Voting Drill on Stock Options

This article was published in the Washington Times, July 8, 2003.

The Securities and Exchange Commission (SEC) wants to require shareholder approval of employee compensation plans that involve stock options or stock. That label of “shareholder approval” sounds so democratic, and the ritualistic vilification of stock options sounds so banal, who could possibly object?

But what is “shareholder approval” really likely to mean? Like many small investors, I own so few shares of any one stock I never vote on proxy statements that flood my mailbox. Individual investors, like consumers, are too diverse and dispersed to be organized into an effective interest group.

Besides, most shares are under the control of institutions. In the real world, “shareholder approval” is designed to enhance the already awesome power of a few managers of other peoples’ money — bosses of the biggest pension funds, mutual funds, hedge funds and foundations.

This is developing into an unhealthy contest between two “agency problems.” One such problem is that corporate executives are hired agents of a company’s principals (stockholders). The personal interests of these agents (executives) can be quite different from the interests of corporate owners. If executives are paid like bureaucrats, they will tend to make life easy for themselves by delegating tasks to a costly army of subordinates and outside advisers, while carefully avoiding making risky changes.

The reason for making a large share of executive pay depend on options or stock has been to induce executives to behave in the stockholders’ interest by holding down expenses, working hard and taking appropriate chances on new opportunities. As Brian Hall of the Harvard Business School remarked, “Options are the best compensation mechanism we have for getting managers to act in ways that ensure the long-term success of the companies and the well-being of their workers and stockholders.”

Managers of pension funds and mutual funds, however, raise a quite different agency problem. They, too, are agents rather than stockholders, and their personal interests also differ from interests of stockholders. The number of managers of the largest funds is quite small, easy to organize for effective political action.

Pension funds of state governments and labor unions have been particularly effective in creating powerful lobbying organizations. By combining, they can make a big show of the huge sums of money they supposedly “represent.” The press always falls for it.

In reporting on the SEC decision, Bloomberg News cited an enthusiastic official from “an association of labor unions with pension assets of more than $1 trillion.” The Washington Post likewise cited a happy official from the Council of Institutional Investors ($2 trillion). The Post somehow listed even the Consumer Federation of America among “shareholder groups” that “lobbied hard” for the new rules.

“Shareholder groups” must not be confused with groups of shareholders. A Dow Jones story called such them “investor advocates,” which was equally naive. In reality, such phrases refer to lobbyists bankrolled by organizations of well-paid fund managers who have neither the information nor the incentive to negotiate on behalf of actual corporate owners.

Managers are not owners, nor advocates of owners. Indeed, actual owners often have no practical choice but to invest in these politically powerful union and government pension funds regardless of how poorly their investments perform. If you work for the State of California, you’re stuck with CalPERS — the huge California Employees’ Retirement System. And, as with anything having to do with the California government, I wish you lots of luck. You’ll need it.

You want to see who really wins and loses from the SEC’s new scheme of “shareholder approval”? Take a look at CalPERS — arguably the biggest winner of all.

A few days before the SEC ruling, CalPERS announced it will only vote to support executive stock option plans if 5 percent or fewer of the stock options go to the company’s top five executives. As columnist Michael Kinsley recently noted, stock options have become “an obsession of high-minded bores.” But this seemingly romantic effort of CalPERS big-shots to use the leverage of other peoples’ money to encourage firms to pay lower-level employees with stock options is inefficient and evil.

People who get more pay from options necessarily get less in salary and benefits. To say 95 percent of stock options should go to lower-level employees is to say such employees should bear most of the risk for managerial decisions over which they have no control.

The critical distinction between mangers of politically connected pension funds and actual stockholders eludes most journalists, but not astute business school profs. A 1997 study by Marilyn Johnson of Michigan State, Susan Porter of the University of Massachusetts and Margaret Shackell of Notre Dame noted that “pension funds like CalPERS appear to be more attuned to what is typically viewed as ‘political concerns’ about compensation than to what is typically viewed as ‘shareholder concerns’ about pay-for-performance.”

A later study by Andrew Prevost and John Wagster of Wayne State University found that firms targeted by CalPERS responded by paying their executives like bureaucrats: “CEOs at target firms are compensated for a decrease in pay by a reduction in the riskiness of their remaining pay.” Fewer stock options were traded for more cash, perks and bonuses, so the CalPERS message to their favored CEOs was to play it safe and take it easy. But minimizing CEO incentives is bad news for investors, particularly for poor souls dependent on a politicized fund like CalPERS.

In short, what the SEC means by “shareholder approval” is to enhance the already awesome power of organized institutional fund managers to block executive incentives to cater to shareholders. This is more proof that whenever the SEC is in the headlines, or offers to help, watch your assets.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.