Given how executive compensation is structured, is anyone really surprised about Jon Corzine or any corporate executive for that matter?
In law, they call it agency risk. It is the risk that anyone takes when she or he appoints another person to act on one’s behalf. Powers of attorney and advanced health care directives are types of agencies we deal with every day. Corporate executives acting for their respective companies are another type of agency we see.
The risk stems from a range of issues. For corporate executives, the primary agency risk stems from compensation. Compensation for many, if not most, corporate executives includes stock options. For many, if not most, stock options represent the lion’s share of their compensation. The idea is that if share price goes up, it benefits the shareholders. And, if the shareholders are benefited, the executives should be rewarded for this.
But, there is a fundamental flaw with this compensation structure. Shareholders own shares outright, whereas corporate executives are long call options. While shareholders have skin in the game, the executives have a lottery ticket. Anyone who is familiar with options pricing knows that there are several factors other than share price that affects the value of options value. One of those factors is volatility (often measured by standard deviation). While a shareholder’s value goes up when the share price goes up, an executive can increase the present value of their options merely by increasing risk. We can look at the corporate junkyard and see what happened to firms whose executives took excessive risks.
Here is the funny think. U.S. securities law and regulations restricts registered investment advisors (an agent) as to whom they may charge a performance-based fee. In general, a client must have net worth excluding one’s primary residence of at least $2 million. And, when a registered investment advisor charges performance-based compensation, by law, the advisor must make a specific disclosure to the client. The disclosure must state that such compensation may induce the advisor to assume a greater amount of risk than the advisor might otherwise assume without performance-based compensation.
Oddly enough, there is no such protection for the average investor when the investor’s agent is a corporate executive.