Misalignment: Compensating Management with Options

As a shareholder, you must be extremely cognizant of how the management team of your company is compensated. An ideal compensation structure pays executives enough so that they're not worried about meeting their family obligations, but otherwise aligns their interests with those of shareholders. Contrary to popular belief, stock options do not align manager interests with those of shareholders, as we've discussed here.

However, when CEO Richard Fuld of the now bankrupt Lehman Brothers recently testified before the House of Representatives, this is how he answered a question regarding the compensation he has received in the last few years:

We had a compensation committee that spent a tremendous amount of time making sure that the interests of the executives and the employees were aligned with shareholders...because we wanted them to think, act and behave like shareholders. When the company did well, we did well. When the company did not do well, we did not do well.

This is absolutely incorrect! Due to the hundreds of millions of dollars in options Fuld received, his interests were not aligned with those of shareholders (if they were, he would not have received $350 million, while the long-term shareholders are left with nothing!). Options encourage managers to take great risks (resulting in the possibility of huge paydays) with little consideration to large losses (as an option can't be worth less than zero!), whereas compensation in the form of restricted stock encourages managers to be aware of downside risks and consider long term shareholder value.

Did Fuld let Lehman tank because he made his money and just didn't care? Such an accusation is without basis. However, the excessive use of options as compensation undoubtedly encouraged management to take risks, which led to Lehman's eventual demise. University of Chicago Finance Professor Luigi Zingales is not alone in his opinion when he states, "Lehman's demise was a result of its aggressive use of leverage." Aggressive use of leverage results in huge profits and huge losses...we saw them both happen at Lehman thanks to a gross management/shareholder misalignment that ended up costing shareholders, but not management.

Before you become a shareholder in a company, look for its compensation structure in its annual proxy filing (a regulatory requirement), and politely decline to invest if confronted with excessive use of options as compensation for management.

Disclosure: None

Comments

[Steven Hansen:]

and knowing about ceo compensation before i buy stock will help me how? i know that it is no clue how well a company will perform.

ceo compensation is a problem like taxation. it is a sword with two edges and there are a lot of unintended consequences when you move from a point of natural equilibrium.

having said that, i really do not see how an executive is worth more than 100 times the salary of the lowest employee.

2008 Oct 28 05:58 AM

[PainfullyAware:]

Robber-Barrons.

Integrity seems to be a thing of the past.

Suffer the masses for the foolery of others.

2008 Oct 28 03:02 PM

[DonaldRay:]

Not even one day of jail time for Mr. Fuld.....hell, who doesn't want his job!

2008 Nov 01 11:18 AM

[Ex employee:]

You don't have a clue- he was paid in restricted stock not options, as were the rest of the employees for the last several years. He told the truth- though no one in the media wants to believe it.

2008 Nov 03 04:36 PM

[Saj Karsan:]

Hi Ex,

You are right that restricted stock was also involved, but your claim he was not paid in options is false. Here's a video where Fuld specifically admits to exercising various options for hundreds of millions of dollars (1:35 mark of the video): www.youtube.com/watch?...

2008 Nov 03 06:48 PM