Man Without Qualities

Sunday, June 30, 2002

Options III

Jane Galt posts a thoughtful meditation on executive options, and cites to a proposal of Mindles H. Dreck in this area. Now the Man Without Qualities is a big fan of Jane and Mindles, and I would not call what follows criticism. But I would like to raise a few questions about some things. Specifically, Jane writes that executive compensation should:

"Preferably, move away from options and towards either a stock grant with a lengthy blackout, or the elegant solution proposed by Mindles H. Dreck: base compensation on the company's stock's outperforming stocks in it's industry sector; after all, we don't want the executive to benefit or be penalized by changes in the sector, but for how well said executive manages to maximize profits given market conditions."

Well, a stock grant with a lengthy blackout has some features that are worth thinking over. Suppose the stock of a public company is trading at, say, $100 on the day of the stock grant. The granted shares dilute the existing shareholders - which is not a problem. But by how much? Well, all the shares look alike and the company could have sold the granted shares to the public for $100 instead of giving them to the executive. So it's hard to see how the company hasn't divested itself of something worth $100. That $100 was given in exchange, we hope, for something worth more than that from the executive - but that's another story.

Is the granted stock worth $100? No. Free trading stock is worth $100 - but this is restricted stock with a lengthy blackout period. Maybe it's "worth" $70. But even this is a highly artificial number, since by definition there is no market for the stock (because there is no market for something that can't be sold).

In short: The company just spent $100, but the executive received much less than that. What happened to the difference? Does one still feel comfortable that the interests of the stockholders and the executive align through this mechanism?

Alignment? How important to an executive holding stock he cannot sell for, say, five years is it for the stock to do well this year? And yet most public stockholders want their stocks to do well this year. In terms of "risk acceptance": Might such an executive have an inefficient incentive to favor long-term or medium-term projects over potentially lucrative short term projects - an incentive which seems to have had an almost inconceivably terrible long-term effect on Japan, at one time the world's champ in "long term planning." If the company pays dividends based on current results, won't the difference between the tax rates on dividends and capital gains tend to make the executive favor projects that yield cash in, say, five years (when he can sell the stock and pay capital gains rates) rather than today (when he has to pay tax at the much higher individual rate)? Are shareholder and management interests "aligned?" It doesn't look like that.

Jane's point (and it is a good one) is that interests of option holders and stockholders are not fully aligned. That is true, because the interests of any holders of different securities are not fully aligned. Restricted stock and free trading stock are not the same securities. To say the executive is a "stockholder" is a kind of pun.

To see this clearly, supposed the company issued to the public two types of stock on a single day: Stock A, which is free trading common stock listed on a national securities market and Stock B, which is preferred stock having all the same characteristics of common except that it could not be sold to anyone else for three years. Does anyone think the price the public would pay for these securities would be close? Suppose the blackout period was thirty years. Of course, the same considerations will apply to stock obtained by exercise of options if the stock is subject to a "blackout period."

For a very long time Anglo-American property law has discouraged most restraints on property alienation. It was not always so. In the Middle Ages, heavy restriction on the right to sell real property was the norm. Eventually, those societies realized that practice was costing them many fortunes - and that was just on the basis of "dead weight loss," without consideration given to any aligning of interests. Neither current property law nor I say that all restraints on alienation are a bad thing - but they are very dangerous and have a very dubious history.

All of the above are corollaries of a very general rule: IT IS NOT POSSIBLE TO ALLIGN THE INTERESTS OF MANAGEMENT AND PUBLIC STOCKHOLDERS, AND DISFAVORING ANY COMPENSATION DEVICE BECAUSE IT FAILS TO ALLIGN THE INTERESTS OF MANAGEMENT AND PUBLIC STOCKHOLDERS IS JUST SUCCUMBING TO A NIRVANNA DELUSION. I am not saying Jane or Mindles so succumb - what they are doing is really trying to find something that aligns these interests better than the other alternatives.

Why is it not possible to align management and shareholder interests? Because, as noted above, the interests of the holders of any two different company securities will not have aligned interests. But because management (by definition) runs the company, management's interest in the company must always be substantially different from that of public shareholders whose involvement is passive up to rare, difficult shareholder votes. Everying managment gets from the company - including expense accounts and use of the corporate jet and even the art on the walls - are all included in the company securities held by management. No public shareholder ever has the same things.

What about "the elegant solution proposed by Mindles H. Dreck: base compensation on the company's stock's outperforming stocks in its industry sector?"

Well, again, I do not mean my observations to be taken as criticisms since the objective here is not to show that the proposed structure does not align shareholder and management interests (a fool's errand, as just described). But consider the following:

Suppose the "sector" under consideration is telecommunications (or some part of it). Should Sprint's and AT&T management get a boon because WorldCom indulged in fraud and caused the stock of that company to decline to zero? On a relative basis within the sector, the stock of WorldCom's competitors have benefited from this disaster. Should the competitors' shareholders pay their management a bonus because of that? Why?

Further, not all companies in the same sector compete with each other. Consider two home-construction companies, one active on each coast. Why should they be lumped together for purposes of executive compensation? Isn't that a thought more at home in considering how to compensate the fund managers who can choose to invest in either of the two non-competing companies. Which is to say: Such companies do compete, but only in the financial markets for investment funds.

More generally, are "sectors" convenient but arbitrary classifications from a market perspective - based essentially on individual prejudices about the past? They are certainly useful from the standpoint of fund managers.

But making company executives act like fund managers would seem to lead to executives structuring their companies to resemble funds. That kind of company is called a conglomerate. Do we want to encourage formation of conglomerates?

And do conglomerates have "sectors?" What "sector" is General Electric in these days?

Jane also suggests that companies should:

"Eliminate the practice of re-pricing options, where an executive's pet board gets to decide that the stock decline wasn't really his fault and he should get to make a profit off his options anyway."

As I noted in a prior post on this topic, the repricing of options is a tool. I do not see the relevance of any concepts of “fault” if they differ from the never-ending task of finding the right incentive structure for future performance. If, for example, some terrorists fly a plane into the World Trade Center and thereby cause Nevada gaming company stocks to tank, an owner of such a company has a choice: (i) reprice or (ii) refuse to reprice and thereby lose the Chairman/CEO and every other good executive to a competitor or retirement (or, worse, continued employment disconnected from any real concern with the stock price). Of course the company should reprice in some way (although NOT by just changing the price on the existing option.) Kirk Kirkorian understood this when he caused the company he owns, MGM MIRAGE, to reprice its options - and most people don't count him as a financial dummy.

The key to Jane’s example is the concept of “pet board.” The board runs the company. If the board has become disengaged from stockholder interests, then they will misuse ANY tool of executive compensation. Almost by definition.

The real problem here seems easy to state: Corporate governance reforms should focus on aligning the interests of members of boards of directors and shareholders. And most “reform” proposals floating around now, such as increasing the number of “outside directors,” DO NOT DO THAT.

What is the best mechanism for aligning the interests of the board and the shareholders? Why, it’s our old friend: THE MARKET FOR CORPORATE CONTROL. That is, HOSTILE PUBLIC TENDERS.

But the market for corporate control has been largely numbed (but not entirely eliminated) in this country in the hunt to get Gordon Gekko. That’s another story.

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