December 13, 2005
Excerpts: The Battle For The Soul of Capitalism - Part XIV
The Spark That Lit the Fire
It should hardly surprise us that one of the chief protagonists that sparked the fire that led to the rapid escalation in stock prices was executive compensation, closely linked with its fellow protagonist, managed earnings. Executive compensation, made manifest in the fixed-price stock option, rewarded executives for raising the price of their company’s stock rather than for increasing their company’s intrinsic value. (I discuss the issue of price versus value in greater depth in chapter five.) When that is what investors measure, in effect, that is what managers manage.
Executives don’t need to be told what to do: achieve strong, steady earnings growth and tell Wall Street about it. Set “guidance” targets with public pronouncements ofyour expectations, and then meet your targets—and do it consistently, without fail. First, do it the old-fashioned way, by increasing volumes, cutting costs, raising productivity, embracing technology, and developing new products and services. Then, when making it and doing it isn’t enough, meet your goals by counting it, pushing accounting principles to their very edge. And when that isn’t enough, cheat. As we now know, too many firms did exactly that.
The stated rationale for fixed-price stock options is that they “link the interests of management with the interest of shareholders.” This oft-repeated and widely accepted bromide turns out to be false. Managers don’t hold the shares they acquire. They sell them, and promptly. Academic studies indicate that nearly all stock options are exercised as soon as they vest, and the stock is, in turn, sold immediately. Indeed, the term cashless exercise—in which the firm purchases the stock for the executive, sells it, and pays the difference to the executive when the proceeds of the sale are delivered—became commonplace. (Happily, the practice is no longer legal.) We rewarded our executives not for the reality of creating long-term economic value but for pumping up the perception of short-term stock market prices. The fact is that executives had created wealth for themselves, but not for their shareowners. Long before the stock market values melted away, executives had made a timely exodus from the market by selling much of their stock.*
*One caveat: Since executives have substantial human and economic capital tied up in their firms and some diversification is warranted, I recognize that moderate portions of their holdings may be sold from time to time. But they should retain holdings that are a substantial portion of their total compensation and wealth.
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