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Retaining And Reinvesting Net Income
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By:
Anthony Green
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A decade ago corporate governance mavens urged boards to pay managers more in stock than in cash to promote an alignment of interests between managers and shareholders. The response was tremendous, a bit like the apocryphal story of Lady Astor�s famous quip on the Titanic: I asked for ice, but this is ridiculous. What the governance gurus got was a proliferation of payment not in stock that was the functional equivalent of the forgone cash but instead stock options with a value vastly exceeding what the cash payment could reasonably have been. The explosion of option-based compensation remains one of the most controversial subjects in corporate governance history.
Some say that the widespread use of stock options in the United States simply reflects the priority given to this alignment goal in the United States and that its relative infrequency in Europe and elsewhere reflects the absence or irrelevance of this goal. However, the talk of alignment is more myth than truth and too often represents an attempt to sanitize management compensation packages that conflict with shareholder interests.
Stock Option Myths
No evidence indicates that the prevailing structure of executive compensation in the United States comes anywhere close to aligning manager and shareholder interests. On the contrary, a great deal of evidence demonstrates that the compensation structure is random. Many corporations give their managers stock options which increase in value simply through earnings retention, rather than because of improved performance resulting from superior deployment of capital. By retaining and reinvesting net income, managers can report annual earnings increases without doing anything to improve real returns on capital.
Buffett makes the point: You can get the same result personally while operating from your rocking chair. Just quadruple the capital you commit to a savings account and you will quadruple your earnings. You would hardly expect hosannas for that particular accomplishment. When that happens, stock options rob the corporation and its shareholders of wealth and allocate the booty to the option. Indeed, once granted, stock options are often irrevocable and unconditional and benefit the grantees without regard to individual performance a form of instant robbery.
Even if stock options encourage optionees to think as shareholders would, optionees are not exposed to the same downside risks as shareholders are. If economic performance improves and thestock price rises above the exercise price, the optionees will exercise the option and share in the increase with shareholders. But if economic performance is unfavorable and the stock price remains below the exercise price, optionees simply will not exercise the option. Shareholders suffer from the corporation�s unfavorable performance, but an option holder does not.
These awards also exacerbate the misalignment of interests between corporate option holders and other workers. The awards dramatically increase the compensation differential between highly paid executives and ordinary laborers, a ratio which is significantly higher in the United States than it is in Europe and elsewhere. Accordingly, when stockoptions are used, they should be spread throughout the employee base as GE has done rather than limited to the top dogs.
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By: Rosie Cameron | 17-06-2010 |
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