I’ve seen some people argue that management’s incentives must be aligned with shareholders because insider ownership is high. I think that this is a dangerous idea. Insider ownership tends to be fairly high in fraudulent stocks and stocks with bad management teams. Scams and frauds involving the sale of shares at inflated prices often begin with the perpetrators owning almost all of the stock.
Fundamentally, there will always be conflicts of interest between management and shareholders in publicly-traded companies. The problem is that insiders own 100% of their personal bank accounts versus some smaller percentage of the publicly-traded company. The insiders will always have an incentive to transfer money from shareholders to themselves. Here are some methods:
- Excessive salaries and other forms of compensation (travel, entertainment, special defined benefit pension plans not available to rank and file employees, etc.).
- Related party transactions.
- Kickbacks.
- Run away with the money. This has happened with at least one Chinese reverse merger.
- Insider selling. Insiders may sell stock at inflated prices. Sometimes they do this secretly.
Shareholders should really be asking: is management honest? One way to answer this question is to look at whether or not management tried to avoid conflicts of interest. In particular, shareholders should ask these questions:
- Are there related party transactions? If so, are they fair?
- Has management tried to avoid unnecessary conflicts of interest? In practice, many related party transactions could have been avoided. They almost always reflect poorly on management.
- Does management own private companies that compete directly with the public company? Honest people would avoid creating such a situation.
- Has management tried to align their interest with shareholders?
- Has management tried to create a situation where their equity stake in the company is more important to them than their salary?
- Is management selling shares? Is their reason legitimate? (There are legitimate reasons for insider selling.)
On the other hand, honest and skilled managers with low insider ownership will still work hard at making money for shareholders. While incentives drive behaviour, the owners of that company will often impose an incentive structure that creates the right incentives. At almost all publicly-traded companies, compensation is linked to performance. Insider ownership often doesn’t matter as managers will often work hard without it. Conversely, there is no incentive structure that will solve the problem of unethical management. CEOs will always own more of their personal bank accounts than their equity stake in the public company.
When insider ownership correlates with good things
Insider ownership tends to be high if the founder is still running the company. In general, I believe that the founders of publicly-traded companies tend to be more skilled than the average CEO of publicly-traded companies. In the initial public offering process, there is some skewed selection that occurs. Poorly-managed retailers tend to stay extremely small- too small for an IPO to be worthwhile. This generally means that only well-managed retailers will be IPOed. For this and other reasons, it is possible that insider ownership correlates with management’s skill. Stocks with high insider ownership may outperform simply due to this correlation.
At the end of the day, looking at insider ownership is a distraction. Often what really matters is management’s skill and integrity.
Glenn Chan's Random Notes on Investing 
At almost all publicly-traded companies, compensation is linked to performance. Really? What evidence do you provide? How are free options provided to management an incentive similar to investors placing their own capital at risk?
Too much insider ownership may cause abuse of minority shareholders. However your article makes lots assertions with no evidence, facts or examples to back it up.
You can do better.
Stock options generally aren’t “free”. The CEO actually has to work at the company to receive compensation. If the CEO works hard and creates value, then in theory the stock price should go up and therefore the stock options will go up in value. In that sense, the CEO’s compensation is linked to performance. Many companies also have bonus incentive plans tied to performance metrics, restricted stock grants, etc. etc. Certainly if management is paid in options then their incentives aren’t perfectly aligned with investors. But there aren’t too many incentive structures where management’s incentives are perfectly aligned with shareholders.
Regarding examples… you’re right in that I did not provide many examples. One problem is that it’s so easy to cherry pick examples that support either side of a thesis. For example, in the QXM/XING fraud insider ownership increased dramatically before the CEO ran off with the cash and the business. To really prove something takes a lot of work and would make a post really long. I didn’t feel that the concept of insider ownership being irrelevant merited a long post. Because I’ve looked at many frauds, it is obvious to me that many frauds have very high levels of insider ownership. I suppose that’s not obvious to other people. But I don’t plan on devoting too many words to less important subjects. And to me, it’s pretty obvious that looking at related party transactions is far more important than looking at insider ownership.
In general: I don’t see value in getting bogged down by unimportant details.
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Hey Glenn, thanks for the article. How do you go about detecting related party transactions? You view on the effects of stock options on aligning incentives seems a little mixed. Would you distinguish a ‘good’ and ‘bad’ way of arranging executive stock options? E.g. amount of rights (as a percentage of outstanding shares?), level of the strike price, expiration time, etc?
The proxy and 10-K and annual reports will have sections on rel. party transactions.
Stock options are mostly like getting paid in stock. Of course, insiders can sell their shares.
In general, shareholders would prefer that the CEO gets paid very little money and has lots of shares (skin in the game). Obviously CEOs like money and some of them deserve to get paid proportionate to performance, which can result in a large paycheque.