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The option of folly is always in demand:

The Worldcom scandal and share options

by Simon Longstaff

If, as it seems likely, WorldCom has been felled by a massive act of fraud, then we need to ask why. My hope is that, in casting around for someone to blame, we will recognise the contribution made by our own folly – especially in relation to the wisdom of using share options to remunerate corporate executives and board members.

Those not familiar with the anatomy of 'folly' should take a moment to consult The March of Folly, a wonderfully insightful book by the late, American historian, Barbara Tuchman.

Tuchman examines a series of episodes in history where 'folly' has reigned supreme. Examples include: the decision by the Trojans to admit the Greek horse within their walls, the actions of the Roman Catholic Church that gave rise to the reformation, decisions by the British leading to the loss of their American colonies.

In each case, Tuchman demonstrates that those in authority were clearly warned of the risks that they took. They were also presented with viable alternatives that would have better protected their interests. Yet, in each case, the decision was taken to act in a manner that led to disaster. Why? Tuchman's best explanation is that human beings have an unremitting tendency to engage in acts of pure, unadulterated folly.

So, how does the decision to remunerate people with share options rate as an act of folly? The first thing to note is that the idea of using options had a seemingly plausible argument at its core. Its proponents argued from the simple proposition that it would be a 'good thing' if employees had their interests aligned with those of shareholders. The simplest way to do this, it was argued, was to use the 'promise' of options to focus employee behaviour on the simple goal of increasing the company's share price.

The reason for structuring remuneration in this way is telling. Put simply, the proponents of options proceed from the assumption that human beings are, first and foremost, self-interested and that a measure of human greed will act to align the interests of option holders and shareholders. Those who bought the idea of options also bought this basic assumption – and in doing so, helped to create the conditions for Enron, WorldCom and I suspect, a host of dodgy dealings that are yet to be revealed.

The self-evident problem with the basic assumption is that if it is correct, then it has an equal capacity to lead option holders to conclude that instead of aligning their interests with those of shareholders, the converse should apply – and shareholders' interests should be aligned with option holders.

This is, in fact, what seems to have happened in a number of cases. Option holders (including executive board members) have contrived financial results in order to be 'in the money' – and have done so in a fashion that has left shareholders to pay the ultimate price. That this should have happened is now lamented. But it should not come as a surprise. Plenty of people were raising 'red flags' in warning a decade ago.

Countless great companies have been founded and built without the use of share options for remuneration. This was done by people who worked diligently and productively for their companies because it was their duty to do so. Surely this approach has something to commend it – people can be trusted to do their best without being 'bribed' to do so.

There is little mystery in the motives of analysts who offered dodgy recommendations to their clients in order to inflate the tech bubble. There is little mystery in the motives of company executives who fiddled the books to inflate their remuneration. There is little mystery in the motives of auditors who turned a blind eye to the corruption of the basic assumptions of the accounting profession.

Why did we (and do we) ignore our instincts about such matters? That we do so is neither a product of reason nor of experience. Rather, we see (once again) the perilous effects of unthinking custom and practice and the habits of the herd. In short, we seem unable to resist the temptation to lapse into acts of folly.

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