Tuesday, July 09, 2002
Bloomberg.com's Graef Crystal has a piece worth reading about WorldCom's CFO and how much money he made. Key points:
* He was vastly over-compensated relative to his peers
* His compensation was more front-loaded than is the norm
* He did not own stock in WorldCom; his only exposure was via options, which meant he had no capital of his own on the line; when he exercised options, he sold the shares immediately
* He was the key man in a position to manipulate the company's books, and thereby the stock price
That certainly sounds like a recipe for corruption. Even if one is inclined to be charitable, and assume that there was no quid-pro-quo, all the incentives are there for serious mischief.
Crystal's main take-home is that the directors who voted for this insane compensation package need to be held accountable. Agreed. But I think it's worth pointing out two other factors that will be harder to correct than BoD incompetance: the malign effects of stock options and of merger mania.
Looking to the second first: one reason why WorldCom's CFO might have been granted such a big package is that CFOs have a crucial business role in mergers, and WorldCom is one of a number of large companies in the 1990s built through mergers and acquisitions (Tyco is another). If your business plan is "out-sell the competition" then your EVP in charge of global sales is your key executive. If your business plan is "build a better mousetrap" then your EVP head of engineering is your key executive. If your business plan is "buy everything in sight with my stock as an expensive currency" then your CFO is your key executive. He's at the top of the stack of people who will be figuring out how to value potential acquisitions - both in terms of defeating the target's CFO's attempts to massage their numbers and in terms of accounting for the deal once it's done. And he's the guy who, though careful "management" of your own numbers, makes sure Wall Street loves your stock. So of course you're going to pay him an awful lot of money. And once your CFO understands that he's a profit center, he really can't continue to perform the control functions that live under him as well: accounting, risk-management, etc. This is most egregiously true in Ponzi schemes like Enron. But it's an endemic problem at companies where financial engineering is important to the business plan, and this is always the case for serial mergers and acquirers.
Stock options, meanwhile, distort incentives all down the management chain. A stock option gives the holder unlimited upside with no downside. If the stock drops, the option holder loses nothing. If the stock rises, the option holder can capture theoretically unlimited profits. Moreover, options expire; if the stock does little or nothing, they generally expire worthless. What does this mean for an investor's incentives? I have a friend whose son was in a junior high school investing competition. He (or, rather, his team) came in second in the state. They had, I think, three months to manage an imaginary portfolio. Whoever had the most money at the end of three months won. My friend's son had the insight that, given the limited amount of time, and given the number of competitors, picking safe stocks unlikely to go down would be foolish. While he would be unlikely to come in last, or even to lose money, he would surely not win; someone would be lucky and pick a stock that doubled. So, to maximize his odds of winning, he picked the most volatile stocks he could find. He would not be penalized if the stocks collapsed and he lost all his fictional cash, and if they went up, they were likely to do so explosively, and so give him a good showing in the competition.
This risk-seeking strategy worked out well for my friend's son in the competition. And it worked out well for many corporate executives in the 1990s who, incentivized by stock options, became risk-seekers rather than calculated risk-takers. Excessive leverage, over-investment, aggressive accounting: all these are ways of making your stock more volatile. If your bets pay off, they'll pay off big. If not, your downside is limited. The idea of stock options is that they will align management's interests with those of shareholders: both have an interest in the stock going up. But they are not equally aligned on the downside: shareholders have far more interest in the stock not going down. That mis-alignment of interests is one systemic reason why things got as bad as they have in corporate America.