firm whose intentions were to promote sound investments. A brief internet search reveals many more unhappy investors outside of Massachusetts who were guided into supposedly “safe” investments by their broker only to find that they were anything but. Several class action lawsuits have already been initiated. Perhaps the SEC and other state regulators will follow up with further sanctions.

This episode highlights the need for investors to truly understand how their financial adviser or brokerage firm is being paid. Firms recommending securities that result in a hefty share of proceeds to the broker selling them ought to be a clear warning. For a security that takes the public in but doesn’t let them out, the time has surely passed.

Writing covered calls sounds like such an innocuous strategy. You own shares in a company that you like for the long term. Its performance has been modestly positive but fairly unexciting. You don’t want to sell but want to make a little more money out of the investment. So you sell call options to generate some income. Covered call writing is widely used. As benign as it sounds, it’s generally not a great way to approach investing.  Most obviously, this is because your underappreciated investment can unexpectedly rise, when the sold calls will deny you the full return you had sought just as it reaches the valuation you expected. It also impedes your flexibility should you decide to sell the stock, since the sold call option will also need to be bought back.

It’s really not as conservative as it sounds. Put-call parity is a Mathematical identity that determines the price of a put option if you know the price of the identical call option and the underlying security. In the jargon of option Math, a long put option can be created by a short position in the stock combined with a long call option. P = C – S. It’s as rigid as 2+2=4. Options market makers routinely make prices based on “conversions” as they’re called. If call options are well bid, traders offset the calls they’ve sold by going long the underlying stock and buying put options. In this case, C = S + P. You can rearrange the symbols following the rules of algebra.

What this means is that if you are long a stock and you sell a call option against it, you have created for yourself a short put option (last bit of algebra: S – C = – P). The returns on a short put option and the equivalent covered call position are identical. They are economically equivalent. You retain the risk of a complete loss of your investment, but the short call means you now have only limited upside. Most obviously, if your risk appetite runs to shorting put options on individual stocks, why not just do that instead of going to all the trouble of owning the stock and selling a call? The transaction costs are lower and it’s simpler to execute. More important though, shorting put options can be bad for your financial health. For some, there is a certain appeal to getting paid an option premium in return to agreeing to buy a stock you like if it becomes cheaper. Put option sellers are happy to commit to buy at that lower price and to be paid in return. Others like to retain flexibility around their price targets – after all, maybe the stock has  fallen 10% for good reason and no longer looks so attractive. You might be happy to be able to change your mind based on new information. The difference is a philosophical one. However, not all writers of covered calls recognize that they are in fact writers of puts.

I once met a hedge fund manager whose strategy was substantially one of selling covered call options. I asked him why he didn’t simply write put options and save himself some trouble and commissions. His honesty exceeded his marketing ability, for he quickly pointed out that few clients would consider investing in a hedge fund that sold put options. That is economically what he was doing, but he was sensibly customizing his message for the audience. I can’t say I followed his subsequent progress, but I imagine that the 2008-09 market collapse and subsequent recovery was a memorable experience for his investors. We were not one of them.

For the client whose financial adviser sells covered calls, there exists an additional problem. As skilled as the adviser may be in selectively selling call options that will expire worthless, it’s hard to evaluate the results. Selling out of the money call options may earn you a small premium most of the time, but markets are full of surprises and occasionally the covered call position will deny the investor a substantial return on a long stock position that suddenly appreciates. To say that most of the time selling call options generates a small profit isn’t the same as saying that selling call options is a profitable strategy.

Importantly, you can no longer simply compare the performance of your account with a benchmark such as the S&P500, because in a strong market your account will underperform as your longs get called away. The premium income may compensate at other times, but you’ll never really be able to evaluate your results with numbers. Performance may be reported to you as “quite good”, or “acceptable under the circumstances” as opposed to “2% better (or worse) than the market”.

Investing results that defy quantitative assessment but instead rely on adjectives are to the advantage of the advisor and the detriment of the client. As much as one wants to retain a positive view of the financial advisory business, as new clients open accounts and transfer over the investments that their former adviser had made on their behalf, one’s faith in the judgment of other investment professionals can be challenged. Recently, a new client’s portfolio was transferred and included therein were short call options doing what they’re not supposed to, which is moving into the money and causing the underlying long positions to be called away, thereby limiting the return on the stocks that would otherwise have been retained.

So next time you or your financial adviser contemplate selling calls on a stock you own, consider whether you would just as readily be simply short the put options. Because that’s the position you’ll have.