All too often, management proclaim that their interest are aligned with shareholders' interest. However, what is proclaimed is often not followed by actions. If the compensation of an executive does not match the performance of the business, then the talk on shareholders' interest is nothing but paying lip's service.
Many times, executive compensation is ridiculously out of line with performance. This will be hard to change given that the deck is stacked against investors when it comes to the CEO's pay. The result is that a mediocre or worst CEO all too often receives gobs of money from an ill-designed compensation arrangement. How did this happen? The answer lies in those inside the boardroom and the so-called consultant and directors who are appointed. These are the ones who have no trouble perceiving who "buttered their bread." As one compensation consultant commented: "There're two classes of clients you don't want to offend - actual and potential."
An instance of how a CEO can receive a bundle while not matching his performance. Take, for eg, ten-year, fixed-price options. If Mr. Futile, CEO of Stagnant Corp, receives a bundle of these, enough to give him a 1% stake in the company, his interest is thus clear. He should skip giving out dividends completely and instead use all of the earnings to repurchase stock. Let's assume he lives up to the business name. In each of the 10 years, after the option grant, the business earns $1B on $10B of net worth, which comes to $10 per share on a 100M shares outstanding then initially. He eschews dividends and regularly uses all earnings to buy back shares. If the stock constantly sells at 10 times earnings, it will have appreciated 158% by the end of the option period. That's because repurchases would reduce the number of shares to 38.7M by end of the 10 years, and earnings per share would thereby increase to $25.8. Simply by withholding earnings from shareholders, he gets very rich while the business remains stagnant since the start of the grant. Astonishingly, he could still have benefited $100M even if Stagnant Corp earnings declined by 20% during the period. He would not have done a splendid job for anyone else besides himself and those executives enjoying the same kind of grant. By simply deploying earnings he withhold from investors into disappointing projects and acquisition (incl of those repurchases), he got extremely rich which they do not deserve. In fact, this mode of compensation on fixed-priced options is a transfer of wealth from one to another with the size of the pie unchanged.
CEOs understand this simple math and know that every dime paid out in dividends reduces the value of all outstanding fixed-price options. Although many preach capital comes at a cost internally, they somehow forgot to preach that fixed-priced options give them capital that is more than free. It's child's play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. However, options of such kind - options tracking the performance of the business performance - are never issued. Indeed, such options with strike prices that are adjusted for retained earnings seems foreign to compensations "experts." Even if a CEO manages a blopper that ultimately costs him his job, it will still gives him a bountiful payday. Indeed, he can earn more in that single day while cleaning out his desk than any average worker earns in a lifetime of cleaning toilets. Today, the rule has kind of changed to "Nothing succeeds like failure." Huge severence payments, lavish perks and outsized paychecks for ho-hum performance often occur because of compensation committees have become slaves to comparative data. The drill is simple: A few directors - not chosen by chance - are bombarded before a board meeting with pay statistics that always ratchet upwards. When comparitives data are used, all too often, everyone want the same treatment. Just like a kid saying: "But Mom, all the other kids have one."
The next question is to logically ask what can be done to align the options more in the interest towards the shareholders as well as not taking everything away from the CEO. Options should not be totally restricted in any way, in fact, a CEO may well receive much of his pay via options, albely in a logically-structure one. This is in respect to 1) an appropriate strike price, 2) an escalation in price that reflects the retention of earnings, and 3) a ban on his quickly disposing of any shares purchased through options. Arrangements that motivate managers must be cheered, whether in cash bonus or options but it must be appropriately and logically structured to benefits both ends. And if a company is truly receiving value for the options it issues, there is no reason why recording their cost should cut down on its use. The simple fact is that CEO knows if their options are rationally expensed, they know their stock would sell at a lower price if realistic accounting were employed, in other words, they will reap less when they offload in the open market.
So how did all this happens? Accountability and stewardship withered in the last decade, becoming qualities deemed of little significance by those caught up in the Great Bubble. As stock prices rise, the behavorial norms went down. It should be noted that most CEOs, man and woman, are people you would be happy to have as spouses or next-door neighbours. However, too many of these people have in recent time behaved badly while holding office - making up the numbers and drawing obscene pay for mediocre performance. These otherwise decent people simply follow the saying: "I was Snow White but I drifted."
Then when able but greedy managers overreach and try to dip too deeply into the shareholders' pockets, directors must slap their hands. But in reality, too few hands are slapped. So why has directors failed so miserably? It is not due to inadequate laws but rather in what is called "boardroom atmosphere." In a boardroom, it is almost impossible to raise question of whether a CEO should be replaced. Moreover, his inside staff and outside advisors are present and unanimously support his decision. Then it is understandable how paychecks got out of hand. When management hires people, or when companies bargain with a vendor, the intensity of interest is equal on both sides. One's gain is the other's loss and the money involved has real meaning to both. However, in executive compensation, the people deciding are those who sit on the board and compensation committee. A CEO may always regard the difference b/w getting options for 100K or 500K as monumental but to a comp committee, the difference may seem unimportant because neither grant will have an impact on reported earnings if options are not expense.
Then more recently, this malfunctioning system cries for "independent" directors. But what really motivates independency has been largely ignored. If independency comes at a price to appoint it, it defeats the purpose. There are two all-important responsibilites for these directors (independent or not) and the entire board is to firstly, to appoint an able and honest manager and then to compensate that manager in a fair way. It is definitely true that it is desirable to have directors who think and act independently but they must also entail three essential qualities - business-savvy, interested and shareholder-orientated. But, often, these people, though decent and intelligent, simply did not know or chose not to be interester about business or care enough about shareholders to question foolish acquisitions or over-the-top compensation.
Many times, however pathetic a management performance had been, directors had routinely rehired and approved the compensation of the managers. If there is real independency between the board, the directors and the management, there may be a better road towards awarding compensation that is more aligned to both the real performance generated and to the interest of the owners. If there is some form of a link existing between these groups where their personal interest is involved, owners will perpetually be paying more than they should to the managers which does not match the performance.
In essence, management of businesses who grant themselves a gob of fixed-price options, mostly likely owners' interest does not align with management interest. On surface, at the end of the period when they cash in on their options, both sides seems to have earned. But, in truth, the management return on their investment is insanely faster than those investors who has held their shares since year when the options were granted. For owners, capital comes at a cost, for such management, it comes much more than free.
In essence, management of businesses who grant themselves a gob of fixed-price options, mostly likely owners' interest does not align with management interest. On surface, at the end of the period when they cash in on their options, both sides seems to have earned. But, in truth, the management return on their investment is insanely faster than those investors who has held their shares since year when the options were granted. For owners, capital comes at a cost, for such management, it comes much more than free.
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