Friday, October 20, 2006

Incentives for the Dead

The Dow hits 12,000, record numbers and so, some must think Paul Krugman is a little nuts today, calling for corporate reform. But he's not. Following up on Gretchen Morgenson's article this past Sunday on the proliferation of obscene executive compensation packages fuelled largely by the use of backdated stock options and comp consultants, Krugman is beating the drum too. As well people should. While it might seem like a complex business story, it's really one of the oldest stories around. It's called greed.

So here's a bit of an overview of the problem. The rationale for the options being issued:
The claim, then, was that executives had to be given more of a stake in their companies’ success. And so corporate boards began giving C.E.O.’s lots of stock options — the right to purchase a share of the company’s stocks at a fixed price, usually the market price on the day the option was issued. If the stock went up, these options would pay off; if the stock went down, they would lose their value. And so, the theory went, executives would have the incentive to do whatever it took to push the stock price up.
The questionable practices that have nevertheless occurred:
Then there were the tricks that companies used to ensure lavish executive pay even if the stock simply seesawed up and down. For example, after a downward move in the stock price, executive stock options would often be repriced or swapped — that is, the price at which the executive had the right to buy stocks would be reduced to the new market price. Heads the C.E.O. wins, tails he gets another chance to flip the coin.

What the backdating scandal reveals is that for many executives even that wasn’t enough. To ensure that executives profited from newly issued options, companies would pretend that the options had in fact been issued at an earlier date, when the stock price was lower. Thus a contract that Mr. McGuire signed in December 1999 included a grant of one million stock options dated back to Oct. 13, the day UnitedHealth’s stock price reached its low point for the year.

What’s wrong with backdating stock options? There’s a tax evasion aspect, but the main point is the bait-and-switch. The public was told that gigantic executive paychecks were rewards for exceptional performance, but in practice executives were lavishly paid simply for showing up at the office.
Where we are:
And there’s no reason to believe that the problem has been solved. Three years ago, Warren Buffett declared that reining in runaway executive pay was the “acid test of corporate reform.” Well, executive compensation, which fell briefly after the Enron and WorldCom scandals, has shot right back up.
The reports of backdated options are coming on a regular basis now with no end in sight. This is definitely an issue requiring greater scrutiny. Fortunately, Krugman's call is being heeded, somewhat, in that the SEC is requiring significant disclosure of executive pay in company filings later this year. The tables included in those reports will make for some interesting reading, to say the least. And possibly, an incentive to keep the obscenity in check.