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Recently I became interested in the insurance industry while looking at the valuation of equities in general. I reviewed over 120 publicly traded companies within the industry and found 24 candidates, at least on the surface, that were worthy of further research. I looked at several areas to determine worthiness. Return on equity, shareholder friendliness, and consistent retained earnings growth were the primary determinants for worthiness. Arch Capital Group Ltd. (ACGL) was one of the 24 companies left after my initial analysis. As you all know, my analysis eventually leads me to reading annual reports. The ACGL annual report for 2004 is the cause for the following discussion(ok, monologue). The 2004 report is yet another shining example of why investors need to read the annual and other SEC financial reports released by the companies in which they invest.
In my world, purchasing stock in a publicly traded company is literally becoming part owner of said company. Any profits made by the company are ultimately the shareholders'. When management, who is supposed to be stewards of the company, invents legal but unethical ways to line it's own pockets, it is upsetting. If I find that management is participating in legal tom-foolery I will not invest in the company and I will more than likely divest if I already own shares. After reading Arch Capital Group's annual I do not consider the company investable. I found that legal theft has been committed.
The following is an excerpt from the ACGL 2004 annual report(page 91). I've substituted the name “Bobby” for the chairman's real name and added commentary which is in italics and bold print. I changed the name since the man died some time ago and I do not make a habit of speaking ill of the dead.
Non-cash compensation expense was $14.7 million for 2003, compared to $49.5 million for 2002. During 2003, 2002 and 2001, we made certain grants (primarily of restricted common shares) to employees and to “Bobby”, chairman of our board of directors, under our stock incentive plans and other arrangements. These grants were made primarily in connection with our underwriting initiative. Non-cash compensation expense in 2002 included $39.5 million related to certain restricted common shares for which the vesting terms had been accelerated, as discussed below. During 2002, our board of directors accelerated the vesting terms of certain restricted common shares granted to “Bobby”, which had been issued in connection with the November 2001 capital infusion, and “Bobby” agreed to repay the outstanding $13.5 million loan previously made to him by us. “Bobby” was granted 1,689,629 restricted common shares which were initially scheduled to vest in five equal annual amounts commencing on October 23, 2002(Read giving him more of an ownership stake because he's a really swell guy). The vesting period and the amounts were changed as follows: 60% of the shares vested on October 23, 2002, 20% of the shares vested on October 23, 2003 and 20% vested on October 23, 2004.(This is really a convenient development when you read further on)The $13.5 million loan made by us to “Bobby” was used by him to pay income and self employment taxes. Under his retention agreement, “Bobby” received additional compensation in cash in an amount sufficient to defray the loan’s interest costs(Read interest free loan. So the company is already losing out to inflation at the very least. And I'm not even getting into the opportunity cost). In order to facilitate the repayment of the loan, we agreed to repurchase an amount of “Bobbys'” shares equal to the principal balance of the loan, less any cash payment made by “Bobby”, for a price per share based on the market price for the common shares as reported on the NASDAQ National Market on the date of sale.(Sooooo, in order to help good ole Bobby repay his debt to ACGL they grant him restricted stock, approve an accelerated vesting period , and then buy the stock back from him equal to the loan minus any cash payments made by him. Are you following this?) In addition,we agreed to make gross-up payments to “Bobby” in the event of certain tax liabilities in connection with the repurchase.(Since he couldn't pay his taxes to begin with thus the original loan was made. Might as well just pay his capital gains taxes on the loan and stock sale. No, capital gains is not another term for interest paid or interest expense.) Pursuant to such arrangements, we repurchased 411,744 common shares from “Bobby” for an aggregate purchase price of $11.5 million. “Bobby” used all of such sale proceeds and $2.0 million in cash to repay the entire loan balance on November 12, 2002.(Essentially he made 11.5 million on the 2 million he paid back. Yeah, that's right, he made money on the loan !) Following such share repurchase, our book value per diluted share decreased by approximately $0.04 per share. During the loan period, compensation to “Bobby” under his retention agreement included payments of $0.6 million from us, of which $0.4 million was used by him to pay interest on the loan and the balance was used to pay his related income tax liabilities.”
So did you catch all that? Just in case you didn't I'll explain it in layman's terms. “Bobby” either couldn't or wouldn't pay his income taxes, so he took out a loan from ACGL, for which he is chairman, in the amount of $13.5 million to pay his taxes. He was charged no interest for this loan. The company then creates stock out of thin air and gives it to “Bobby.” To help him repay the loan he owes the company, the company offers to buy his stock back from him in the amount of the loan less any payments he has already made or will make. “Bobby”, out of the kindness of his heart, generously pays $2 million out of his own pocket back to the company and then settles the rest of the loan with the sale of the stock, that they created for him, back to the company. To show their gratitude for the repayment of the loan, ACGL also agrees to pay any tax liability that “Bobby” incurs from the sale of the stock back to the company. It's not like he was going pay taxes on it. That's how this thing got started in the first place.
Frankly this type of behavior really pisses me off. A multimillionaire essentially skips out on his tax liabilities while I'm still paying my share(and you are paying yours.) Furthermore, he did it using the resources of the company he was supposed to be watching over. What's worse is that he was enabled by the rest of the board. As I mentioned earlier, the resources ie the profits, the cash, ultimately belong to the shareholders. I'm pretty sure most shareholders would frown upon a company executive using their profits as a personal piggy bank. Behavior like this is generally a predictor of future bad behavior, at least in my experience.
As an investor it is absolutely imperative to read the financial statements and SEC filings of the companies you are considering investing in or have already invested in. Not only can you determine the health of your company by reading the statements and filings, you can determine whether the executives are aligned with you or against you. By reading Arch Capital Group's 2004 annual report I determined that the executives were not aligned with the company's shareholders. If the executives are not on my side I will not invest in the company. I would highly recommend other investors look elsewhere rather than invest in ACGL.