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Monday, December 08, 2008

Does the corporation's interest "align with shareholder value"?

There is a massive world unto itself of literature on corporate governance, and I seldom venture into it, so I have no idea whether the following comment is just turning over well-plowed ground or not.

However, there is also a large body of literature with the ingrained assumption that executive compensation should be “aligned” as closely as possible with the interests of the shareholders. Sounds like, sure, why not, unless, of course, you’re an employee but not a shareholder, or the mayor of the town completely dependent on the huge local plant.

Maybe we should take a deeper look. The result of this concept of alignment is compensation dominated by incentive payment over salary, and especially with stock grants and stock options. There has been considerable critique of the stock options form: the fear that it will tend to distort executive interest away from the interests of the corporation and towards the self-interest in affecting (or in worst case manipulating) stock prices with potentially enormous personal rewards.

However, it occurred to me that the critique should go deeper. Shareholders may think otherwise, but the corporation is legally distinct from the shareholders. States and countries grant corporate charters with special privileges and powers in order to advance the public interest, not only the interests of those currently with the money to invest in it. Without getting into the heavily-loaded subject of other publics that ought or ought not be considered in making corporate decisions – employees and the local community -- we can say as a matter of fundamental principle that the fiduciary duty of officers of a corporation is to serve the best interests of the corporation itself as a separate legal entity from its shareholders. It is really irrelevant how we might define the public interest in the success of a corporation. As a matter of law the state has in order to advance the public interest created the corporation as an entity, a citizen apart from every other citizen, with a perpetual life.

The health of the corporation, not shareholder value, must be the sole and entire focus of the corporate officer. While present shareholder value may be one important indicator of that health, it is not the shareholders themselves or the return on their investment that the corporate officer should be considering. Although it may often be easier said than done, it is certainly not the return of current investors at the expense of later potential investors, which is strongly implied in the very concept of making corporate decisions that “advance shareholder value.” It is only – only -- to do one’s best to maintain and advance the health of the corporation, to make sure the corporation is just as healthy or healthier when the officer leaves as it was when he or she started, so that it is just as likely to live forever as it was. The corporation was created to live forever, as a vehicle for investors forever and whatever public interest could be served by its existence forever, and advancing that purpose, subject to law, should be the sole and entire guidepost for decision-making. It is this interest that will help management make appropriate decisions between distributing earnings to shareholders and retaining earnings to make the business grow.

At least for a mature corporation, executive compensation theoretically should be a salary only. Why should it be assumed that someone making several million a year needs more incentive than a healthy salary on top of an innate desire to excel is necessary? OK, if we assume human nature might cause a well-established executive to lose the competitive edge and do little to earn the salary, then perhaps it should be a salary with well-defined corporate performance incentives that probably are completely untainted by the stock price at any given time.

But the mantra “aligning executive compensation with shareholder value” based on the vagaries of a stock price that can be affected by all kinds of unpredictable and ultimately unimportant events, and even by manipulation by the company’s management to prop up its price – should be seen as just that, a mantra that is wrong-headed to boot. Yes, weak stock price can affect the fundamental health of the company, so efforts to prop it up may be justified sometimes. But that must be the sole focus. When such action is undertaken for the purpose of satisfying the wants of current stockholders, with the natural consequence of making sure the executives’ compensation packages are not undermined, the servant is taking care of the wrong master.

Compensation in the case of start-ups is a different matter. In that case, equity participation serves a different purpose, because the nascent entity cannot afford to pay the talented executives who really are needed in such environments the necessary compensation. Some day, I will try to figure out what the principle is for separating the two: when does the start-up phase end, and the impropriety of excessive stock and stock option components of executive compensation begin? There is also the not-unimportant matter of how change in current practices of executive compensation could be implemented. For now, let’s just say there’s something out of whack when the CEO of a major, long-established corporation earns $5 million in salary and non-stock corporate performance awards, and $50 million in stock and stock options. No wonder he or she will go on and on about the central importance of shareholder value.

A blog with tiny a following is a good place to preserve your thinkpieces. Flashdrives get lost, hard drives crash or get tossed, etc. If this is utterly commonplace stuff, well it wasn't to me.


Anonymous Equal Opportunity Cynic said...

For reference, here's my reply to you on Political Animal's comments. Keep in mind the context there is talking about the present financial meltdown/bailout:

Is the problem that the CEO compensation is too tightly coupled to stock performance, or not coupled tightly enough?

Although there are some problems with rewarding execs based on stock price (namely, a severe short-term orientation), that's only a small part of what we're seeing here. Looks to me like the problem is that these guys ran their companies into the ground, but they're still getting the golden parachutes.

Maybe compensating them with LESS base salary or severance and MORE equity would make them more diligent or at least more regretful. And maybe adding in a 5-year component that vests only after the company stays in good financial condition well after they leave would be a good thing, too.

8:02 PM  

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