Statins, cholesterol, health; fancy employee compensation, EBITDA, and company value
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Have public company Boards learned any lesson from Enron? A March 31, 2008 article [sadly not online] about Stan O’Neal, the former CEO of Merrill Lynch, suggests not.
The Board at Merrill Lynch Enronized their company by promising to pay Stan O’Neal roughly $50 million per year if he made some numbers look good. One of the numbers that they wanted to see improved was Return on Equity. O’Neal managed to improve it by using the company’s cash to buy back stock. By reducing the amount of equity in the firm, whatever profit they managed to earn in a given year would be a larger percentage of the remaining equity. Unfortunately, for a company that faces risk, reducing the cash supply inevitably means courting disaster.
The Board also decided to give bonuses to executives based on where Merrill ranked in the business of creating mortgage-backed securities. O’Neal and colleagues managed to grab the number-one spot by 2005, near the tail-end of the real estate bubble. Merrill would buy up garbage mortgages from retail banks, mortgages that by 2005 hardly anyone else wanted. These were loans on houses that had never been independently appraised to homeowners who had never proved that they had any source of income. Merrill’s goal was to package up this junk and sell it to fools in the institutional investment community. This worked great for a while and Merrill pocketed a lot of fees. By 2006, however, the supply of fools to buy up baskets of junk mortgages was dwindling. Merrill could have simply stopped buying the mortgages, but that would have resulted in a loss of fees and a reduction in executive salaries. O’Neal, who had been the Chief Financial Officer of Merrill, and his subordinates decided to continue buying the junk mortgages and wrapping them up into CDOs but, because nobody out there was dumb enough to buy the CDOs, keep the CDOs for themselves and account for them at the value that they wished they could have sold them for. Merrill ended up with $32 billion in nearly worthless debt. O’Neal retired with the savings from his $50 million per year salary plus a lot of bonuses and retirement extras.
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So… if you’re on a Board and you decide to compensate a manager with anything other than cash or a long-term stock option, make sure that you’re not granting compensation based on a number that the manager can easily manipulate. Keep in mind that managers are often a lot more clever in doing things that will benefit themselves than things that will benefit the company.