Over the past decade, directors, CEOs, senior managers, governance experts, and compensation consultants have preached that by giving directors and management equity stakes in the business, their interests are aligned with those of the shareholders. The implied promise has been that by linking interests through equity ownership, the agency issue—the need to ensure that management acts in the interests of shareholders instead of self-interest—is solved and that enhanced shareholder value will result.
This widely held premise deserves closer inspection, but not because today’s CEOs, directors, and managers are necessarily overpaid. (In fact, many directors are underpaid for the responsibilities they shoulder, and those CEOs and managers who build real long-term value for shareholders should be paid handsomely for their efforts.) The reason to review this logic is to ensure that the equity component is structured intelligently and that those who receive it exercise it appropriately. Because stock price can be so easily massaged by executives, as described in How Options Work and The Share Price Game, and because they can time their stock purchases and sales to coincide with lows and highs in their shares, the equity portion of compensation should be carefully crafted and constantly monitored. And, in fact, while equity compensation in the form of stock options can be appropriate as an incentive to build real value, many other types of incentives may be more appropriate for better aligning management’s interests with those of the shareholders.
When executives and directors have stock options, they compete with other shareholders when buying and selling, and they always have information unavailable to other investors.
The Roots of the Equity Compensation Model
The leveraged buyout (LBO) movement of the 1980s provided the model and justification for public companies to compensate both management and directors in equity-based securities, primarily options. As management teams of LBOs profited handsomely from their “equity” in the form of a carried interest in profits, other CEOs from some large, established companies argued for and received large option grants so they too could enjoy the same kind of upside. Soon, still more corporate executives joined in the bonanza, uniformly supporting options and other forms of equity as the major component of compensation.
The flaw in their logic is that an LBO results in a private company, a very different entity from a public company. The stock is not traded, and value is generally created as expenses are slashed and cash flow pays down debt. Management and owners make money by maximizing cash flow and, if anything, minimizing earnings to reduce taxes (already reduced by high debt levels and the associated interest expense). As this process unfolds, no shareholder sells while others hold or buy. All shareholders benefit from retiring debt. What they can do is time everyone’s exit, or partial exit, by selling in one transaction or through an initial public offering (IPO). Unless the company is sold to another LBO group and releveraged, the exit generally converts the private company back to public ownership, either as a stand-alone company or as part of an existing public one. When this occurs, the new company creates value for shareholders not by paying down debt, but by growing earnings and cash flow, which ultimately will benefit shareholders.
The LBO precedent set in the 1980s also prompted directors of public companies to endorse equity compensation for themselves. In 1995 the Committee on Director Compensation of the National Association of Corporate Directors recommended abolishing obvious conflicts such as lavish benefit plans, providing other services for compensation, and, for the first time, requiring full disclosure of compensation for directors. At the same time, the Committee also recommended that options or other stock-based compensation be the primary source of director pay.
When options for both management and directors became widely adopted, many heralded it as a radical reformation of corporate oversight. That it was, but not to the benefit of investors. Paying directors in equity, or in options that could be cashed in on a regular basis, cemented the interests of directors with those of management, tightly binding their personal interests to relatively short-term stock price performance. Forgotten or ignored was the lesson of the LBO era—that aligning interests required not only participation in upside but also in downside risk. Ignored were the differences between private and pubic companies.
As things turned out, these differences were not just theoretical. Widespread earnings and stock price management, earnings manufacture, and the gaming of options have focused management’s attention on these practices rather than on managing the company to create long-term value. And directors, rather than acting as a check against these tendencies, now have parallel interests with management rather than with shareholders.
The leveraged buy-out movement of the 1980s provided the model and justification for public companies to compensate both management and directors in equity.
Are All Options Programs Bad for Investors?
The next article “How Options Work,” offers a more in-depth discussion of executive and employee stock options, including how they work, who gets them, and why. Because so many employees and executives have made so much money from options—often just before investors learned that inflated stock prices did not reflect real value—this discussion is understandably a contentious one. It is nonetheless important in gaining a better understanding of how shareholders’ interests may not always take precedence.
Boards that use options to compensate executives who have the ability to manipulate earnings are asking for trouble. This is not to say that boards should never use options as a component of executive compensation, but it certainly does place an added burden on directors to monitor executives’ behavior. Former SEC Chairman Harvey Pitt summed up the options-for-executives quandary succinctly, “If managers can reap profits from their options while shareholders are losing some or all of their equity stake, the options create conflicting, not aligned interests.” Certainly, when options are extended to those in control of the numbers, they should be structured in a way that requires the recipient to hold them long beyond a time when they can willfully manage stock price.
Granting options to nonexecutive employees is more easily justified. This group cannot directly manipulate stock price, so the risk of creating bad behavior is minimal. One would certainly expect employees to contribute more to the company and to care about its real performance if part of their compensation is in the form of a long-term equity interest. Many employees, in fact, have such an interest through their 401(k) or pension plans. At the same time, because of external events or internal company issues entirely out of their control, employees can perform exceptionally well and still not profit from options. This alone can mitigate the level of incentive that options provide. Would it not make as much or more sense to reward employees through incentives related to behavior and performance measures?
Who Changed the Rules?
How did executives come to behave as if their primary responsibility was to manage stock price? Why have boards consistently rewarded them for doing so? One interpretation could be that it was an honest mistake. In this charitable view, the executives and directors truly believed that increasing the price of the stock, regardless of how much real value had been created, benefited all shareholders.
But many executives have behaved like competitive individual shareholders, selling their stock high and rationalizing that behavior by asserting, “If it’s good for me, it must be good for everyone else.” In reality, the good only accrued to those who got out at the top. And who had the best shot at that? The executive insiders who knew how much the share price stood over its real value, and could initiate their sell decisions in advance of the inevitable and precipitous decline, usually won.
A more cynical explanation of this behavior would be that some executives created the system deliberately, and many others came to view it as “business as usual.” They knew they could boost share price and then profit personally by doing so. They had opportunity. And despite headlines of a few CEOs having charges pressed against them for egregious corruption, in the broadly played game of hyping their stock prices, they knew there was little risk of getting caught, and even less chance of being prosecuted.
Whether one takes the more charitable view or the more cynical, one thing is certain: By ignoring the well-being of those who would buy high when current shareholders (executives and directors included) sold near or at the top, many executives failed to protect the interests of all shareholders.
That is why the system of equity compensation in the form of stock options raises such a serious corporate governance issue. Options not only fail to resolve the agency problem, but also exacerbate it if executives can freely trade that equity. Not all managers and CEOs who receive large option grants are manipulating the articles. But investors in those companies that issue significant options to the CEO and other senior executives should certainly consider it a cause for caution. They should also expect directors on the boards of those companies to pay close attention to the behavior of executives and measure management’s performance in building true value in the company and not just on increasing its share price.