Many stocks rise as the larger economy expands. Sometimes this explains away most or all of the stock’s appreciation. There is little room left in the equation for brilliant management, which is the rationale for stock options.
Alan Greenspan made the same point at a May 2002 conference at the Federal Reserve Bank of Atlanta:
STOCKOPTIONS: THEWARBETWEENMANAGEMENT ANDSHAREHOLDERS 119
One problem is that stock options, as currently structured, often provide only a loose link between compensation and successful management. A company’s share price, and hence the value of related options, is heavily influenced by economy-wide forces—that is, by changes in interest rates, inflation, and myriad other forces wholly unrelated to the success or fail- ure of a particular corporate strategy. There have been more than a few dismaying examples of CEOs who nearly drove their companies to the wall and presided over a significant fall in the price of the companies’
stock relativeto that of their competitors and the stock market overall.
They, nonetheless, reaped large rewards because the strong performance of the stock market as a whole dragged the prices of the forlorn compa- nies’ stocks along with it.31
This bias could be removed through peer evaluation, that is, comparing a company’s stock price with the overall performance of its economic sec- tor.32Alfred Rappaport proposes something of the kind:
Look for the first companies that adopt indexed option programs, which link exercise prices to movements in either an industry index or a broader market index like [the] S&P 500. These programs align the interests of managers and shareholders seeking superiorreturns in bull and bear mar- kets alike. Indexed option programs have the support of a growing chorus of institutional investors, but management continues to view them as too risky an incentive.33
The goal should be to reward executives for improvements in the company’s results that are truly of their making. The global economy is beyond their reach, but so also are changes in the company’s financial circumstances that occur before they have had any chance to affect them. Some observers, myself included, think that corporate officers cannot have any real influence on their company’s performance in the first 3 to 5 years of their employment. It is like turning an ocean liner: It takes a lot of time and running room.
LESSONS FOR THE INVESTOR
Retirement of debt is a legitimate use for earnings.Debt—which creates costs that live independent of operating results—is a threat to the investor. Remember that creditors hold a rightful priority over shareholders if the corporation becomes insolvent.
The tax system is shareholder-unfriendly.Oh, I know I’ve said it before, but it’s time to say it again. Among many other offenses, it is far too lenient regarding corporate debt.
Stock options are almost always bad for the investor.Through stock options, corporate officers get the benefit of having made advances of capital to the company without actually having con- tributed any capital. The compensation they are getting in this way is being transferred to them from investors. Stock-option plans involve misappropriation of corporate profit from shareholders, pure and simple.
Think kindly of the company that expenses its stock options.
Thanks to public pressure and the new Standard & Poor’s defini- tions, Boeing and Winn-Dixie will no longer be so lonely in expens- ing their options.
Dump the company that reprices its stock options.Repricing makes a mockery of the principle that stock options constitute a managerial incentive that is aligned with the shareholders’ interest.
Similarly, watch out for the Microsoft gambit, whereby the corpo- ration simply ignores outstanding grants and replaces them all with new ones with a lower strike price. Good for them; bad for you.
Money can be lost—even large amounts—after stock options are exercised.But do not lose a lot of sleep over this one. Greed is the most common cause. If you exercise stock options, sell the stock to realize the capital gains.
Do not borrow money to buy stock.Remember that the lowest value for a share of stock is zero.This is much lower than the loan you are taking.
Understand the tax implications of exercising your stock options.The “alternative minimum tax” applies to the difference between the stock price at the time the stock option is exercised and the initial strike price—notto the stock price when the shares are ultimately sold.
Pick your moment.If you believe—for whatever reason—that the price of the stock may still rise, do not exercise your option. Wait.
Above all, however, never exercise your option and thenwait. If you STOCKOPTIONS: THEWARBETWEENMANAGEMENT ANDSHAREHOLDERS 121
do, you have replaced your certain gain with a chance of gain com- bined with a risk of loss.
Do not get fooled by bogus share-buyback programs.A share- buyback policy that simply aims at countering dilution of earnings per share is of no benefit to the investor. It simply restores the sta- tus quo ante that an executive stock option plan has upset. And by the way, a share-buyback policy is beneficial to the investor if the stock is undervalued. Otherwise, it can even be detrimental to your interest.
Keep an eye out for the first indexed options programs.This is one of Alfred Rappaport’s good ideas: Make sure that the stock- option program that your money supports links option exercise prices to broader market indicators—meaning that they have a frame of reference for judging executive performance.
Wretched Excess
Where were the directors? I can understand when you’ve got a company doing extraordinarily well and beating its peers, and you feel some anxiety about retaining top people, but when a company is stumbling terribly, I don’t understand cutting deals for people. We’re not about class warfare but about everyone having the chance to move up, so this isn’t just a business issue, it’s also a social issue.
—ROGERA. ENRICO, CEO of PepsiCo1
And how do you feel about that and the employees, one of which wrote me recently—had $330,000 in his 401(k) account, his entire life savings, worked many years for your company, lives in the state of North Dakota. That $330,000 is now worth $1700.
You still have most of your $66 million. That family has lost their life savings. How do we reconcile that? How is it that the people at the top got
123
9
C H A P T E R
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
wealthy and the people at the bottom got broke?
. . . But it occurs to me that, at least from those of us who view Enron, if one were to make a similar comparison, in the Titanic, the captain went down with the ship. And Enron looks to me like the captain first gave himself and his friends a bonus, then lowered himself and the top folks down the lifeboat, and then hollered up and said, “By the way, everything is going to be just fine.”
—SENATOR BYRON DORGAN, Democrat of North Dakota, questioning Enron’s former CEO Jeffrey Skilling2
The Enron’s debacle triggered intense public indignation about executive compensation. There appeared to be three aspects to that indignation. The first was the sheer size of the dollars involved. The second had to do with how much license top executives had in the exercise of their daily duties to divert large amounts of money—measured in the millions or even tens of millions of dollars at a time—into bonuses or other types of personal finan- cial advantage. The third derived from what Senator Dorgan captured in his Titanicanalogy: Executives seemed to be emerging unscathed from the con- sequences of their own bad decisions, whereas employees and shareholders were left to bear the full burden of the company’s demise.
Let’s look at each of these in turn, with a particular focus on Enron and similar companies, and then look at the broader arena of executive com- pensation and perks.
Do you know how much your portfolio companies’ chief executive offi- cers (CEOs) are paid? I suspect that it is a relatively small percentage of individual investors that reads the fine print in financial statements to find out exactly how much top executives are being paid. In a second, much larger group of investors—those who invest through a financial advisor or through mutual or index funds—I suspect that there are very few who search out this fine print. (They do not even getthe annual reports under normal circumstances.) And finally, there are those investors who are shareholders only in the context of their 401(k)s, most of whom restrict their investment decisions to the allocation and reallocation of funds within their plan.
In other words, although many thousands of people held stock in Enron, most of them were in the second and third categories of investors just defined. For the most part, they had no clear notion before the Enron affair of how much the company’s senior executives were being paid. Many first heard about high levels of executive compensation on the same day that they heard about the life-shattering losses suffered by Enron employees with the collapse of their 401(k)s.
The second facet of public indignation, as noted, derives from the pub- lic’s “discovery” of exactly how much freedom Enron’s top executives had to divert huge sums of money in directions that would benefit them per- sonally. Obviously, these huge cash flows could have been used in ways that would have benefited shareholders—retiring company debt, acquiring strong companies, repurchasing company stock, or making judicious rein- vestments in the company.
One example of management taking good care of itself was Enron’s so- called Performance Unit Plan, a program that gave executives cash bonuses
“if Enron’s total shareholder return—a combination of dividends and the increase in the stock price—ranked sixth or greater compared with a num- ber of alternative investments.” Under the terms of this plan, Enron’s top executives received payments amounting to millions of dollars. CEO Ken- neth Lay got a cool $10.6 million in 2001 under the terms of this plan.
There were lots of slugs of cash sloshing around on the Enron boat.
Among the first big slugs to make the news were the commission fees earned by Chief Financial Officer (CFO) Andrew Fastow and his aides—
extra compensation for running those notorious partnerships. Fastow is known to have “earned” a fee of about $23 million on the LJM1 partner- ship and about $22 million on LJM2. Michael J. Kopper and William D.
Dodson together “earned” a fee of something like $10.5 million. When the press started investigating Enron’s earlier dealings, it soon became clear that these payments were not anything unusual. One Rebecca Mark was granted a $54 million bonus when the deal was struck on what became the calami- tous Dabhol project in India; a certain Joe Sutton made $42 million on the same deal. The justification for those extravagant bonuses on deals that turned out to be giant money losers was that at the time these deals were struck, they were marked to market and therefore would appear in Enron’s next financial statement as huge money makers.
A similar case, although far away from Enron, involved Peter A.
Boneparth, president of the Jones Apparel Company, a clothing and footwear company in Philadelphia. The story was reported in the New York
WRETCHEDEXCESS 125
Timesby Gretchen Morgenson. Boneparth’s contract stated that if share- holders did not approve a costly stock-option provision (see Chapter 8), he would receive the equivalent of a $1.5 million share grant in cash. Thomas D. Stern, managing director of Chieftain Capital, Jones’s largest shareholder, had this to say: “Peter is a capable executive, but he hasn’t proven he can create value for the Jones shareholders. To award him $35 million in options and guarantee him $10 million in compensation, after nine months at Jones, is egregious. It appears that this company is continuing to be run more for the management than for the shareholders. This is unacceptable.”3
Kudos to Mr. Stern for a clear statement of the obvious. Should corpo- rate earnings be diverted from shareholders simply because management can get away with it? Of course not.
A third facet of the public’s indignation about executive compensation derives from what Senator Byron Dorgan captured in his Titanicanalogy.
Not only do corporate executives get to poke holes below the waterline—
or at least watch what happen as a result of larger economic troubles—they also get the opportunity to loot the ship before it goes down. In the case of Enron, the awarding of retention bonuses was particularly offensive. At a time when the company was publicly claiming that no additional cash could be found to relieve some of the hurt and the misery inflicted on ordinary employees, executives were being courted with wads of cash. “Enron paid a total of $55 million,” a Wall Street Journalreporter noted, “or an average of $110,000 apiece to about 500 employees at all levels who were consid- ered critical to its survival.”4This “average” was somewhat misleading, in that a single executive was allocated $5 million of the $55 million just to keep that individual around for an additional 90 days.
Sometimes it is worth running these kinds of numbers through the lens of everyday reality. Let’s assume that your average elementary school teacher earns $50,000 a year—this is probably on the high end—and works for 40 years (perhaps also optimistic). He or she therefore earns a totalof
$2 million over a working lifetime. Now look again at that $5 million reten- tion bonus—paid to someone in addition toall the other sorts of compen- sation known to corporate America just to keep that critically important executive on the sinking ship’s deck for an extra 3 months.
Of course, retention bonuses aren’t uncommon when a company files under Chapter 11 of the federal bankruptcy code. They are part of a bigger picture—a way to give the wounded corporation the best possible shot at sur- viving while it reorganizes. However, the public tended to think along the lines of Salon.com’s Jake Tepper, who argued that “. . . [senior management’s]
performance during Enron’s meltdown casts some doubt on some of those executives’ managerial worth.”4When Enron proposed to create a $5 mil- lion emergency fund for 4500 laid-off employees, Lowell Peterson—a lawyer representing 20 former employees—noted that the size of this proposed emergency fund matched exactly that notorious $5 million retention bonus.
The sentiment of the public was aptly reflected in whistleblower Sher- ron Watkins’ comments at a House hearing in February 2002: “Some of the amounts I find shocking for 90 days’ retention. And I do not believe that it was in the best interests of creditors to—yes, we should retain certain peo- ple, but I don’t think they needed to be paid three and four times their base salary to stay for 90 days. And I think it is an insult to the 4000 people that were let go with $4000 checks that there are a handful of people—more than a handful—that were paid $600,000, a million five, two million—
$450,000—I mean, gargantuan sums of money to agree to stay at Enron for 90 days. I am appalled by that list.”
These big sums are unpalatable to the public in good times; they are obnoxious in bad times. It makes it seem that there are lifeboats only for the first-class passengers. “Although American Express Co. last year suf- fered from a spate of bad news that depressed its financial performance,”
the Wall Street Journal recently reported, “Chief Executive Kenneth Chenault’s compensation, excluding option grants, more than doubled to almost $14.5 million. . . . In its filing with the Securities and Exchange Commission, the company’s board noted that American Express ‘did not meet its long-term financial targets.’”5
Recall the comments of PepsiCo’s CEO Roger A. Enrico cited at the beginning of this chapter: “When a company is stumbling terribly, I don’t understand cutting deals for people.”
I will do a little stating of the obvious myself: Excessive compensation of a company’s executives is an unwarranted transfer to entrepreneurs of the capital growth that rightfully belongs to shareholders. A study published in August 2002 revealed that the CEOs of the 23 companies then under Secu- rities and Exchange Commission (SEC) investigation were paid 70 percent more than the average CEO of a large U.S. company.6
As an investor, you need to objectto this excessive compensation. (It is your money.) Go looking for it in either the corporation’s printed or online version of its annual report. Look in the “Footnotes”—almost always a good place to go rummaging—as well as under “Certain Transactions” and
“Other Compensation.” It has to be there somewhere because companies are required to report it.
WRETCHEDEXCESS 127