The arrest of John Rigas and two of his sons, all former executives of insolvent Adelphia Communications, on securities fraud charges, and revelations that executives at Qwest Communications International made hefty profits from the sale of Qwest shares while the company was engaging in fatal earnings massage have even the daily press abandoning its cats-in-trees stories for business news.
It may be seen as Judgment Day for the free-wheeling executive class that battened on the last bull market, but don’t hang the bunting off your front porch yet.
While the public pillorying of top executives may make for fine summer theatre, it doesn’t attack the cause of the problem: because management owned and controlled the stock of established companies to a greater extent than at any time since the Gilded Age, the recent bull market made management rich.
This was a direct result of a corporate-governance philosophy that said management should have a direct financial stake in the success of the company through ownership of stock. And of course, if stock appreciation (which was unquestioningly assumed to benefit the ordinary shareholder) was an incentive, stock options, through leverage, were a far more powerful one.
The managerial class did not miss the lesson in this; and through its control of boards of directors, it let the magic of stock options work. The results are plain enough today. Stock-based and option-based compensation acted as an incentive . . . to pump the stock price.
One remedy that has been suggested from many quarters is presenting stock options as an expense. (Among mining companies, Inmet Mining recently announced it would be doing that, using agreeably simple arithmetic. So much for the objection that shareholders can’t understand the Black-Scholes model.)
Whatever arguments there may have been over the issue seem clearly to have been won by the side that favours expensing the cost of stock options. But accounting changes, however much they increase transparency and believability, don’t sever the connection between stock-based compensation and the conflict between the interests of management and those of shareholders.
For many years, management theorists and others have made the case that a company’s management should own stock and be paid at least partly in options, the better to align management’s interest with that of the shareholder. If executives can make themselves rich only by making shareholders rich too, then this is perfect alignment.
When the case is made respectably, it rests on an oversimplification, conflating ephemeral market prices with shareholder “value.” Less respectably, the case for stock-based compensation falls back on the old lie that shareholders get what they pay for in management talent. This is no more true in the boardroom than it is on a hockey rink (Mr. Rigas’s successors at the Buffalo Sabres, wherever you are, take note); and in the most recent recession, well-paid failures litter the ground. Moreover, high compensation is an incentive for incompetents to stay on, not for talented and responsible managers to push them out.
The revelation that executives at Qwest made US$500 million selling Qwest stock between 1999 and 2001 is not comforting reading for the proponents of this kind of “alignment.” Joseph Nacchio, purged as chief executive last month, made US$227 million on the stock. He may be vilified all the way to the bank, but he’ll live; rather well, in fact.
Robert Woodruff, who retired as chief financial officer on early 2001 to “spend more time with his family,” took out US$29 million to cover the baseball gloves and birthday cakes that that kind of thing entails. On Woodruff’s retirement, Nacchio praised his “achieving 15 consecutive quarters of excellent results” — to be very precise, the quarterly results that are now being restated.
Drake Tempest, still Qwest’s corporate general counsel (this would be the gentleman in charge of compliance procedures at the company since 1998), is US$13 million richer from his sales of stock in those same years.
Yes, these sales were quite likely legal. Yes, they were reported properly, or The New York Times and Thomson Financial wouldn’t have got hold of the information. Yes, Qwest’s board voted for that stock-based compensation scheme.
And yes, all three of those facts are resounding irrelevancies. These men were failures at creating shareholder value, except for shareholders like themselves, who cashed in at the top of the market. Stock-based compensation did not align the interests of management with those of the shareholders; it created a situation where Qwest executives could walk away with millions regardless of the state of the company.
It may be objected that shareholders could have shared in the rise in Qwest’s share price too, but that is fatuous; apart from anything else, if they had all cashed in at once, the share price would have collapsed. Nor is it sufficient to say that shareholders failed to time the market; an inability to do that is not a test of whether an investor should receive a return.
Some commentators have contrived to see disillusionment with the top management of these large failed companies as an attack on executives, or as a witch hunt. In a recent signed editorial in the financial section of the National Post, Terence Corcoran bemoaned the people that want to “turn North America’s corporate executives into fun fodder on the way to some larger political or ideological objective.” Yes, Mr. Corcoran, for authorities to have raided John Rigas’s house when he was shortly going to turn himself in was pure photo-op. No, Mr. Corcoran, that is not the same thing as taking a critical look at executive compensation and questioning the dogma that stock options make managers more accountable to shareholders.
And the evidence is fairly strong that this pattern of executive compensation didn’t work the way it was supposed to. Executives of high-flying companies in the 1990s were not notable for their solicitude for shareholders — who were, it should be remembered, the real capitalists in these enterprises — but for their appetite for big payoffs, in the form of insider selling and in the form of termination deals that in effect rewarded them for being forced out.
To the investor, it may be prudent now to think of heavily stock-weighted compensation schemes to be a drawback, rather than an advantage, in picking companies in which to buy stock. It may even be that competent salaried people are looking out for the shareholders’ interests far better than those with options and golden parachutes. It certainly behooves the investor to take a look.
What is material is that stock-based compensation is supposed to make management bear some of the equity risk in a business, not to help them transfer it from themselves to the shareholders through can’t-lose exercise prices. If paying executives with paper rather than cash is to mean anything, it must mean that those executives will sometimes go down with their proprietorship.
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