Statins, cholesterol, health; fancy employee compensation, EBITDA, and company value

It is the year 2000. A fat sedentary guy eats steak and bacon three meals per day. His cholesterol is high. A doctor prescribes a statin. Now he is a fat sedentary steak-eating guy with a low cholesterol lab result. Is he as healthy as a thin active guy who eats mostly vegetables?

Fast forward to 2008. We have discovered that statins have some side effects and that fat sedentary steak-eating guys with low cholesterol scores drop dead at about the same rate as fat sedentary steak-eating guys with high cholesterol scores.

What’s the equivalent situation in the corporate world? The true health of a company is measured by its long-run stock price. That is tough to manipulate and reflects what investors are willing to pay for the enterprise, taking into account all risks, all news, and any deferred expenses. At Enron, following the advice of the best minds of McKinsey, employees were compensated for book profit, as certified by Arthur Andersen, and EBITDA (earnings before income tax, debt, and amortization). The result was a company with tremendous reported profits, strong EBITDA, and an ultimate market value of less than zero. Conspiracy of Fools chronicles one of the discussions about EBITDA among Enron senior managers. One guy pointed out to Rebecca Mark, a Harvard Business School graduate star of the company, that EBITDA was meaningless because one could improve EBITDA simply by borrowing money at 10 percent and investing it in T-Bills at 5 percent and that was essentially what Mark was doing. She was borrowing money at X% to purchase businesses that would return no more than (X-4)% in a best-case scenario. This fattened her paycheck, but led the company towards bankruptcy. Another McKinsey idea was to set up a bonus as a percentage of profits; the employees went to the Clinton administration’s SEC and got permission to account for 20 years of future profits in the year that a gas contract was signed. This resulted in a 20X pay increase for employees in that division, but resulted in the company having no profits to report in future years, even if they continued to make cash profits on those gas contracts. The prospect of going to Wall Street and saying “we’ve already recorded all of our profit for the next 20 years” was so grim that the senior executives resorted to accounting fraud instead.

Enron worked out very badly for investors and average employees, but it was a great place to be a senior manager, some of whom are now among the wealthiest Americans (e.g., Lou Pi walked away with $250 million and become the second largest landowner in Colorado).

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.

Oftentimes the debacle on Wall Street is painted as too complex even for the executives involved to understand.  Merrill’s near collapse was easy to understand, though.  They bought mortgages that nobody else wanted and repackaged them into securities that they couldn’t sell.  They had a couple of huge warning flags.  AIG stopped insuring these securities against default in 2005; when one of the world’s largest insurance companies says that these things are too risky for it to insure at any price, you’d think that anyone holding $32 billion of such items would take notice.  The fact that the securities couldn’t be sold and were clogging up their balance sheet should also have been a warning sign for any executive with a pulse.  The likely fact is that these were warning signs of doom for Merrill’s shareholders, not for executive bonuses, which were computed regardless of the risk that Merrill was taking or the collapse in overall firm value.

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.


  1. Mark

    April 22, 2008 @ 2:15 am


    The book “The Smartest Guys In The Room” is an excellent account of the Enron disaster written by two reporters from Fortune whose investigative sleuthing was part of Enron’s undoing.

  2. JB

    April 22, 2008 @ 6:04 pm


    If you’ve enjoyed this weblog post, you may enjoy this recording of a lecture given by Charlie Munger on the nature of incentives, and our continued failure to recognize the power of them to shape behavior.

    Also, if you haven’t already read it, Malcom Gladwell wrote an article for the New Yorker about how different these sorts of cases of financial malfeasance are compared to those that we are familiar with. I think Gladwell would take the tack that a lot of these situations *are* extremely complicated and difficult to evaluate, but he also writes about the fact that at the end of the day, the information needed to realize that e.g. Merrill is not behaving in a fiscally responsible manner is publically available. He also makes the point on his blog that complicated or not, a lot of the analysis that broke the Enron story was done by Wall Street Journal reporters, so its not as if we’re talking about figuring out whether or not M-Theory is a fraud (no offense intended WSJ reporters).

    As absurd as I think it is that anyone with half a brain ever believed the AAA ratings on these securities, I sometimes wonder if perhaps we aren’t already in an overreaction situation. Like, could the same mark-to-market accounting rules that let people like Merrill keep these things on the books at absurdly high values also be forcing them to be marked unrealisitically low now? Obviously, there is no buying side for these securities. The fair market price of someone trying to unload a bunch of these types of deals right this second is de minimus, as I understand it. Also, lets assume the junior tranches are all wiped out. Looking at the senior tranches, how are they set up internally? Do the underlying mortgages get delivered to the CDO holder? It seems extremely unlikely that every single borrower will default, and every single house/motorcyle/credit-card-receivable will have zero value after going through the foreclosure, factoring, or workout process.

    I’m not bringing this up cause I like to talk about investment opportunities that are not open to me on other people’s weblogs. I bring it up because is it possible that regulatory controls such as MTM accounting may have an unnecessarily deleterious effect on the real economy? I’m a big bank, I have to mark all my senior CDO tranches to zero since I can’t sell them, but there *are* future cashflows that are due to me even under the most horrific conditions, and they have some net present value, but I can’t recognize it. Consequently, capital constraints force me to sell of other securities, reducing liquidity throughout the system and continuing the vicious cycle. It seems like for a lot of securities, standards intended to promote fair and orderly function of the markets (MTM accounting, for instance) may actually have quite the opposite effect in times of extreme stress. By forcing all “quotational” losses to be recognized don’t we risk accelerating the loss of credit substantially? At some point this becomes systemic and effects the real economy, no?

  3. Matthew Brown

    April 22, 2008 @ 6:06 pm


    The same applies to any compensation or reward scheme tied to a metric, at all employment levels. Employees will efficiently do whatever rewards them the most, if they consider the rewards worthwhile.

    A common flaw is to tie compensation or employee assessment to some metric that seemed to correspond to real increased productivity and profit WHEN EMPLOYEES WERE NOT MOTIVATED TO MANIPULATE THE METRIC. Programmers being paid for line-count is a simple instance.

  4. Neil

    April 22, 2008 @ 7:45 pm


    “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.”

    And in doing so, you should add, become criminals that should be prosecuted with the same determination and severity as robbery, theft and the like is. Those leaving companies in shambles with huge joblosses and such payout packages should go to jail , and not stand a chance to become Colorado’s 2nd largest landowner.

    So if you are a member of the board and decide on compensation of managers also consider their legal prosecution…..

  5. K

    April 23, 2008 @ 8:04 am


    I Matthew Brown has a good point, however I disagree somewhat with the “at all levels of employment.” CEO’s have a wide scope of authority, and therefore flexibility to game the system than ordinary employees.

    Another issue is that an employees’ manipulation will be quickly noted by a manager:
    “The good news is that you mowed twice as many lawns as our average worker. The bad news is that our complaint rate is usually 3%, but 95% of your customers called to complain. We think the other 5% are probably traveling, so you’re fired.”

  6. PDJ

    July 29, 2008 @ 1:56 pm


    EBITDA means Earnings Before Interest, Taxes, Depreciation and Amortization (not “Earnings Before INCOME TAX, Depreciation and Amortization”} Interest is excluded from the calculation, which is why Rebecca Mark’s borrowing seemed profitable.

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