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Roger Martin

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Old CEO Pay Theories Die Hard -- and Damagingly

Posted: 05/05/11 09:57 AM ET

Old theories die hard and my fellow business school Dean Mark Zupan makes that clear in his blog post on my book and articles. Apparently there is no problem with stock-based compensation. It is the answer. The problems are dismissed with the modest admission that "expectations do not always prove to be accurate." Not a problem for Dean Zupan.

The fact that expectations do not always prove to be accurate turns out to be pretty crucial. Their massive inaccuracy creates a wonderful opportunity for CEOs to exploit mismatches between reality and expectations to profit monumentally. If a CEO can get expectations to go from $50/share to $20/share and back up to $50/share, he can make a fortune on his stock options granted at $20/share while shareholders don't make a dollar from $50/share to $50/share. And manipulating expectations is child's play in contrast to altering the real performance of the company.

Dean Zupan's commentary is typical of the apologists of the current theory. He doesn't cite a single fact or statistic in making his theoretical point. That is safe territory. In theory his argument holds: expectations hue closely to reality so they are a great proxy for reality all the time. Sadly, it doesn't manage to help us understand why expectations swung so wildly from an index of 100 at the all-time high of the S&P500 in October 2007 to an index of 43 in March of 2009 and back to an index of 85 in April of 2011. Not much of a parallel with reality from any sensible perspective. But it provided wonderful arbitrage opportunities for clever and willful CEOs.

In addition to providing no data, Dean Zupan tosses in some absolutely false assertions. Check out the following: "More broadly, think about all the reasons why we ended up in the recent economic mess precisely because relevant agents didn't have sufficient skin in the game." I think that most would agree that the behavior and performance of major financial institutions such as AIG, Bank of America, Bear Stearns, Citigroup, Lehman Brothers and Merrill Lynch had more than a little to do with the economic meltdown. Zupan asserts that the problem is that these executives didn't have stock-based "skin in the game" so their interests just weren't aligned with shareholders.

Two clever scholars, Sanjai Bhagat and Brian Bolton (Bank Executive Compensation and Capital Requirements Reform) decided to check this out factually rather than theoretically or impressionistically. They looked at the stock holdings and sales of the 14 CEOs who headed the 14 US financial institutions declared to be "too big to fail" by the US government and given massive amounts of TARP funding to survive. They included the above five mega-losers plus 9 others including Goldman Sachs and Morgan Stanley.

So what did they find? Oops, the 14 CEOs held $6.8 billion of stock in their own financial institution in 2000 (before the crash) -- that would be $485 million per CEO for those of you calculating at home. Interestingly (consistent with the theme of my book), they were active traders, playing the expectations market cleverly to net a profit of $1.8 billion in trades of their stock in their own institution between 2000 and the 2008 crash - on top of their paltry cash compensation of $890 million. And yup, they took it in the teeth in the crash, incurring paper losses of $2.0 billion in the crash. But there weren't too many bake sales. From 2000 through the crash, they were collectively up $649 million and still had $939 million in net stock holdings -- for 14 guys! The rest of the country imploded and they scored $ 46 million per CEO with another $67 million in their stock portfolio.

By any measure (other than Dean Zupan's apparently) they had massive "skin in the game" (what? You want more than $485 million?) and still did ridiculous things that destroyed most of their organizations, yet came out with +$100 million per CEO.

Sadly, we are still in the first stage of the death of the theory and Dean Zupan illustrates brilliantly the first stage: denial. Maybe I will elicit stage two: anger. And then we can move through bargaining and depression to get to where capitalism needs to get: acceptance that the current theory is bankrupt.