There Have to Be Some Sticks, Too

“What you have to change in Wall Street is you have to make sure that in addition to carrots, there are sticks. And it can’t be a one‑way street where they are making ungodly amounts of money when things are good and then they move on to someplace else for a while when things are bad. You have to create a downside. I hope there are some practices put into place – and I’ll have a few thoughts on them myself – but Congress undoubtedly will have a few thoughts too. You have to put in something where there is downside to people who really mess up large institutions and we need some new help in that. Too many people have walked away from the troubles they have created for society, not just for their own institution, and they have walked away rich. They may not be as rich as they were before, but they have walked away better than they should have. There have to be incentives – not only to get rich, but to behave well.” – Warren Buffett (in the interview above)

If you’re able to watch the video, please disregard all the promotion for PYMNTS.com. I don’t know anything about the company and I’m not trying to endorse them, here. This is just the only context that I could find this video in. Also ignore the interviewer reading the questions off of an 8×11 piece of paper;)

I personally think the government should stay out of the executive compensation question as much as they’re able to. For them to be able to do that, though, the companies need to step in and examine the incentives they’re creating.

Stock options, for example, often create the wrong incentives. Because they expire at some predetermined date in the future, executives have an incentive to try to drive the stock to the highest possible price in the shortest amount of time. This incentive isn’t in line with the interests of the long term shareholder, which is to increase value – but with sustainability over time. Executive incentives are geared toward the short term.

Studies have shown that companies whose management has an ownership interest tends to be a better investment than companies in which ownership has little interest. Stock options are poor on this front as well, because stock options are rarely used as part of a buy and hold strategy. Instead, the stock options are almost always exercised and sold all at once. Executives take profits while shareholders remain fully invested in the fate of the company. It doesn’t seem right does it?

“Too many people have walked away from the troubles they have created for society, not just for their own institution, and they have walked away rich.”

A couple of quick examples (there are far too many to choose from): Ken Lewis, a key destroyer of shareholder value in this whole deal (see the Merrill Lynch deal), recently “retired,” and walked away with a retirement package of over $100 million.

Or how about the people at Long Term Capital Management, the people behind the hedge fund who almost crashed the entire market before this meltdown happened. They almost crashed the entire market (I highly recommend Roger Lowenstein’s book on the topic). Then they liquidated their fund, walked away, and promptly set up another one with many of the same principals and a fresh $250 million in funding (though rumor has it that the newer fund, JWM, is on the way down as well, though not as dramatically).

Re-aligning incentives needs to be a top priority of management in this country, especially on Wall Street. Shareholders need to assert their voices when there’s an opportunity. That’s a problem, too, though, because the largest shareholders tend to be institutions (such as pension funds and endowments), led by Wall Street alumni. They aren’t exactly the people most likely to stand up and call out their buddies for making too much money under the current system.

The small, individual shareholder remains at almost an insurmountable disadvantage in this regard. There’s very little incentive to try to make your voice heard as a shareholder, too, because there’s an easier way to show your disdain for management than a proxy fight – simply sell your stock and move on to your next project. It’s a quick way to wash your hands of a situation, but it’s not going to inspire a lot of change.

Sorry if I sound like a bit of a downer. The good news is that Buffett is still the smartest guy in the room, and, as usual, he’s optimistic about the future. I’ll try to be the same. He does make an odd comment about black and white TVs, but we’ll forgive him that in exchange for the benefit of all his folksy wisdom;) Thanks for reading.