The most recent edition of Knowledge@Wharton, one of that famed business school’s prime organs of knowledge dissemination, has an interesting summary of recent research on another way shareholders lose out to managers. The article is entitled “Managerial Myopia: How CEOs Pump Up Earnings for Their Own Gain.” The reported research shows vivid examples of how managers whose options are close to vesting may pump up short run earnings by cutting expenses, even when new investment might be the better long term strategy for the firm. The authors (Professors Edmans, Fang and Lewellen) show”how an approaching vesting of stock options can cause a CEO to pump up the firms earnings, and thus its stock price, by cutting investment in research and development, advertising and capital expenditures. Assuming those would have been beneficial investments, the approaching vesting puts the CEOs interests at odds with the firms.” This shouldn’t surprise readers ofDisorganized Crimesbecause it is just another way for shareholders to lose out while supine Boards ignore the interests of the shareholders they are to defend.
One remedy to this ‘pump and dump’ sequence would be to make the options strike price an average of several years earnings and allow only partial vesting over a future series of years. That would dampen “one time effects.” Arguably, such a practice could also lead the managers themselves to more thoughtful promotions of younger managers since these option grantees would be leaving the value of their options in the hands of their ultimate successors.
“Short Termism” by managers is well known. The antidote are boards truly dedicated to promoting shareholder returns. That illustrates the point we have often made that the conflict of interest between directors and shareholders needs to be addressed, both by legal sanctions against derelict directors who are too often captured by the very managers that appointed them and by incenting true risk management supervision by boards. “Capture” always looms large when shareholder interests are ignored.