Monday, October 10, 2011

Capitalism Without Capital: Why Executive Stock Options Should Be Outlawed

Lehman Brothers and Bear Sterns survived World War I, World War II, and The Great Depression. Why then did the mortgage crisis of 2008 cause these firms to fail? What was different with this economic crisis?  The answer: employee stock options.

In the past 20-30 years, income disparity from the CEO and other executives down to the rank and file employees has dramatically diverged with C-level executives (CEO, CFO, COO) now making 300-400 times the average worker up from 30-40 times just 20-30 years ago.  What changed?  The answer: the invention of employee stock options.

Actually, I am talking about “executive” stock options. Rank and file employees rarely receive stock options as compensation, and when they do, it is a trifling amount.  Typically stock options are awarded from the very top CEO level down to mid-level managers.  But, the allocation of stock options is greatly skewed with the largest grants made to the highest level executives.

In the past, investment banks were partnerships.  Every decision within these firms was a really big deal since the vast majority of every partner’s net worth was at risk.  Becoming a partner was a huge decision and NOT a no-brainer.  Becoming a partner meant the individual would share in the profits of the firm – generally a lucrative option.  However, becoming a partner quite often required the employee to buy into the partnership.  Thus, the employee actually had to save their own money and then put it all into the firm.  While the new partner shared in the profits of the firm, those profits largely stayed in the firm until retirement.  Most of these partners became quite wealthy on paper, but the vast majority of their wealth was tied up in the working capital of the firm until they retired.  Having everyone’s wealth at risk made these folks fairly balanced in their decision making.  Sure, they knew if they bet big they could win big.  But, since their personal wealth was at stake, they also were somewhat cautious.  In addition, every partner was VERY interested in what was going on in EVERY division of the firm.  Just because a partner worked in the equity division, he was not immune to a blunder in the fixed income division of the firm.  Thus, everyone monitored everyone, and that form of checks and balances worked pretty well for more than 100 years through thick and thin.

Then, over the last 20 years or so, investment banks “went public” by issuing stock to the public.  Suddenly, anyone could own a piece of Wall Street and share in their profits.  However, more importantly, investment bankers could now gamble with other people’s money instead of just their own. 

This switch from partnership to a stock form of company structure resulted in two significant changes in compensation.  Investment bankers have always had a large portion of their compensation tied to profits of the firm.  Wall Street bonuses have always made up the majority of employee compensation.  However, in the partnership form, a large portion of this bonus would stay within the capital account of the firm.  With the new stock form, cash bonuses were taken home free and clear by the employee. 

In addition to the new portability in bonus payments, executives were given stock options in what has been falsely sold as an effort to “align employees’ incentives with stockholder interests.”  But, this is not a perfect alignment.  For example, imagine you own one share of stock in XYZ Corporation that is currently worth $60.  Also imagine a company executive has been given one stock option.  Typically, an executive stock option has a life of 10 years and gives the executive the “option” to buy the stock at some point in the next 10 years at the current price of $60.  Thus, the executive wants the stock to increase in value.  If, in 7 years the stock trades at $100, the employee has the ability to convert the stock option into stock.  The executive pays just $60 and receives a share of stock now worth $100.  However, the executive rarely keeps the stock.  Most executives don’t have to put up any money at all.  Usually, an executive in this circumstance will exercise the option and immediately sell the stock.  So, the executive buys the stock for $60 and immediately sells the stock for $100 and pockets the $40 difference.  In fact, companies facilitate this process and the executive usually does not have to put any money up at all – they just pocket the $40 gain.

We have been sold a false bill of goods in the thought that this executive’s incentives have been perfectly aligned with actual owners of the stock.  Let me now point out another scenario that shows how wrong this thought is.  Let’s take the same example as above.  Let’s say you own a $60 stock and the executive has a stock option with a $60 exercise or strike price.  But now imagine the employee makes a very bad bet with the firm’s capital.  Perhaps the executive buys a complicated collateralized debt obligation that falls dramatically in value.  Further assume that this large loss causes the stock to fall to $20.  As a shareholder, you just lost $40.  However, the company executive has lost nothing.  The executive still collects his salary and probably a much smaller bonus, but the executive never actually owned the stock.  The stock option expires worthless.  So, the executive did not get the added kicker of cashing in his stock option, but he also did not incur any loss whatsoever.  I suggest that executive stock options do not align company executives’ incentives with shareholder’s best interest.  Sure, stock investors and stock option holders both want the stock to go up, but actual shareholders are much more concerned about the possibility of the stock going down than someone who merely has the “option” to buy the stock in the future.

In addition, stock options encourage company management to stop paying dividends. Stocks with large dividends tend to be much less volatile than stocks that pay no dividends.  This lowers the value of executive stock options.  Plus, the value of the stock goes down by the exact amount of the dividend every time.  Thus, an executive who owns a stock option has two reasons to not want the firm to ever pay a dividend.  Executive stock options encourage company managers to take undue risks as there is no downside for the employee. 

Executive stock options also encourage managers to over leverage the firms that they run. Imagine an employee conceives of a project that costs $100 and believes it will result in earning either $15 or a loss of $5. The owner of a stock option will likely make that bet while a stock holder might not be thrilled with those odds.  In addition, the executive knows that this project could increase the stock price by 15%.  This same executive knows that if he can borrow another $100 in the bond market that he can magnify the impact of this project and its impact on the stock price by a factor of two.  With no downside, the owner of an option to buy a stock would likely make this gamble.  Why not really roll the dice and borrow $1,000 or $10,000 or $10 billion?  The executive might hit it big and be able to retire early.  And, if it blows up, so what?  It’s not like he had anything personally at risk.  He’ll still get his salary and bonus, but just won’t cash in on the stock option.

The incentive to over leverage the firm is further encouraged by the U.S. tax code since interest on debt payments is tax deductible while dividend payments are not tax deductible. 

So here is a recipe to take advantage of the current state of capitalism without capital.  Start a company with other people’s money by selling stock in your firm.  Use that money to borrow 20 times the amount from the bond market.  Invite all your friends to sit on your board of directors and issue yourself a whole slew of stock options.  Then take all the money everyone has given you and go make a huge bet on something.  Repeat as necessary until you win and cash in.  (This recipe works anywhere, not just Wall Street).

Directors at US corporations have no idea what they are paying their executives.  Let me repeat that. Boards of directors at companies that issue executive stock options won’t know what they really paid their executives until the options are cashed in or expired.  That means many firms won’t know the true compensation of their executives for another 10 years!  How is an investor supposed to forecast the financial statements of a firm for the next 10 years when we don’t really know the true profitability of any firm for the last 10 years? 

Executive stock options have led capitalism down a path where capital is misallocated.  Boards of directors have no idea if they are over paying their executives, and investors have no idea if companies are profitable or not.  Thus, managers within companies are possibly misallocating company funds and investors may be allocating funds to companies whose financial statements are not known with any certainty.  With executive stock options, company executives actually have no capital at risk.  A stock option allows the executive to win or break even, but there is no risk of loss.  Isn’t the reason capitalism succeeded for as long as it has is that it properly allocates capital to those people and those projects and those firms that deserve it?  Capitalism does not work without proper allocation based on specific measurable profits. 

Executive stock options should be against the law as there is no downside for the company executive. Instead, executives should be compensated with actual shares of stock – not options on stock. And, executives awarded stock should not be allowed to sell until they leave the firm.

Capitalism without capital is just gambling, with other people's money, and destined to fail.  We need to outlaw executive stock options, now.

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