Joe Nacchio and the Conservative Investors

The best thing about mark-to-market accounting is that it forces investors to ignore sunk costs. If a stock is trading at $30, it's either a good investment at $30 or a bad investment at $30, regardless of whether you bought it at $3 or at $103. If you mark to market every day, that essentially forces you to justify every one of your holdings every day, at its market price that day. (The bad thing about mark-to-market accounting is that it forces you to justify every one of your holdings every day, which can mean that you trade in and out of stocks much more than is optimal.)

Now let's say you own a quiet and boring utility, like US West. If you mark to market, you'll wake up one day realizing that you no longer own the quiet and boring US West, and instead own a high-flying dot-com called Qwest, trading at some enormous valuation. Whatever reasons you had for owning US West would probably no longer be good reasons for owning Qwest, and so you would probably sell your Qwest stock and buy something more boring instead.

Or let's say you own an old and storied publishing company, like Time-Warner. One morning you wake up and realize that you suddenly now own AOL instead. Eek! That's not what you wanted to own at all. So you sell, and invest the proceeds in a nice new mattress.

In an ideal world, that's how M&A would work. There would be no difference between cash offers and stock offers, because cash can always be used to buy the stock of the new company, while the stock of the acquiring company can always be sold for cash.

In this world, however, M&A deals never work like that. If people get paid cash, they're unlikely to spend that cash on the stock of the company which just bought them out. On the other hand, if people get paid in stock, they're likely to keep it.

That's why Floyd Norris is so upset about the six-year sentence that Joe Nacchio received today.

There are some companies that are meant to be speculative vehicles. Others are supposed to be the kind of stock that the proverbial widow and orphan can safely own. When investors in one of those are defrauded, the crime takes on a special level of venality...
As the local telephone company, US West had attracted conservative investors. Retirees trustingly left their life savings in the stock. And they were all but wiped out. By the bottom in 2002, an investment of $64 in US West at the end of 1998 was worth less than $2.

It's easy, but unrealistic, to say that conservative investors, if they were really conservative, should never have held onto their Qwest stock in the first place: the conservative thing to do would have been to sell it and invest it in bonds or something instead. But of course the twin obstacles of inertia and capital-gains tax meant that many fewer individuals – and even institutional investors – did that than should have done.

So is Norris right that Nacchio should have received a harsher sentence on the grounds that he defrauded "the proverbial widow and orphan" alongside more sophisticated investors? I do think that sentences for white-collar crimes should indeed be tougher than they are: many people were much more badly harmed by Nacchio than they would have been had he simply come up to them on the street, bashed them on the head, and stolen the contents of their wallets. Which might well have resulted in a harsher sentence.

And CEOs do, ultimately, have a responsibility to their shareholders – if their shareholders are conservative, then they should be conservative; if their shareholders are aggressive investors wanting outsize returns, then the CEO should take more risks.

But in practice it doesn't work that way. Shareholders can change their mind much more easily than CEOs can. So if you want something conservative, you choose a company run in a conservative manner; if you want something more aggressive, you choose a company run more aggressively.

So while I agree with Norris that Nacchio's sentence is too short, I disagree that it should have been bumped up just because he inherited some conservative shareholders when he bought US West. The least that a shareholder can do is be aware of what kind of company he owns. And if you don't like the kind of company you own, the easiest thing to do is simply to sell your shares. You might not like the tax consequences, but a 15% capital-gains tax bill is a lot less painful than owning a stock which plunges to zero.