Cross-Posted at My Left Wing
For the first time that I am aware of, a ratings agency has studied the relation of executive compensation packages to a company’s financial performance. To end the suspense, the report concludes, “Companies that sweeten executive compensation with unusually large bonuses or options plans tend to have deeper and more frequent credit downgrades and higher bond-default rates than those that don’t offer such plum packages.”i>
First, executive pay is a pretty complicated arrangement, but it usually breaks down into two components: a base salary and incentives. The base salary is, well, just that – a base salary. However, incentive packages are usually tied to the company’s stock price. The company will give the executive inexpensive stock options as part of the executive’s compensation. A stock option allows a person to purchase a stock at a specific price, usually below the market price of the stock. The person then sells the stock in the open market and profits the difference. For example, suppose you have a stock option that allows you to purchase the stock at $10/share when the stock is trading at $30/share. This is a no-branier – exercise the option and sell-the stock.
Here’s the problem with the stock option packages. An executive is in a position to influence the stock price by authorizing poor or questionable accounting practices that increase his net worth. Accounting is not an exact science. There are different ways to report certain financial items. The executive has the option of using an accounting policy that makes the company’s numbers look good in the short run, which increases the stock price. The executive exercises his options and sells the stock long before the financial press or independent auditors uncover the problems. However, by then the damage is done. The executive is very rich and stockholders are left holding the bag.
The study noted:
“Moody’s found that of the 43 companies rated “B3” or higher that defaulted between 1993 and 2003, 22 offered their CEOs much-larger-than-expected bonuses or stock-option grants or both at least once. Of the 214 that experienced large downgrades — that is, three or more ratings notches within 12 months — CEO compensation was higher than expected in 140 cases. Some 50 of those finished in the top 10% for plan generosity across their industries
Moody’s sees three possible correlations between excessive compensation and default risk: excessive compensation may be indicative of weak management oversight by the board of directors; large pay packages that are highly sensitive to stock price or operating performance may induce greater risk-taking by managers; and large-incentive pay packages may lead managers to focus on accounting results, which may divert management attention from the underlying business or, at worst, create an environment that ultimately leads to fraud.”
This is a very complicated issue. On one hand, I am all for incentives to increase performance. However, there is a question of “how much is enough?” At some point, an incentive package is so large that it would compromise the Pope’s morals. While the specific level will vary with each person, it does exists with most people. In other words, everybody essentially has a price.
I also want to point out that there are numerous people in corporate America who try and do the right thing and who act morally in regard to their position. Are there bad apples in the bunch? Yes. Does that mean that everybody in the bunch is bad? No.