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The agency dilemma is an often studied issue in management classes. Basically, the dilemma states that an agent will do what is in their best interest more times than they will do what is in the best interests of the principal if the principal is not watching them like a hawk. In a stock market context, management are the agents of the shareholder principals and their job is to do what is in the best interest of shareholders.

This has failed again and again as management has gorged themselves on rich pay packages while the Board of Directors (the shareholders’ representatives) have been asleep at the wheel. Backdated stock options are another symptom of this broken system that rewards agents at the expense of the principal.

I’ve previously blogged on another large section of the principal-agent problem in response to a Ben Stein article. He’s back with another excellent article on how management has completely turned the buyout process on its head to enrich themselves at the expense of shareholders.

There is no better example than the current battle over Caremark RX. Caremark is the largest pharmaceutical benefits manager, which if you have prescriptions filled via mail you know what they are. It’s a big local story because the spurned suitor is one of the largest companies in St. Louis. Basically, Caremark’s CEO shopped his company to suitors that met two conditions. The first was that he would keep his job. The second is that the company would personally indemnify him from any suits due to backdated options that enriched Mr. Crawford, his son, and other executives to the tune of hundreds of millions of dollars.

CVS, the drugstore chain, who desperately wanted to get Caremark’s mail-in order business to help compete with Walgreens which started their own PBM. They agreed to Mr. Crawford’s conditions and set the price of the merger at $48.50/share. They also gave huge change of control agreements to most of Caremark’s executives so that if they lost their jobs in the merger they would be taken care of to the tune of tens of millions of dollars. Oh, and for negotiating the deal Mr. Crawford would receive $50 million.

Seems pretty sweet, huh? Well, if you are a Caremark executive it is. Shareholders got hosed in the deal. The price of $48.50/share was 21.6% below where the stock traded a month prior to the deal. It also banned Caremark from seeking higher offers and included a $650 million penalty if the deal did not go through.

Enter Express Scripts, who offered 25% more than CVS. The Caremark board refused to even listen to the offer. They cited the breakup fee and the fact that the deal was already done in refusing Express Scripts’ offer. What they didn’t cite was more telling. Express Scripts refused to include large payments to Caremark’s executives or offer golden parachutes. They refused to indemnify Mr. Crawford for the sins under his watch (which makes me wonder if this is the primary motive for the deal?). They made an offer that was better for the shareholders but worse for management. And management stuck its fingers in its ears and hummed.

The classic principal-agent dilemma personified. This is what happens when shareholders (and their “representatives”, the Board) are asleep at the wheel. Unfortunately, most large shareholders, the mutual fund companies, don’t want to upset the apple cart and go along with management as well so the individual shareholder is left out to dry.

Unfortunately, there is no real fix in the era of mega-global corporations. Congress has trotted out fixes but they won’t work. Giving massive equity to management didn’t work either and led directly to the stock option scandal. It seems that as smart people come out with ways to fix the current system, smart people on the other side come up with ways to exploit that system. Wall Street is (and always has been) a chummy atmosphere, which is why the Fidelitys of the world don’t want to upset the apple cart because it is their friends that they would be outing.

I don’t know what the solution is other than to have shareholders take back the companies from executives. But that ain’t gonna happen any time soon. And the Crawford’s of the world will continue to get their windfalls from the skins of the shareholders they are supposed to be representing.