THE QUANT by Richard Booth

BIG SHOTS AND BIG BUCKS

Why do big shots make big bucks? The standard answer is that the prospect of a bonus encourages corporate executives to maximize stockholder return. But some behavioral economists argue that incentive compensation may be counterproductive. See Dan Ariely, What’s the Value of a Big Bonus?, New York Times, November 20, 2008, at A33:1. In a series of experiments, Ariely and his team discovered that if they offered a big reward for performing a task that required even rudimentary cognitive skill, performance was worse than when they offered a modest reward. On the other hand, a big reward induced better performance if the task required effort only and no skill. They found a similar effect when the tasks were performed in public rather than in private.

 

The suggestion is that generous incentive compensation for CEOs and other high ranking officers of public corporations may be counterproductive. If so, a big bonus is a waste of money and stockholder wealth. Moreover, Ariely suggests that the effect may be due to stress. So maybe it is really for their own good that we should limit incentive pay for corporate executives.

 

The problem with the argument – and the implicit assumption behind the experiment – is that incentives are intended to affect performance. There is another more likely possibility. It may be that incentives are really about sharing gain. Maybe incentives are about attracting the best talent possible to do whatever they do however they do it.

 

Is there any reason to think that Tiger Woods plays better in a major tournament than he would play for lesser stakes? Possibly. Tiger may play better in a major because he thrives on the stress and because the stress makes others choke. But the more likely reason is that Tiger plays only in a handful of tournaments because he knows how good he is.

 

Similarly, in the business world, incentives may be more about attracting talent than about encouraging better performance. Indeed, it may be that the best CEOs thrive on stress. So maybe incentive compensation is about attracting those who do better under stress and maybe even increasing the stress that goes with job.

 

Presumably, a talented businessperson with choices will sign with the company that is most likely to succeed. And sometimes that success may be assured by attracting the talent that already knows what will work – like the engineer who arrives on the scene, pushes one button, and sends a big bill for his services. From the company viewpoint, it may be more efficient to buy talent than to train it. From the employee viewpoint, a job is like an investment. You seek the highest return at the lowest risk. Nothing wrong with that. So a better experiment would be to see if it makes any difference if individuals can choose the task or the incentive or both.

 

A cynic might reply that incentive pay should be about inducing better performance and not about bribing folks just to do their job. An economist would call it rent. But so does a holder of a patent or copyright command rent for existing goods. Why should talent or a business strategy be seen as different from other forms of intellectual property?

 

Many critics cite greed and unregulated executive compensation as causing or contributing to the current financial mess. At the very least, they advocate a crackdown on executive compensation at the troubled banks and other financial institutions that get government assistance. There is little doubt that those who originated and securitized subprime mortgages did so to make money. Nor is there any doubt that many did enjoy handsome compensation in the process. But it is not at all clear that cracking down on compensation makes sense.

 

The problem at the moment appears to be that the banks refuse to lend even to many good customers with good credit. One way to thaw out the credit markets is to reward bankers who make good loans. But if we ban pay for performance because of the worry that it will induce risky business, there is little reason for anyone to make good loans. There is no reason to take a chance when there is no upside. Better to buy risk-free government securities – even if they yield next to nothing – rather than risk one's job on making a bad loan.

 

Moreover, limits on pay are likely to drive much of the banking and finance business into the private realm. No one would suggest that a trader who trades for his own account enjoys excessive pay when he makes a killing. Pay is one thing. Profits are another. Or maybe not. The point is that compensation is an issue only if the employer is a publicly traded company. If we limit pay, the talent is likely to gravitate to nonpublic companies -- private equity and hedge funds. That is not necessarily a bad result. It would effectively insulate investors in the future from the risks that have come home to roost in the current crisis. But it would also deny the public access to the returns that go with that risk. Do we really want to go back to the days when we had a soviet-style choice between a fixed return on passbook savings or a Series E savings bond?

 

Still, one might argue that it is wrong that Wall Street executives should be able to keep the pay they took over the past few years. The argument seems to be that past performance was somehow a fraud or that those in charge knew what was coming or that taking generous pay implicitly guaranteed future performance (despite explicit warnings to the contrary on every pack of stocks sold by mutual funds). The fallacy in this argument is that the market always looks forward. Market prices reflect a guess about the future. So when stock prices increase, and CEOs cash in their options, it is because the market approves. To be sure, a stock may rise because of fraud as with Enron. But the current crisis is not about one or even a few companies. It is about the whole of the market. No one would seriously argue that the entire financial services industry was engaged in a coordinated fraud. But it is easy to take pot shots at individual CEOs. So what we have is an odd collective action problem in which it is easy to cast blame on individuals who cannot defend themselves. No one would dare argue that everyone was doing it, even though in this case that appears to be a perfectly good excuse.

 

Moreover, suppose that we could somehow claw back past pay for no performance. What if -- as Deep Throat suggested -- we follow the money? Where is it now? Maybe it is sitting as cash in a bank account somewhere. It is more likely that the money was invested in stocks, or bonds, or real estate, and has shrunk with all such investments. There is no place to hide in a financial meltdown.

 

Finally, many critics have focused their ire on severance pay which they see as pay without performance or indeed reward for failure. Never mind that A Rod gets paid to play win or lose. (And Marbury gets paid no matter what.)

 

There is another side to the severance story. Golden parachutes were invented in the 1980s to counter the tendency of CEOs to resist takeovers even though stockholders stood to gain from such deals. Equity compensation was an obvious extension of the idea. Equity compensation is the best way to induce the CEO to maximize stockholder wealth -- whether by growing or shrinking the company. In the old days, CEOs got paid for reporting ever higher earnings, which encouraged growth – whether sensible or not – and conglomerate corporations. Since the early 1990s, most CEO pay has been in the form of stock options and restricted stock. And conglomerates have gone the way of the wooly mammoth.

 

Equity compensation also means that the CEO has a significant ownership stake in the business. So generous severance pay should not be seen as a reward so much as a buyout. A CEO who is forced to depart his business, loses the chance to finish what he started and to share in future gains. In any other setting it would seem quite natural for a part owner to be paid in exchange for his share of the business. This is not to say that the system cannot be abused. It is only to say that one must see severance for what it is. It is at least as much buyout as payout. 

 

The real question is where did we get the idea that a CEO is a glorified employee – or indeed a volunteer -- and that executive pay is really a big tip that the stockholders might or might not choose to pay? Is there some reason that working for a piece of the action is inconsistent with the public corporation as an institution? There is also a grand tradition of sweat equity. I suspect that attitudes toward executive pay are an outgrowth of the notion that a corporation is owned by the stockholders. But it is the height of irony that executive pay has become the big gripe of stockholder activists when for years the complaint was the separation of ownership from control. Stockholder ownership is a useful metaphor. But we should not let metaphors get in the way of good sense.

HENRY FORD AND THE GOOGLE GUYS

The pronouncement by one of the Google Guys that the company is not run for the long term value of the stockholders but rather for the long term value of the end users, is reminiscent of Henry Ford's decision in 1916 to stop paying dividends in order to improve the lot of workers and customers. Or is it? There are a couple of big differences.

First, Ford admitted that the company had a pile of cash that it did not need for any business purpose. The Michigan Supreme Court ordered him to distribute it as a dividend and the Dodge Brothers (who owned 10 percent of Ford) used the money to start their own car company. The court also said that Ford's decision to use an even bigger chunk of change to lower prices and to build housing for workers was OK too under the business judgment rule. Who were they to say that happy workers and lower prices were not the best way to maximize profits? So the case supports the proposition that the stockholders own the company and that management can manage virtually without interference. King Solomon would have been proud.

Second – and this is a big difference – most stock today is held by highly diversified investors through mutual funds, pension plans, and the like. Diversified investors prefer individual portfolio companies to maximize value (however that might be measured). But they do not want portfolio companies that try to coddle investors by reducing risk by managing earnings, diversifying through acquisitions, hedging, and other such gimmicks. Investor diversification deals with all that – and for free. So it is a waste of investor money for portfolio companies to do it too. The bottom line is that companies that stick to their knitting – focus on their core business – and do not try to second guess the market. See Stockholders, Stakeholders, and Bagholders (Or How Investor Diversification Affects Fiduciary Duty).

Google has shown itself to be more in tune with such thinking than most companies. A few months back one of the Google Guys announced that the company would make no effort to smooth out earnings. For an undiversified investor like the Dodge Boys, it could be a bumpy ride. But for a mutual fund investor it all evens out. Well diversified investors like those that invest through mutual funds should cheer.

By the way, managers who are willing to give the market what it really wants – a focused company that seeks to do what it does best – assume more risk than managers who seek to manage earnings. They should be compensated accordingly. Thus, it is really no surprise that CEO pay seems to have risen in recent years. I say seems because aggregate executive pay as a percent of earnings has been remarkably flat since 1980. But I do suspect that more of it goes to CEOs than before. See Executive Compensation, Corporate Governance, and the Partner-Manager.

The takeover wars of the 1980s were all about breaking up idiotic conglomerates and rationalizing capital structures. Stock prices went up. Folks figured out what the market wanted. CEOs began to insist on a piece of the (risky) action. Stock options became the norm.

I am sure that stock options can be and have been abused. And we should deal harshly with those who manipulate things in order to cash in at the expense of stockholders. But let's not lose sight of the fact that it is now quite routine for managers (and even major stockholders) to voluntarily break up their companies when it makes economic sense to do so, because the market likes focus. Is this a great country or what?

Thanks to Securities Litigation Watch for a heads up on this story.

A FURTHER NOTE ON KIRCHER (AND MUTUAL FUND LITIGATION IN GENERAL)

No one will be surprised if the Supreme Court affirms Kircher (thus permitting Judge Easterbrook's opinion to stand). The plaintiff fundholders will thus be left without a remedy, because as holders they have no cause of action under federal law. The losses they suffered in the value of their fund shares because of abusive trading at the fund level will become permanent. Note that this is not a case like a conventional securities fraud case in which the value of the fund shares would have fallen anyway when the truth came out. Here, the value fell because insiders were permitted to trade in fund shares. Innocent fund holders saw NAV fall bit by bit but only later found out why. In other words, the harm was real and not just a matter of a market correction.

The good news is that the plaintiffs may still have a cause of action (though it may now be barred by the statute of limitations).

First, they could sue derivatively on behalf of the fund. After all the fund was a party to the abusive trading in fund shares. So the fund clearly has standing under federal law. One problem is that the plaintiff must make a demand on the board of directors of the fund to sue the culprits. The board will likely refuse, but it is unclear that such a decision would be upheld even under the business judgment rule. Another problem is that in a derivative action the fund should ordinarily recover. That might lead to speculative trading in fund shares. (Outsiders might buy into the fund seeking a share of the recovery which would presumably be added to NAV at some point.) That could be avoided by individual recovery. But the courts are reluctant to order individual recovery.

Second, the plaintiffs could file a class action for equitable relief under FRCP 23(b)(2). Presumably, the reason they sued in state court in the first place was that they knew (or worried) that they could not maintain a class action in federal court because they were mere holders. But suppose they filed an action against the fund seeking to compel the fund to sue the culprits and to distribute the proceeds (if any) by issuing new shares to members of the class. (That would avoid the problem of speculation in fund shares by soaking up the recovery.) To be sure, this procedure looks a lot like a derivative action, but for the bit about issuing new shares to the class members. But so what?

For a fuller discussion, see How to Compensate Mutual Fund Investors for Late Trading and Market Timing.

TO HAVE AND TO HOLD (AND PERHAPS TO RECOVER DAMAGES)

To hold or to fold? That is the question. The stakes are high in two securities fraud cases pending in the Supreme Court. Both involve plaintiffs who suffered losses as a result of holding onto shares that later fell in value. Under federal securities law, a claim of fraud must be in connection with the purchase or sale of securities. So these plaintiffs sued under state law. But since 1998 federal law has also required that any class action based on allegations of fraud in connection with a purchase or sale must be litigated in federal court. (The worry was that plaintiffs had begun to sue in state court as a result of 1995 federal legislation designed to prevent abusive securities fraud class actions.) To be sure, there were a few fewer such cases filed last year: 176 compared to 213 in 2004. But as the Wall Street Journal recently opined, it is remarkable that plaintiff's lawyers could find that many cases to file in a time of such flat markets. The one factor that may account for such action in market for litigation is the Sarbanes Oxley Act, which coincidentally gives holders new grounds for griping.

In 1975, the Supreme Court handed down Blue Chip Stamps, holding that a prospective purchaser of stock who had been persuaded not to buy had no standing to sue for damages when the stock later increased dramatically in price. The case became a landmark, not only because it came to stand for the purchase or sale requirement, but also because it signaled the beginning of the Court's checkered campaign to limit the reach of federal securities law as a basis for private actions for damages. In 2002, the Court loosened up a bit but reaffirmed the rule in SEC v. Zandford, upholding an action against a broker who sold customer securities and then stole the money. 

The Supreme Court recently heard oral argument in Dabit v. Merrill Lynch, in which the Second Circuit held that a claim by investors who were fraudulently induced to hold shares could proceed under state law. (It will likely hear that argument again now that Justice Alito has joined the court.)

The Court has also agreed to hear an appeal in Kircher v. Putnam Funds, in which the Seventh Circuit dismissed an action by holders of mutual fund shares who claimed that the value of their shares was reduced by abusive trading schemes that fund managers should have blocked.

It is usually a good bet that the Court takes a case in order to reverse it. But Dabit and Kircher are more or less polar opposites. The better bet would seem to be that the Court is likely to retreat from the somewhat expansive holding in Zandford and to side with the Seventh Circuit in Kircher.

That would be unfortunate. In Kircher, mutual fund investors saw their shares decline in value because of abusive trading by others in fund shares.

Clearly the fraud was in connection with those trades. As in Zandford, the net effect was as if shares has been stolen from investor accounts. Still, the plaintiff investors did not themselves trade.

Dabit is a case based on fraudulent investment advice coming from a broker. The argument is that the plaintiff class was induced to hold when it would have sold.

Some might argue that holders are different from the non-purchasers in Blue Chip Stamps. After all, holders once bought. They put their money where their mouth was. As they say on Wall Street, every hold is a buy. And indeed Judge Motz of the federal district court in

Baltimore

so held in a case very like Kircher, noting that Blue Chip Stamps is a judicial rule of convenience for a judicially created cause of action.

But there are dangers lurking in recognizing the claims of holders. Dabit could easily have made his claim against a company that issued a falsely optimistic press release, suing the company for losses suffered by all non-trading holders. If successful, the company would presumably be ordered to compensate holders for their losses. But what good would that do? For every dollar a holder gets in damages the company would decline in value by a dollar. What's the point? And incidentally, if we had a system in which holders could sue for compensation, the market would presumably react by discounting the stock price of a target company stock by the amount of the likely award, which would increase the award, and lead to a further discount in the price until -- guess what -- the stock is worth zip. It is the financial equivalent of a black hole.

On the other hand, holders are the real losers in the typical securities fraud class action. Buyers (or sellers in some cases) can sue. But the company ultimately pays. It is holders who lose. Indeed, in the typical case involving negative news that causes the price of defendant company stock to fall, holders suffer a triple whammy. They lose because the price falls. They lose because the company pays the damages (which causes the price to fall even more). And they lose because the litigation costs the company a small fortune in attorney fees. (Ironically, buyers and sellers come out about even over time because they never need to give back their gains when they are on the winning side of a trade.)

It would seem only fair to let holders recover. But it is mathematically impossible to make them whole.

The answer is to junk the system that permits securities fraud class actions by aggrieved investors. Claims based on the notion that one bought or sold stock at the wrong price should be summarily dismissed. For diversified investors, such claims come out in the wash anyway. Their only net effect, other than to generate hefty attorney fees, is leave holders worse off. In other words, we can fix things for holders by eliminating securities fraud class actions by which holders end up footing the bill for traders. That would let the loss lie where it falls with those best able to bear it through diversification. And it would end the effective subsidy that the system provides for stock pickers who persist in trying to beat the house in a world of efficient markets.

The situation in Kircher is different. There the claim is not one based on having bought or sold or held stock because an investor was fooled about the price. Rather the claim is one of simple (or not so simple) theft by something similar to insider trading. Moreover, the plaintiffs can be made whole if the culprits simply disgorge their ill gotten gains back to the fund. It is not a matter of taking money out of one pocket and putting it in another.

To be sure, the claim in Dabit is also against a third party. It is not a conventional class action against an issuer. But it is difficult to see how the courts permit an action by holders against a broker and not an action directly against an issuer. This is not to suggest that Dabit somehow should have had a federal claim. Dabit's claim is under state law. But it is still a direct claim for damages -- not unjust enrichment. So it is difficult to imagine that if Dabit is upheld holders will not have a claim against issuers in future cases.

The Court would be right to reverse Dabit and nip this trend in the bud. That is not to say that holders are not entitled to truthful information. Indeed, shortly after SLUSA was enacted, the Delaware Supreme Court ruled that stockholders can sue when management knowingly spreads false information. But to do so they must show that the corporation was harmed. And recovery must go to the corporation. In other words, the claim must be one against directors, officers, or agents of the corporation -- not the corporation itself. In contrast, Dabit is a claim directly by investors who want compensation so they can live to trade another day.

There is another important difference between Dabit and Kircher. The plaintiffs in Kircher are mutual fund investors who presumably value diversification and conservative professional management and have eschewed a life of stock picking and active trading. Ironically, during oral argument, Dabit's lawyer disingenuously portrayed his clients as subscribing to the street wisdom of buy-and-hold. At least they happened to be holding when the music stopped in this case. The Kircher plaintiffs did the rational thing and got screwed. All they want is their money back. They should get it.

THE MYTH OF LIMITED LIABILITY

At first blush, limited liability for corporate shareholders appears to be an anomaly. The trend over the last few decades has been to hold businesses liable for an ever increasing array of harms, ranging from defective products, to pollution, to gender and race discrimination, and sexual harassment. In the argot of economists, an enterprise should internalize its externalities. If a business can avoid paying some of the costs it generates, it will be able to sell its product too cheaply, the business will be more profitable than it should be, and more of the resources of society (capital) will flow to the business than would do so if the product reflected its true cost including its social cost. Limited liability for the shareholders of corporations seems totally at odds with the idea of enterprise liability. It allows shareholders -- the owners of a corporation -- to walk away from a losing business leaving various creditors holding the proverbial bag.

On the other hand, limited liability has become even more readily available since the late 1980s with the advent of new entities such as the limited liability company (LLC) and the limited liability partnership (LLP) among others. Businesses that were traditionally required to operate as partnerships, including law firms and accounting firms, with partners exposed to unlimited personal liability for the wrongs of fellow partners, can now enjoy the benefits of limited liability. So how do we square this with enterprise liability?

The traditional argument for limited liability is that it is necessary to encourage investment. In other words, by protecting entrepreneurs and investors from excess losses, limited liability reduces risk and encourages investment. But there is something wrong with this argument. If we really mean it when we say that a business should bear its costs (assuming we know what they are), then each investment should be considered on its merits. Limited liability would seem to be a subsidy of sorts -- albeit a universal subsidy available to anyone who wants it in connection with starting a business.

The answer to this seeming paradox is that limited liability is not about reducing risk. It is all about deciding how much risk to take. There is a big difference.

Consider the plight of an entrepreneur (call him Ace) who wants to go into the trucking business. He has heard that with a corporation he can get limited liability. So he forms Ace Trucking Corporation. Ace (the individual) enters into an employment contract with ATC. When he tries to buy a truck in the name of the corporation, the dealer insists on a personal guaranty for the loan. Same for the lease on a garage and even to get a telephone installed. Then on his very first delivery, he falls asleep at the wheel and plows into a fruit stand. Ace is protected from liability in his capacity as a stockholder. But so what? He was driving the truck. Ace the individual is liable.

Despite this initial setback, ATC has prospered and grown. Ace now spends most of his time behind a desk, hiring and firing new drivers and supervising the office and maintenance staff. Ace might be tempted to hire the cheapest rookie drivers and staff he can find in order to maximize profits. But his entire personal fortune is tied up in the business, and one serious accident could wipe him out. He is not likely to get reckless in his middle age. Indeed, Ace knows that he cannot expect any employee to care as much about the business as he does. So Ace will think long and hard about whether the benefit from adding each new truck and driver to the fleet will outweigh the cost of inevitable accidents. Moreover, although Ace takes some personal comfort from limited liability, he knows he may still find himself exposed individually for negligent hiring or supervision.

Time passes. ATC thrives and eventually goes public. Perhaps this explains limited liability. Without it, no one would buy stock, because the prospect of loss suffering a loss without some practical ability to control risk would be unacceptable. Wrong. That may once have been so. But today, most investors are well diversified. They can easily absorb losses from one portfolio company, because there will always be others that do better than expected. If we did away with limited liability for publicly traded companies it would not likely affect the market at all. As it is, the bankruptcy of one big company ripples through the market reducing the value of other companies such as banks, insurers, suppliers, and customers that must foot the bill. Practically speaking, diversified investors have waived limited liability. (Ironically, some commentators have stressed an argument that limited liability permits investors to diversify by investing in many stocks. The truth is investors would be even quicker to diversify if they could be held liable for the excess debts of the corporations in which they invest.)

The point is that limited liability adds no new risk to the system. Rather it permits an entrepreneur to decide how much risk to take. Without limited liability, Ace would need to risk it all in order to go into business. With limited liability, it is up to Ace's potential creditors to seek protection. Some may choose to raise prices, while others may seek a personal guaranty. As for the victims of accidents, they are in no different position than if Ace were an unincorporated sole proprietor. Forgive us our debts. Maybe. Forgive us our trespasses. No way. In the absence of limited liability, creditors would not likely negotiate with entrepreneurs about limiting their liability. And they would probably jack up prices as well. In short, limited liability addresses a potentially serious market failure.

This is not to say that limited liability cannot be abused. But it is less likely to be abused in a very small one-person corporation than it is in a somewhat more established corporation. To mix a barnyard metaphor, the owners of a more established business may be tempted to milk it dry before contingent claims come home to roost. Or they may sell the assets without the liabilities. Such tactics are not likely to work in a start-up business that has no one to cheat. As for the established company that engages in such shenanigans, the law has many ways to right such wrongs.

For a fuller exposition, see Limited Liability and the Efficient Allocation of Resources, 89 Nw. L. Rev. 140 (1994).

THE REAL VICTIMS OF ENRON

Although plenty of folks lost plenty of money in the Enron debacle, the biggest victims may have been the employees whose retirement plans were invested heavily or solely in Enron stock.

As I have argued elsewhere, a broker who fails to recommend that a customer diversify violates the NASD suitability rule and his fiduciary duty (assuming that the customer relies on the broker). The Suitability Rule, Investor Diversification, and Using Spread to Measure Risk, 54 Bus. Law. 1599 (1999). The rule is the same for trustees under the common law. And the rule should be the same for employers. To be sure, ERISA expressly imposes a fiduciary duty on plan trustees and expressly requires that the trustee diversify "so as to minimize the risk of large losses unless ... it is clearly prudent not to do so." See ERISA §404. The trouble is it is never prudent not to do so.

On the other hand, if the plan is a profit-sharing plan or ESOP, diversification makes no more sense than compensating a CEO with shares in a mutual fund. But ERISA has exceptions for such plans. The real problem is that most employees do not understand the difference between a retirement plan and a profit-sharing plan. And ERISA more or less precludes the provision of investment advice, because of worries about conflicts of interest. If employees are going to be responsible for their own retirement, they need disinterested investment advice.

The shift away from traditional defined benefit plans is inevitable if US business is to be globally competitive. So it is not surprising that business has been pushing it. (What is surprising is that business has not been pushing for national health insurance. But that is for another post.)

But there is one another change that might change things. Under the corporation laws of most (if not all states), shares reacquired by a corporation (treasury shares) lose their vote. In the absence of such a rule, the board of directors would get to vote treasury shares, and they could easily insulate the corporation from takeover by buying back a majority of shares.

There is a huge exception to this rule. Shares held in a fiduciary capacity retain their votes. See DGCL 160(c); MBCA 7.21(c). So the board (or whomever the board appoints to serve as trustee) can vote the shares. How many companies do you suppose would load up their retirement plans with their own shares but for the fact that it augments takeover defenses?

The problem is that I cannot imagine any state being so bold as to be the first to make this change. The race to the bottom is one thing, but jumping off a cliff is quite another. One hope is that the framers of the MBCA might rethink this provision and catalyze change at least in those states that tend to follow suit.

WHY IS INSIDER TRADING ILLEGAL?

A recent item in the The Ethicist (New York Times Sunday Magazine, 1/22/06) resulted in a flurry of postings about why insider trading is wrong. See, e.g., Thom Lambert, Correcting “The Ethicist” on Insider Trading.

It has never been entirely clear why insider trading is illegal. The insider does not cause the outsider to trade at just the wrong time. The insider simply takes advantage of the fact that an outsider is always there to take the other side of the trade.

So the courts have resorted to theories based on the duty owed by the insider either to the corporation and its stockholders or to the source of the information not to use the information for personal gain. The problem is that if the corporation or the source gives permission to use the information, there would seem to be no reason for insider trading to be illegal. Yet no one has been so bold as to test the theory.

One might also argue under the fraud on the market theory that outsiders rely on the accuracy of the market. But that argument proves too much. It suggests that outsiders should be able to recover whenever insiders fail to correct the market.

There is another possibility. Most investors are well diversified. They do not care whether the market price is somewhat high or somewhat low when they trade as long as insiders do not use the opportunity to trade. As far as a diversified investor is concerned, you win some, and you lose some, but only the average matters. If insiders can trade at will when they know the price is wrong, the math no longer works, and there is no safety in numbers for outsiders.

So here is the theory: Insider trading is illegal because publicly traded companies and their directors, officers, and agents have effectively made a deal with outsiders (the market) not to take advantage of the situation when they know prices are wrong. Why? Because the most important reason for being a publicly traded company is not that you once raised a pile of money from an IPO, but rather that you might want to go back to the market for more, or pay your help with options, or just cash out some day. To sort of paraphrase Ed Koch and Ryan O'Neal: When you are publicly traded you never need to ask how you are doing.

THERE IS NO ACCOUNTING FOR STOCK OPTIONS

If ever there was a bad idea that would not die it is that the grant of stock options should be treated as an expense for accounting purposes. After more than a decade of trying, the FASB succeeded in imposing such a rule by adopting SFAS 123R in 2005, though the rule is still in the process of phase-in and there are many questions about what it requires.

The reformers’ seemingly simple argument is that options are a substitute for cash compensation. But an option may just as easily be viewed as a deal in which an employee works in part for a share of the profits or a partnership in the business. Is that an expense? Hardly.

This is not to say that an option has no value at the time of grant. But the value lies in the possibility that the price of the underlying stock will rise. Even the almighty Internal Revenue Code agrees that the recipient of options has income only when the option is exercised. And no income means no expense. On the other hand, the value of an option can now be calculated with relative precision. The rub is that one of the variables that must be considered is the volatility of the underlying stock. Curiously, options on riskier stocks are more valuable than options on safer stocks, because riskier stocks are more volatile and more likely to jump to the exercise price at some point. Thus, other things being equal, it costs more for a growth company to use options as compensation than it does for an established company to do so.

For example, on March 30, 2005 Intel closed at $27.43, and an option to buy Intel at $30 in January 2006 closed at $2.25 per share, for an aggregate premium of $4.82 per share over the current share price. On the same day, McDonald’s closed at $28.66, and a January 2006 option to buy McDonald’s at $30 closed at $1.85 per share, for an aggregate premium of $3.19 per share. In other words, the Intel option was worth about 50 percent more than the McDonald’s option even though the Intel option was farther out of the money. Why? Because Intel is riskier than McDonald’s. If the two were to make identical option grants, Intel would be required under the proposed rule to book an expense of $1.51 for every dollar booked by McDonald’s. To add insult to injury, options are more important for growth companies that need to conserve cash and whose employees seem to prefer working for a piece of the action. In short, expensing will affect growth companies disproportionately, not only because each option is more valuable, but also because growth companies tend to grant more options.

One of the goals of accounting should be to facilitate comparisons between companies. Treating the grant of options as an expense will do just the opposite. In order to compare the performance of Intel and McDonald’s, an investor will need to adjust for the fact that Intel’s earnings are disproportionately reduced by the recognition of more expense per option granted. Moreover, expensing will lead to a string of bizarre adjustments likely to confuse things. Currently, earnings per share are reported on a fully diluted basis -- as if all outstanding matured options have been exercised. Effectively, options are already treated as an expense because they reduce per share earnings. If we expense them at the time of grant, per share earnings will need to be reported on the basis of actual shares outstanding. And that in turn will mean that investors must fend for themselves to figure out the potential dilution if outstanding options are exercised.

In fairness, one could recognize option expense at the time of exercise and in an amount equal to the simple difference between market price and exercise price (as the tax man does). That would avoid the disproportionate impact of valuation methods and would reflect actual dilution as it happens. But that is not the proposal. And in fairness, recognition of expense at the time of exercise would give option holders a new way to manage earnings. The solution is not accounting rules but rather disclosure (of which there is plenty already). There is no reason to think that the market cannot understand and adjust for the (potential) dilution that comes with the grant of options.

In the end, it might not matter whether a company treats the grant of options as an expense. Studies show that a company’s choice of accounting convention makes no difference as to stock price. As it is, analysts can translate earnings into cash flow, while CFOs can explain away the aberrant effects of accounting rules by calculating pro forma earnings. But does it really make sense to invent yet another way by which the numbers diverge? Moreover, it will be exceedingly difficult to unwind the effects of expensing options. First, expensing options may change management behavior by eliminating the incentive to distribute cash through repurchases. Second, option pricing models are based on an options market composed of diversified investors who can use options for hedging. For the CEO who gets paid in options, they are an all-or-nothing proposition. If your stock goes up, you win. If it goes down, you get squat. It follows that options are worth a whole lot less as compensation than they are as market instruments.

Indeed, management compensation has been declining as a percentage of income as options have become the primary form of compensation. In 1985 officer compensation was more than 70 percent of corporate taxable income in the aggregate, whereas during the five years up to 2000 it averaged about 40 percent of taxable income. Thus, the perception that management compensation is out of control is mostly about the redistribution of pay from losers to winners.

Aside from the difficulties inherent in expensing options, it is not clear that options do have a cost. An option will be exercised only if the value of the underlying stock increases. Who is to say that the rising stock price is not the result of the added incentive created by stock options? Do options have a cost if shareholders also enjoy a gain as a result? Moreover, an option that expires unexercised presumably costs the company nothing even though it would have been booked as an expense under the new order. Will the company recognize income if its stock price remains flat and options are never exercised?

Some say that the problem with options as compensation is not accounting rules as much as options themselves. The argument is that because options are risky too many options must be granted to substitute for cash compensation. But that is the nub of the matter. Options require managers to assume more risk. The trade-off is the prospect of more return. Stockholders, on the other hand, can diversify and avoid company-specific risk. A diversified investor knows that you win some and you lose some but only the average matters.

During the 1950s and 1960s managers sought to smooth out earnings by diversifying at the company level through conglomerate mergers. With the ascendance of mutual funds in the 1970s, stockholders found a cheaper way to diversify. The proof is in the pudding. The market places a lower value on diversified conglomerate companies than it does on more focused companies. Hence the junk-bond-financed bust-up takeovers of the 1980s. Bidders discovered that they were able to sell the pieces of conglomerates for more than the price of the whole, because investors prefer focused and leveraged companies.

Managers learned the lessons of the 1980s well, and stock options became the primary form of compensation -- to the tune of 90 percent of pay. Stock options focus management attention where it belongs -- on increasing the value of the company rather than on second-best indicators like earnings or sales (or oil reserves). It is difficult to believe that so many companies in the 1990s would have been so quick to spin off underperforming divisions if management had not been induced to maximize share price by taking most of its compensation in the form of options.

In addition, options induce granting companies to buy back stock to avoid dilution. The critics cite such maneuvers as part of the problem. Does anyone else perceive a contradiction here? One of the factors that led to the takeovers of the 1980s was the reluctance of management to distribute available cash. Options are a powerful incentive to share the wealth.

Still, it has been suggested that payment in stock would make more sense because it would give management the same kind of stake as an investor. Wrong. Aside from the fact that managers cannot diversify, with an outright grant of stock, management assumes the risk that stock price will fall and not simply fail to increase. With stock, management will have some interest in undertaking conservative strategies designed to maintain stock price. On the other hand, in a bear market, creating incentives to maintain stock price may sound like a pretty good idea. Then again, if one is interested primarily in safety of principal or a reliable return, there is always the bond market. It makes no sense to invest in stock unless one seeks a higher return. So it makes no sense to create incentives for management to pursue a conservative strategy. Again, investor diversification is key. A diversified investor prefers that each individual company maximize return even if it means that a few may go bust. If one is adequately diversified, the winners will usually outperform the losers by more than enough to generate a superior return. But few CEOs would bet the farm on a promising new line of business if it were not for stock options and plenty of them.

In the 1930s, academics decried the separation of ownership from control and the rise of a managerial class with little or nothing invested in the business. Now it seems the complaint is just the opposite. The classical view of the corporation is a business owned by the shareholders with management serving at their pleasure and paid primarily by salary and bonus. But it may be more accurate to think of a corporation as a partnership between management and investors. Only a Luddite would, suggest that we should seek to discourage the use of options in favor of basing compensation on some manipulable number like earnings, particularly when earnings management seems to be a real problem. Indeed, because stock options ultimately depend on the stock market, which is exceedingly difficult to manipulate, they are essentially self-regulating. No rational CEO would want so many options that it would reduce stock price.

The ultimate question is which view best comports with what shareholders want. Do they want managers who see themselves as employees? Or do they want managers who act like partners working for piece of the action? This is not a rhetorical question. The answer may differ company to company. But we should not use accounting rules to stack the deck in favor of one model or the other.

WHY REASONABLE INVESTORS MUST DIVERSIFY

Rational investors diversify. Through diversification an investor can eliminate the risk that goes with investing in a single stock without any sacrifice of expected return. Studies indicate that one can eliminate more than 99% of company-specific risk with a portfolio of as few as twenty stocks. And with 200 to 300 stocks all company-specific risk is gone. The only risk that remains is market risk -- the risk that the market as a whole will rise or fall.

Moreover, investors have no real choice but to diversify. The fact that company-specific risk can be avoided means that the market sets the price of individual securities as if no such risk exists. To see why, suppose that market prices did reflect company-specific risk. Portfolio investors would buy up securities -- which would be underpriced from their point of view -- and hold them in portfolios that eliminate company-specific risk. The price of stocks would rise and eliminate any return attributable to company-specific risk. Undiversified investors would then be forced to pay higher prices for individual stocks even though the return remained the same. In other words, an investor who buys a single stock as a stand-alone investment takes more risk than is necessary to achieve the expected return from that single stock. Such behavior in an investor who is able to diversify is irrational by definition, because the fundamental goal of investing is to generate the greatest possible return at the lowest possible risk.

            Finally, it is virtually costless to diversify. Although it might at first seem as if only the very wealthy can afford to hold as many as 200 or 300 stocks, complete diversification is available very cheaply through mutual funds for investors with as little as $1000 to invest. In short, it is so cheap and easy for investors to diversify that it is simply unnecessary for investors to take company-specific risk. There is no downside to diversification. Accordingly, a rational investor must diversify. By the same token, it is fair to say that it is irrational for an investor who can do so not to diversify.

CONTROL PREMIUMS & STOCKHOLDER DIVERSIFICATION

As I argue in Market Prices & Imbedded Discounts the price of a stock as set in an active market should usually be higher than the price set by a willing seller and a willing buyer in a one-on-one negotiation. Most stock is held by diversified investors who avoid company-specific risk. Thus, stock prices reflect the value of stocks as part of a portfolio and as if there is no company-specific risk involved. Less risk means higher price. The bottom line is that in most cases market prices are higher than they would be if they were set by well informed buyers and sellers of whole companies. In other words, the notion that market prices are inherently low is a total myth.

This analysis implies that when a bidder makes an offer for a target company at a premium over the market price, the real premium from the point of view of the bidder is bigger than it would appear to be in comparison to market price. In other words, the market acts as a natural barrier to takeovers motivated by marginal gains. The fact that bidders must clear this hurdle in order to make a bid, suggests that target managers should bear a significant burden in justifying takeover defenses (which generally they do).

It is also possible that bidders find targets by looking for companies that trade at a discount to the price that CAPM indicates should be the price. Indeed, I am sure that they do. But if the premium offered is nothing more than the difference between a market price that is depressed for some reason and the price calculated under CAPM, then really the premium is no premium at all. I am not aware of any studies that have sought to determine the extent to which takeovers are prompted by discounts rather than offering true premiums. It is also possible that many takeovers involve mixed motives, that is, exploitation of a discount combined with some amount of premium.

If it turns out that most takeovers (or even a significant number of them) are motivated by discounts, then the idea that a court in an appraisal proceeding should tack on a premium is nonsense.

To put it bluntly, if bidders use CAPM to find undervalued targets, and then bid up to the CAPM price, it makes no sense for a court to add on another premium.