Excessive Short-Termism

Much has been made recently of the short-term outlook that seems to have plagued the management of America's financial companies.  The CEO's and risk-management officials at these companies, the argument goes, focused only on short-term revenues in earnings; consequently, they lost sight of the severe, and sometimes systemic, risks that their institutions were facing.  To a large extent, this is true; Wall Street is focused on earnings - earnings per share, earnings quarter over quarter, earnings year over year.  But to what extent is this focus on earnings a result of management compensation structure and the Internal Revenue Code?

I think we're all aware that CEO's (especially of financial institutions) get low base salaries and are compensated through the use of stock options that vest after some period of time.  This is in part due to the IRC which restricts the amount of money a corporation can deduct from its earnings for base compensation to its CEO.  That is, if you pay a CEO $5 million in base compensation each year, you are not allowed to deduct that entire amount from earnings when determining your gross income (you're only allowed to deduct 500k or $1 million, I don't remember which).  Looking at this from a public policy perspective, this provision is intended to align CEO and shareholder interests.  Since the CEO will be compensated less in base salary and more through stock options as a result of this IRC provision, the CEO will have a personal, financial incentive to see the stock price rise. 

But let's take a look at this in terms of a dividend/stock repurchase/retained earnings perspective for a second.  The CEO's compensation will largely be through stock options that vest after a number of years (lets say 3 years).  Until then, his base salary is likely to be the same (either $500k or $1 million depending on what the IRC says), lets say $1 million.  Most of his salary is coming through stock options that vest over a period of time and have a strike price of $X, $X being what the company's stock is trading at today. 

Now what really matters, and what I'm going at, is how dividends are paid out to investors and management during the 3 year period during which the CEO's restricted stock option vests.  If the CEO decides that dividends are appropriate while his options haven't vested, what happens to his share of the dividends?  I assume that they are not distributed to him since he does not have any actual shares of the company's stock.  If he gets no dividend even though everyone else does, the CEO has no incentive to declare dividends.  In fact, he has a disincentive to declare a dividend; when his options do vest, the company will have less money than before. 

Ironically, the CEO has an incentive to either preserve the cash in the corporate till until his options vest (keep in mind that he is getting options every year, so all of his options have never vested until he leaves his position), or do attempt to use the money to increase the share price of the company's stock.  He would not want to preserve the cash in the company's bank account because it would make his company ripe for a takeover and because his options never vest until he leaves; he always has an incentive to not distribute the money.  Instead, his best option to spend the money, perhaps unwisely, to increase share price.  Thus, does compensation structure actually incentivize the CEO to waste money at the expense of shareholders?  Is his personal interest in increasing share price so dominant that he will corporate squander money rather than dividend it out?  How are we incentivizing him to make good decisions with retained earnings?

Now all of this depends on how dividends are distributed to those with restricted options, and to the extent that I'm wrong about my assumption, this entire article is useless.  But I've been mulling this idea around for a few days in my head, and I needed to get down on paper.

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