|Man Without Qualities|
Friday, July 19, 2002
With his customary instinct for excess, Senator John McCain again proves that the awful price of purity is Puritans.
With his customary acuity, Mickey Kaus points out one obviously perverse incentive of one of Senator John McCain's current obsessions, an obsession described as follows:
Top executives should be precluded from selling their own holdings of company stock while serving in that company. Executives should be allowed to exercise their options, but their net gain after tax should be held in company stock until 90 days after they leave the company.
KausFiles notes that "this create a highly undesirable incentive for competent executives who've actually improved their companies, and hence their companies' stock prices, to immediately quit in order to exercise their options," which is obviously correct. Which means that if the company wants to retain its executives, it has to come up with some other way or rewarding them. Mark Salter, Senator McCain's aide had this to say to KausFiles:
[T]he senator consulted a number of people, (retired and currently serving CEOs) as he prepared the suggested reforms he identified in his speech last week. we tried to anticipate criticism for each one, and did discuss the criticism you made with his advisors. the thoughts below are typical of the rebuttals they offered. ...
That argument has always been fallacious. Typically, companies restrict grants of options and stock from becoming fully vested for 3-5 years after they're awarded. Because new grants are made annually, execs always have a sizeable amount of unvested awards that they will forfeit if they leave voluntarily before the vesting period’s end. Vesting may be automatic if the executive leaves after the normal retirement date but sales of stock may still be restricted for the remainder of the original vesting period. During that restriction period, some companies reserve the right to cancel vesting if the executive joins another company deemed to be a competitor.
You can be sure that companies will be creative in altering their compensation plans to retain desired execs if the Senator's proposal is enacted. For example, restriction periods on new grants could be extended to strengthen the retention element, and the mix of cash, stock and options awards could be adjusted to assure that the executive has ample current income and therefore little incentive to leave before normal retirement age.
Secondly, even if executives would like to leave their company in order to sell their stock, there aren't many other companies to which most top managers can go and have similar responsibilities. Most people won't voluntarily walk away from power, prestige, perks and pay just to sell their vested stock.
There are a substantial number of companies (see an article in Saturday's Times that cites BankOne, Citigroup and others as examples) that have already prohibited executives from selling stock before retirement. As Jamie Dimon, BankOne's CEO, said, "management should eat its own home cooking."
Issues of executive compensation and human incentives are complex and always a judgment call, but Senator McClain's approach seems particularly dicey.
First, Mr. Salter seems to be agreeing with KausFiles' point that the McCain proposal creates an increased incentive for executives to leave. What Mr. Salter is saying is that the Senator's proposal doesn't eliminate all incentives for the executives to stay. But he admits that there would be a serious weakening of those retentive incentives, which the company will have to find some way to counteract by paying the executive more in some other way. ("You can be sure that companies will be creative in altering their compensation plans to retain desired execs if the Senator's proposal is enacted.") So there is actually a rather tricky question here - even on the Senator's own terms - as to whether such extra costs will be more than compensated by whatever presumed extra benefits the shareholders get from the Senator's restricting their representatives' (i.e. the Board of Directors) flexibility in crafting executive compensation.
Management should eat its own home cooking? What management eats if they're not properly incentivized and watched is the shareholders' winter provisions and seed corn.
If the Senator's proposal would increase shareholder value, why do we not have a chorus of institutional investors and academic theorists calling for amendments in corporate charters to effect this change regardless of whether the Senator’s proposal is enacted into law? But that chorus is silent.
Which brings up another odd statement of the Senator's aide, that "the senator consulted a number of people, (retired and currently serving CEOs) as he prepared the suggested reforms," a procedure which might charitably be compared with consulting with a number of foxes as one prepares to reconstruct the chicken coop, at least if it is not done with the careful understanding that executives don't really care whether shareholders prosper if the executives are well paid. That is the exact problem options are suppose to address.
The possible methods of compensating for the Senator’s proposal mentioned by his aide are revealing:
“For example, restriction periods on new grants could be extended to strengthen the retention element, and the mix of cash, stock and options awards could be adjusted…”
Yes, all of these things would “strengthen the retention element” – in each case at the cost of retaining an executive with a severely reduced interest in increasing the company’s share price. But an increase in share price is the only way shareholders are rewarded. The correct question is NOT whether there are ways to “strengthen the retention element.” Simply agreeing to turn the company over to management lock, stock and barrel could do THAT. The correct question is whether there are ways to “strengthen the retention element” on terms that cause the interests of the shareholders and management to be aligned, and which increase the chance that share value will rise without cooking the books.
And how about the priceless assertion that "even if executives would like to leave their company in order to sell their stock, there aren't many other companies to which most top managers can go and have similar responsibilities." Perhaps the Senator and his aide have spent too much time in Washington, where it is true that a Senator looking for other employment finds no other Federal Senate in which to seek a seat. But in the business world executives who succeed in raising shareholder value generally do not want for other shareholders whose representatives would be more than pleased to take such an undercomensated executive off the hands of his or her current employer. Or perhaps Messrs.Salter and McCain are under the impression that, say, Jack Welch simply had no place else to go while General Electric's stock was soaring on his watch? Might I suggest to Messrs.Salter and McCain that it is executives who do not make their shareholders money that have fewer alternative places of employment - but why Messrs.Salter and McCain care a fig about assuring companies that they will not be in danger of losing such executives if the Senator's plan goes through is a mystery to the Man Without Qualities.
One of the few things worse for the shareholders than a legal structure that creates an incentive for executives to leave prematurely would be a legal structure that creates an incentive for executives who don't care about shareholder value to stay on in office, fully compensated and comfortable.
Senator McClain’s proposal doesn’t even come close to reaching the correct goal. That’s not surprising, since there are no affirmative indications that he or his aide is even aware of the correct question. Indeed, from what has appeared in the media, the Senator appears too interested in purity to get his hands dirty rooting around for something as prosaic as the correct question to ask.
UPDATE: Virginia Postrel also provides insight on Senator McCain's proposal.
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