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The Angry Economist

The Next Big Business Scandal
Posted by William P. McGowan, Ph. D. on Apr 30, 2006 - 7:43:00 PM

UNITED STATES— An interesting story recently appeared in the Wall Street Journal on a slow news-day about a month ago, that is likely to grow into one of the biggest corporate scandals of the decade.  The issue is obscure, but the more people learn about it, the more they are convinced that chief executive officers of some of America's companies are stealing.  By rigging the compensation system in their favor, America's chief executives are essentially playing a game of "heads you lose, tails I win" with lots of real money.


Please understand dear reader that The Angry Economist has no problem with people earning exorbitant salaries per se.  What bothers me is the very rich stealing to become even wealthier.  That's what's happening with an obscure executive compensation mechanism known as "options timing."  This is the process by which an officer of a publicly traded company is induced to improve his firm's performance by making a majority of his compensation tied to the performance of that company's stock.  


Usually, CEOs get paid a small "base" salary and then have most of their compensation come from stock options, where they get the right (or "option") to buy company stock at advantageous pricing, usually the value of the stock the day they became chief.  If the company's stock rises as a result of the executive's efforts, they could potentially earn an additional $10 to $20 million a year on top of their base salary; then the executive's bonus is worthless.


At least, that's the theory. 


It seems that a statistician for a prestigious eastern university started looking at companies that paid their executives this way, and he stumbled into what may be the biggest business news story of the year. The researcher found that an inordinately high number of executives had the "luck" of pricing their options just when their company's stock prices were at (or near) historic lows.  What was even more interesting was that in almost every case, days after an executive locked in their option price, the company's stock would rise significantly.


What makes this statistical anomaly stand out even more is that these were not one-time events.  In most cases, the executives being compensated in this fashion could change the option date from year to year.  Again, their timing was perfect, in that they routinely "optioned" stock that turned out to be the yearly low.   This pushes the statistical probability into odds of billions-to-one.


While initially proud of their "pay-for-performance" contracts, many executives who got paid like this are suddenly hard to reach.  Their public relations departments are having a hard time explaining how so many executives could be beating one-in-seventeen million odds on a regular basis


No matter how you cut it, this form of "compensation" is stealing.  No one but the chief executive seems to know the value of the options being awarded for "performance." Based on the amazing performance of the stock in the days and weeks following these stock option price lock-in dates, it is pretty clear that these guys were "managing earnings" so that good news came out after they could personally benefit. That's why this is now a federal issue. 


Happily, the SEC read the same story I did.  They've announced numerous new investigations into the timing of executive compensation systems, including the executives of several Southland Companies.  So in the coming weeks, remember, you read it (and understood it) here first.




Cliffside Malibu




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