2 Lessons Annaly Can Learn From the NBA Scandal

There are few business practices more reprehensible than nepotism, the hiring of relatives irrespective of merit. Though, another that measures up is unjustly enriching oneself at the expense of your employer and/or shareholders. Recently, two organizations that couldn't be more different from each other have shared common experiences in this regard.

Nepotism and the NBA
In the middle of last month, a report commissioned by the NBA Players Association questioned its executive director Billy Hunter's leadership and "exhaustively" documented questionable business practices including nepotism.

The most damning conclusions reported by Bloomberg News were that Hunter's $15 million employment contract was never properly approved by the association's executive committee and player representatives, and that the association had paid almost $4.8 million to Hunter's family members and their professional firms since 2001.

According to ESPN, his daughter-in-law made $173,219 in 2011 and has earned a total of nearly $1.2 million over the course of her tenure there. His daughter earned $82,954 last year as the union's benefits director. His son works at investment advisory firm that's been paid almost $3 million since 2005. And a second daughter has secured hundreds of thousands of dollars in fees from the organization for two law firms she's worked at since 2007.

While I have no basis to question the quality of work that Hunter's relatives have provided to the union, suffice it to say that the decision to hire so many of them certainly creates an appearance of impropriety. As we came to find out at the end of last week, moreover, it also fueled the association's decision to suspend Hunter from his duties.

So what about Annaly?
At this point, you're probably wondering what Annaly Capital Management (NYSE: NLY  ) has to do with any of this. The answer is that Annaly has employed, and continues to employ, many of these same unacceptable business practices.

In the first case, like Hunter, Annaly's executives have a history of enriching themselves at the expense of stakeholders. In 2011, both its then-CEO Michael Farrell and then-COO Wellington Denahan-Norris were paid $35 million each. By means of comparison, Jamie Dimon -- the CEO of the nation's largest bank by assets, JPMorgan Chase -- earned $23 million that year. You do the math -- Farrell and Denahan-Norris oversaw $109 billion in assets while Dimon presided over $1.1 trillion.

Now, suffice it to say, making a lot of money isn't a crime. In fact, it doesn't even amount to an appearance of impropriety so long as shareholders -- or in Billy Hunter's case, the executive committee of the players association -- approve.

The problem for Farrell and Denahan-Norris was that there's reason to believe Annaly's shareholders weren't comfortable with the extravagant payouts. At the company's annual shareholder meeting on May 26, 2011, its shareholders voted overwhelmingly in favor of yearly say-on-pay votes -- 268 million in favor of annual votes versus 102 million in favor of tri-annual votes -- under which they have the opportunity to express their approval or disapproval for the company's compensation system.

What do you think Annaly's executives and board members did? If you guessed that they ignored the shareholder vote, then you'd be right. Later that same day, the board voted against annual say-on-pay votes, choosing instead to hold them every three years. Here's how Annaly justified it in a regulatory filing with the SEC:

The Board has considered the appropriate frequency of future non-binding advisory votes regarding compensation awarded to its named executive officers. Among other factors, the Board considered the voting results at the Company's 2011 Annual Meeting with respect to the non-binding advisory vote regarding the frequency of non-binding advisory votes regarding compensation awarded to its named executive officers. The Board has determined that future non-binding advisory votes regarding compensation awarded to its named executive officers will be submitted to shareholders of the Company every three years.

In other words, when Annaly's board says that it "considered" the results of the vote, it should probably have included a disclaimer explaining that it also decided to reject them.

Beyond this and perhaps more alarming, Annaly's practice of nepotism puts Billy Hunter's to shame. While we're limited with respect to how much information we have in this regard -- as publicly traded companies are only obligated to reveal information about their most senior leaders -- we know that relatives of Annaly's board members currently occupy the CEO and CFO positions in Chimera Investment Corporation (NYSE: CIM  ) , a separately traded mREIT controlled by Annaly's wholly owned subsidiary FIDAC. We also know that each executive was paid in excess of $1.2 million in 2008, the last year Chimera reported these figures, according to S&P's Capital IQ.

One could argue, of course, that Chimera CEO Matthew Lambiase and CFO Alexandra Denahan simply used connections to get positions they were otherwise qualified for -- to say nothing of their seven-figure compensation packages. However, at least in the case of its Denahan's resume, there's little tangible support for this.

In the company's first proxy statement, filed in 2008, her bibliography provided only that Denahan -- the sister of Annaly's current CEO and then-COO -- got her MBA and bachelor's degree in accounting from Florida Atlantic University and was a "business consultant in Fort Lauderdale" before joining Annaly in 2002 at the approximate age of 30. Thus, as far as we know, she became the CFO of a multibillion-dollar company with simply an MBA and four years of pertinent experience. That's not exactly something that happens every day.

And this is not just a theoretical problem. Since the end of 2011, Chimera has been embroiled in an accounting mess, which obviously falls under the CFO's purview. The company is now in the process of restating effectively every meaningful financial statement that it's published since going public. One of the few things we know in this regard, as Chimera has been otherwise tight-lipped about the whole matter, is that its net income between 2008 and 2011 is estimated to fall by 66%. In addition, Chimera has now failed to file its quarterly financial statements with the SEC for over a year now.

While these problems and Denahan's inexperience could certainly be a coincidence, it's hard for me to accept this possibility at face value. Instead, this appears to serve as a cogent example of the dangers of nepotism. Of course, like Hunter above, it won't be Denahan who genuinely suffers here, since she's already been paid an inordinate amount of money and can put "CFO" on her resume irrespective of the eventual outcome. The people who have lost out are the shareholders. And that's inexcusable.

What Annaly should learn from the NBA
The lessons that Annaly should take away from this are twofold. First, as the media and public's reaction to the NBA Players Association scandal have demonstrated, nepotism and enriching oneself at the expense of your employer are unacceptable business practices. And second, when these things are unearthed, there should be consequences for the offending parties.

To learn more about Annaly, check out our brand new premium research report on the company, which takes readers through a number of absolute must know topics, as well as the future opportunities and pitfalls of Annaly's strategy. Click here now to claim your copy now.


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