Man Without Qualities

Thursday, June 20, 2002


Today the United States stands at a point of prosperity almost inconceivable not only to our forebears, but to most witnesses to the economic decline and malaise of the 1970's.

The Man Without Qualities suggests keeping this observation in mind if one is subjected to talk about how American executive compensation, or capital markets or corporate governance "don't work as intended."

And when the talk comes in the form of a front page Wall Street Journal article [link requires paid subscription] on corporate honor with supporting quotes from Gordon Gekko and John Kenneth Galbraith, it is time, with apologies to Emerson, to count one's spoons in overdrive.

The article, among other confusions, repeats criticism offered now by many who should know better, including the Wall Street Journal [And at least the WSJ editorial page does! See Options II above.]. After framing the long-understood issue of the separation of ownership from corporate control with a quote from that trusted expert in corporate governance, Gordon Gekko, the article notes:

"The solution, widely embraced in American business, was to use stock options to link executives' and shareholders' interests. It sounded reasonable: Executives would benefit if they managed companies in a way that lifted share prices. It didn't work as intended. A soaring stock market rewarded executives not for good strategic management, but for riding the roller coaster. And when the stock price dipped below the exercise price -- essentially making the options worthless -- some companies simply revised the terms or, in Wall Street jargon, 'reloaded' them. Even worse, the incentives to do almost anything to increase the stock price were huge. And the incentives weren't to increase profits and share prices over a decade or two, but rather to increase profits -- never mind if they have to be restated later -- just long enough for executives to cash out, often without ever risking any of their own money to buy shares in the first place. Stock options, [Security and Exchange Commission Chief Harvey] Pitt says, were 'a device that was supposed to align shareholder and manager interests -- and actually disaligned them.' Not all executives were swayed, of course, but an ill-designed compensation system pushed them in the wrong direction."

Is this true? Must executive stock incentive plans create "incentives to do almost anything to increase the stock price?" Do options necessarily create incentives "to increase profits ...[that] have to be restated later?" It doesn't seem so. In fact, as with any form of compensation, the structure of the option package probably makes all the difference, and the WSJ reporter - David Wessel - may ambiguously suggest as much at the end of the above quote, but he is more naturally read as reporting that all executive option programs are "ill-designed compensation."

Consider two simplified stock option plans:

Plan #1 all at once gives executives a large number of fully vested options, immediately exercisable at the price the stock is trading on the grant date.

Plan #2 gives executives an even larger number of options, but they vest in escalating numbers in annual (or even semi-annual) installments and become exercisable at the time they vest and at the price the stock is trading on the grant date.

Plan #1 obviously creates some of the incentive described in the Wall Street Journal article. If the executives can get the stock price up, even for a moment, they can exercise, sell and get out rich. Does even this plan create a "huge incentive?" Well, if the stock inflation effort is a naked as the article describes, how about the little problem that to effect this scheme the executives probably have to engage in a criminal conspiracy. True, the conspiracy may be hard to prove and detect - but the downside risk is rather large (Leavenworth, fines and triple and punitive damages). Further, the collapse in a public stock price and a restatement of earnings are impossible to conceal. Although they do not themselves constitute actionable events creating claims against management, such public adverse developments, especially a post-exercise-and-sale restatement of earnings, certainly creates the basis for a civil class action and an SEC investigation. Once the action is filed, the plaintiffs have ample opportunity to explain to the jury why the plaintiffs think management "cooked the books to generally accepted standards," as Treasury Secretary O'Neill is quoted in the article. But if such a scheme succeeds, the payoff to management can be large - and some people will therefore take such large risks. But the considerations are vastly more complex than the trivializing assertions that stock incentive plans create "incentives to do almost anything to increase the stock price and "to increase profits ...[that] have to be restated later." And this is true even with respect to absurd Plan #1.

What about Plan #2? Suppose 100% of the options are granted the day the executive arrives, but only 10% vest then, with an additional 20% vesting on the first anniversary of the arrival, 30% on the second anniversary, and 40% on the third anniversary (a total vesting period longer than the life span of most internet companies). Suppose further that each year the executive receives a new batch of options exercisable at the trading price of the stock on the grant dates - and which vest in the same 10%, 20%, 30%, 40% sequence. If the executive manipulates the price at any particular time to a high that then collapses, not only does the executive run the risks described with respect to Plan #1 (but for a much smaller payoff), but the value of the portion of the options which vest thereafter will be impaired. In short, it is very hard to argue that Plan #2 create "incentives to do almost anything to increase the stock price and "to increase profits ...[that] have to be restated later."

The two stock option plans are simplified from those offered by most corporations. Many additional features can be included, especially relating to performance - of the company and of the executive. Each plan will create complex incentives that shift over time. Those incentives can be quantified using the same mathematical techniques used by, say, options traders to value those securities. The corporate board of directors should have such analyses performed.

Which leads to the real heart of the issue - not options, but boards of directors. The article says sweepingly: " One culprit was stock options , which gave executives huge incentives to boost near-term share prices regardless of long-term consequences. No CEO pay package seemed to strike any board of directors as too big." Well, if a board is going this route, options are the least of the company's worries. Certainly options can be used to gut a company in favor of its management - but options are hardly necessary for that. For example, the Enron board is accused (in part) of enriching the company's Chief Financial Officer the old fashioned way: selling pieces of it cheap to entities controlled by him. Whether or not the Enron board is culpable, the fact is that any board that is looking out for management rather than shareholders is big trouble. Options are just a tool - and, when properly used, they just happen to be the best tool for aligning the interests of shareholders and management that anyone has come up with. And anyone who tells you anything else is selling snake oil. Or, to put it another way, executive options are the worst way of aligning shareholder and management interests - except for all the others.

What about "reloading" - that is, resetting the exercise price of options that have become worthless? Well, this again is a tool - and it can be used for good or ill, if the board of directors cares to see the difference. First, most "reloading' is not accomplished by simply repricing at a chosen point in time - that is almost always destructive. Instead, most companies effect an exchange offer of new options for old, with the new options having an exercise price set at the stock's trading price, say, 90 days after the exchange offer is completed. this makes management bear at least a moderate amount of market risk.

Why would a company do that? Well, an example should make the answer clear. Consider MGM MIRAGE, the well-run gaming company. Following the disasters of September 11, gaming and hospitality companies, including MGM MIRAGE, saw their stock prices fall dramatically - this rendered many of the options of MGM MIRAGE management worthless. Did it make sense to charge MGM MIRAGE management with the consequences of September 11? Of course not. MGM MIRAGE effected an exchange offer like the one described in the above paragraph. This exchange offer was approved by the MGM MIRAGE board of directors - which is, of course, entirely determined by the company's largest shareholder: Kirk Kirkorian. Could anyone seriously believe Mr. Kirkorian didn't understand what he was doing or that the exchange offer was hostile to his interest as a stockholder? Of course not.

And the final irony in the MGM MIRAGE case is that by the time the exercise price of the new options was set, the MGM MIRAGE stock price had recovered - and management benefited hardly at all.

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