Alan Reynolds

The Securities and Exchange Commission (SEC) wants to require shareholder approval of employee compensation plans that involve stock options or stock. That label of "shareholder approval" sounds so democratic, and the ritualistic vilification of stock options sounds so banal, who could possibly object?

But what is "shareholder approval" really likely to mean? Like many small investors, I own so few shares of any one stock that I never vote on proxy statements that flood my mailbox. Individual investors, like consumers, are too diverse and dispersed to be organized into an effective interest group.

Besides, most shares are under the control of institutions. In the real world, "shareholder approval" is designed to enhance the already awesome power of a few managers of other peoples' money -- bosses of the biggest pension funds, mutual funds, hedge funds and foundations.

This is developing into an unhealthy contest between two "agency problems." One such problem is that corporate executives are hired agents of a company's principals (stockholders). The personal interests of these agents (executives) can be quite different from the interests of corporate owners. If executives are paid like bureaucrats, they will tend to make life easy for themselves by delegating tasks to a costly army of subordinates and outside advisers, while carefully avoiding making risky changes.

The reason for making a large share of executive pay depend on options or stock has been to induce executives to behave in the stockholders' interest by holding-down expenses, working hard and taking appropriate chances on new opportunities. As Brian Hall of the Harvard Business School remarked, "Options are the best compensation mechanism we have for getting managers to act in ways that ensure the long-term success of the companies and the well-being of their workers and stockholders."

Managers of pension funds and mutual funds, however, raise a quite different agency problem. They, too, are agents rather than stockholders, and their personal interests also differ from interests of stockholders. The number of managers of the largest funds is quite small, easy to organize for effective political action.

Pension funds of state governments and labor unions have been particularly effective in creating powerful lobbying organizations. By combining, they can make a big show of the huge sums of money they supposedly "represent." The press always falls for it.


Alan Reynolds

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