Back in 2008, in the wake of the subprime debacle as the financial crisis was affecting every corners of the world economy, equity-based compensation packages of senior executives and traders in financial institutions came under the scrutiny as one possible culprits for the excessive risk-taking behaviors that eventually led to the financial crisis.
IRONICALLY, equity-based compensation systems and in particular Stock Options were initially devised as a form of risk control to resolve the conflict of interests inherent in the agency problem in organizations i.e. the possibility of opportunistic, self-interested behaviour on the part of the Management (i.e. the AGENT) that could work against the welfare of the Shareholders (i.e. the PRINCIPAL). How do Stock Options work? In simple terms, the stock options mechanism allows the recipient to purchase stock in the future at the price it is valued today (i.e. option price). It means that if the share price rises above the option price, the recipient will be able to pocket the difference when he/she exercises the options after a certain required period (i.e. the vesting period).
To its advocates, stock options were seen as the “magic carrot and stick”, an ideal and cheap incentive designed to foster great management performance by encouraging optimal risk-taking and management simply because it was supposed to ALIGN smartly an organisation top management interests with those of the shareholders.
Let’s now take a closer look at how stock options were supposed to resolve the inherent conflict of interests between the management and the shareholders. The rationale was that shareholders are essentially interested to see an increase of the share price of the companies they have invested into. So, it means that share price movements upward…
- seemed directly related to shareholder’s wealth creation
- furthermore, it is easy to monitor as the share price is publicly listed for everybody to see
On the contrary, if the share price stagnates or worse goes down, the stock options are worthless penalising the management for its poor performance. It means that options would pay off ONLY if the company’s share price went up.
Hence share price movements seemed at first glance to be a fair and reasonable way to:
- evaluate senior executives contributions to an organization wealth creation and
- reward them in reasonable proportion of it.
Based on that understanding, from the late 80’s, stock options started to be widely granted to the seniors management and senior traders quickly becoming an essential part on their compensation packages.
Unfortunately, it did not work as it was initially intended to (Here is another example of the law of ‘Unintended Effects’).. Data about corporate failures/troubles over the past 2 decades have showed that Stock Options FAILED to resolve the Agency Problem. In fact, they made the problem worse by the exacerbating the the moral hazard issue in senior management behaviour.
Obviously, something went wrong.. painfully wrong! Let’s try to find out what happened… I would now like to elaborate on the following 2 key reasons that will shed light and explain the ineffectiveness and dangers of using Stock Options as a top executives performance management tool:
- The mechanism of stock options was perverted by the management to ensure and magnify rewards
- Even when used as it was intended, Share Price is NOT very well-suited as a Performance Management metric on its own
1- Perversion of the Stock Options mechanism
In many public-listed organizations, stock options became an additional form of compensation that was often just added up on the top of already very generous packages. Furthermore the stock options system was quickly perverted by the management through the use of various techniques that essentially aimed to ensure that the management would get ‘their huge bonuses’ no matter what was their individual performance and the performance of their organizations.
I have listed below some of the most popular techniques used for that purpose:
- Backdating (Allows the recipient to purchase stock at yesterday’s price, resulting in immediate wealth increase)
- Spring-loading (Granting of a stock option at today’s price, but with the inside knowledge that stock’s value is improving)
- Bullet dodging (Delaying of a stock option grant until right after bad news)
Many organizations distributed options to their senior management teams like candies in ever-growing numbers and it ended up to generate the biggest bonanza yet for top executives leading to exponential growth in their compensation packages.
Advocates of options compensation, postulate that options mechanisms shouldn’t be judged on the basis of the perverted use made of them in some organizations, that the issues highlighted can be corrected with proper controls (i.e. better oversight, longer vesting periods, etc) ensuring that organisations will benefit from the option mechanism. They also claim that exponentially rising senior executives compensation is not the result of the use of options but is rather due to the intense competition for top experienced managers in a globalised world. They finally claim that stock options have helped to foster business innovation, by giving young and promising but cash-poor start ups a bait with which to attract the human capital talents necessary to engineer their growth. Let’s now explore this issue.
2 – Share Price is NOT well-suited as a Performance Management Metric
Can stock options really help align the interests the management with those of the shareholders and provide a fair and reasonable basis for executive compensation?
In order to be able to answer that question, we must realise that the validity of the stock options mechanism is based on a very important hidden assumption.. It goes as follows: “If the share price is going up, it MUST mean that the management team has done a good job!”… Is this assumption realistic and reasonable?
A primary school child should be able to figure out that this kind of reasoning is not just simple, it is simplistic! As a matter of fact, the assumption it is based on, proved over time to be highly questionable and incidentally highlights one key ROOT Cause of Management’s Problems in organizations.
This root cause of management’s problems is that… People and Organizations are typically evaluated on OUTCOMES i.e. Results (often financial) Metrics/Indicators such as revenue, earnings, share price, turnover, etc.
Why are Results Metrics PROBLEMATIC?
It is because they work like ‘thermometers’. These ‘temperature indicators’ aim to tell you if you are healthy or not! For example, when the share price goes up, it is supposed to indicate that the organisation is doing well. On the contrary, if it goes down, it is a sign of troubles!
However one essential limitation of those kind of metrics is that it will NOT tell you HOW you achieved the Results!
This limitation is easily overlooked as people are naturally inclined to assume that the positive movement of a result metric (in our example the share price) must indicate that there is a very effective leader doing a great job.
Unfortunately the reality is that, beside somebody doing a good job, there are many other problematic reasons that can lead to GOOD RESULTS on the short to medium term. Results could LOOK good because of:
- Luck. Even when there is excessive risk-taking, randomness can play in your favour as brilliantly demonstrated by Nassim Taleb (author of the Black Swan Theory);
- Taking credit for somebody else work (All too common in large organizations. There is always a team behind who also deserves credit);
- Benefiting from a favorable situation (Should the management be rewarded for key external factors they had no control over?)
- Benefiting from timing issues where short-term gains are made at the expense of long-term costs and risk exposure;
- Hiding losses by fudging the figures through creative and fraudulent accounting (You will all too often find out when it is too late).
As Warren Buffett once declared: ‘Risk comes from not knowing what you’re doing’.
The disconnect between Results on one side and decision/actions on the other side is a so-called unintended “side effect” of the focus on metrics such share price and will inevitably lead to the creation of black boxes in organizations… And black boxes will open the door for all kind of abuses by the managers in charge who can do whatever they want with no proper scrutiny of they decisions and activities as long as they operate within the perimeter of the black boxes.
I trust I have highlighted both the ineffectiveness and dangers of stock options schemes. Do keep in mind that from a risk management perspective, if you evaluate performance using indicators that are not clearly related the critical success factors of your business model, it means that you do not understand what you are doing, and that you are actually GAMBLING away the assets of your organization.
Hence it is time to recognise that stock options should never be used on their own as a performance management and reward mechanism. In fact, don’t waste your time trying to improve something that is inherently flawed. The best solution is probably to drop or at least limit drastically your stock options compensation scheme and reward primarily your staff based on metrics that put the spotlight on their real risk-adjusted performance. I know it will not be easy … indeed why would senior executives who are, by their human nature, primarily self-interested, agree to change a flawed system that is so skewed in their favors? How we can make that happen will be the subject of another post..
Risk Management Demystified 