Are Stock Options At the Root of Executive Malfeasance?

To me, the biggest justice of the Patriots’ losing of the Super Bowl was not that Tom Brady had snickered with overconfidence at Plaxico Burress’ ultimately accurate prediction or even that Bill Belichick had stormed off the field before the game was over, it was the fact that the Patriots are a team of admitted cheaters! Am I the only one to feel that “Spygate” taints the Patriot’s “perfect” regular season just a little?

Admittedly, I am a Rams fan, and the possibility that the Patriot’s squeaking by the Rams in Super Bowl XXXVI was the result of cheating does kind of irk me. But the larger question should concern any sports fan: Why does it seem that professional athletes these days are always doing something crooked?

In baseball we have steroids, in the NFL we have spygate (and steroids too I guess although it hasn’t been as publicized as in baseball) and in basketball we have referees being bribed by mobsters. Doesn’t it seem a little ridiculous to be dealing with these issues in an arena as inane as sports? These are silly games played with bouncy balls for pete’s sake.

To me, this is just an outstanding illustration of the power of financial incentives. When there is money at stake, everyone’s attitude changes. It is no longer just a matter of pride, there are dollar bills waiting for these players should they perform well. What else, besides money, would entice anyone to go to such lengths to get a leg up, particularly given the risks? In the spygate scenario, the risk is getting caught and the humiliation and condemnation that comes along with it – call it “negative pride” perhaps. That is, Bill Belichick saw the expected financial return as being appropriately balanced against the enormous amount of disgrace that getting caught would cost.

Baseball is where this is most obvious. Not only is there a large amount of shame associated with being known as a doper (see Roger Clemens), using steroids will actually shorten the user’s life! Considering these risks taken collectively, clearly the expected return from the use of steroids must be huge. Of course, it is.

It is thus my contention that the rise in sports cheating, whether it be spying, doping or gambling, is the direct result of the huge amount of money that is now at stake – money that was not at stake during a more innocent era of professional sports. It is also my contention that the rise in cheating is not the result of some degradation of American society or a failure in the moral upbringing of our children. It is simply the result of humans acting the way they always have.

With the possible exception of certain biological incentives, there is no other incentive that humans, in general, find stronger than money. This is not inherently a bad thing, of course. Indeed, it is fundamental to the functioning of a capitalist society. But I do think that everyone ought to be cognizant of the overwhelming power of financial incentives.

In business the phenomenon is much more obvious, if for no other reason than that employees work for money. But parallels between sports cheating and business cheating are numerous. And if we have seen humans in the locker room take unbelievably large risks in pursuit of money, it shouldn’t surprise anyone to see them do outrageous things in the board room.

Enter Jeff Skilling. Having read several accounts of the accounting maneuvers undertaken at Enron, it is hard to believe any of them really thought they could get away with it. I think of this whenever I hear of some idiot trapped in a check kiting scheme. It is unavoidable that he will get caught, yet the lure of the dollar is so strong he tries anyway. Would it be outrageous for me to suggest that it was the rise in the use of stock options as executive compensation that, for the first time, created a financial incentive strong enough to coerce managers to cheat as overtly as those at Enron?

That would likely be a controversial assertion. After all, options are supposed to align the incentives of managers and shareholders. I believe, however, that it is possible to align the incentives of managers with shareholders even while maintaining the incentive to cheat. This is due to the rise of short-term or day trading. When the shareholders of a company are constantly changing, the long-term prospects of the company cease to be of central concern. The day trader doesn’t care if the company ultimately goes bust (as Enron did) because he isn’t maintaining his position for any amount of time. Likewise, Jeff Skilling might not have cared since he planed to dispose of his options long before the day of reckoning.

The corporate governance literature has provided empirical evidence of the problems with option compensation including a) the fact that options reward luck (Oyer (2003)) and b) that the recipients of the options value them at far less than their true cost to the company and therefore demand far more than they would otherwise demand in cash (Hall and Murphy (2003)). But I have yet to hear anyone assert that using options as compensation shifts the time horizon of the relevant parties and is thus detrimental over the very long term to the company as a whole.

I think this is part Warren Buffett’s objection to the use of options. While some Berkshire (BRK.A) subsidiaries use them, Mr. Buffett generally has not been a proponent. He was very vocal about the need to expense their issuance, and is adamant that they do the holders the unjust favor or rewarding handsomely for sub-par returns on capital. He has also argued that options don’t expose the holders to any downside risk, since they are typically issued at the money and without any intrinsic value.

The natural alternative to an option compensation program is a targeted stock ownership program. In such a plan the manager is required to own a certain amount of company stock. So long as he stays employed with the company he will continue to be exposed to both the upside and the downside of the performance of the stock.

It also stretches his time horizon as far as possible and, if the shares are simply granted to the manager, there is no ambiguity as to their cost. The stock will rise in value at a rate commensurate with the company’s return on capital. Academic literature has been very supportive of these types of programs – see Core and Larcker (2002) – but not necessarily ownership as a mechanism to align interests in general. I think it would be very interesting to investigate this shrinking-of-time-horizon phenomenon.

Comments

[MarineCorpsVet]

I think it is significant to mention at this point that there has not been a single golf pro involved in one of these scandals. Why has golf maintained it's character? There are certainly large amounts of money involved. Could it be that the pros have a certain amount of character to go along with the game? Money only tempts those that are open to temptation.

[WAKEUP]

Golfers are cagey, but they'll get caught, too. Maybe this year.

[Editor, myStockOptions.com]

This creative and interesting essay strikes close to the heart! I am editor of myStockOptions.com , a website with content and tools on employee stock options and other forms of equity compensation, plus we are located in the Boston area.

First, as for the Patriots, I suspect there is more to the story. Taping the other team and its coaches may be as common and deep rooted in football as trying to steal the signs in baseball. I'm still waiting for some investigative reporting on this and what really happened to cause the big fine.

As for employee stock options, they take too much of the blame for executive misbehavior. Any type of incentive compensation is subject to abuse when not properly designed and monitored. Stock options did get out of control for many reasons related to securities and tax law changes, the accounting rules, and the overall euphoria about anything related to the stock market. They can be an effective incentive and retention tool both company-wide to all employees and managers, and with executives.

However, except for situations with individuals that already have questionable ethics, stock options alone do not cause a well-educated, already financially successful executive to commit fraud. Even if there was never an invention such as "employee stock options," those same companies would have had another type of incentive "pay for performance" compensation that would have likely been abused.

It is useful for companies to have some type of share retention policy that encourages (or requires) executives to hold their stock after exercise and restricted stock vesting. They could only sell shares to pay taxes. This helps prevent the perception that executives are playing games with their stock price or know inside information. Before the SEC Rule changes with Section 16 in the early 1990s, this holding after exercise had to be done.

Bruce Brumberg
Editor, www.mystockoptions.com