Executive Privilege?

The Stock Option

Ten years ago, Harvard University professor Michael Jensen co-authored an influential study that concluded that the pay of top executives was unrelated to the performance of their companies' stock. Jensen studied the period 1974 through 1988, during much of which stock prices, adjusted for inflation, stagnated. He concluded that as long as corporations continued to pay their leaders as if they were bureaucrats, the self-interest of those executives would remain fundamentally different from that of their shareholders.

By then, Wall Street had already come to a similar conclusion. In a wave of hostile takeovers, corporate raiders showed that huge fortunes could be made by buying up undervalued and undermanaged corporations and bringing in managers ruthlessly focused on the bottom line. Faced with the threat that they might be the next takeover target, executives quickly realized they had no choice but to do whatever was necessary to quickly generate competitive returns to shareholders. A new era of shareholder-focused capitalism was born, and with it a new favored instrument for getting executives to behave more like owners than bureaucrats -- the stock option.

An option usually gives the holder the right to buy a share of the company stock anytime over the next five or 10 years at the price prevailing on the day it was issued. And when companies began conferring on executives grants of options on 100,000 shares a year, the executives stood to pocket as much as $1 million for every $10 increase in their companies' stock price. On the other hand, if the stock price fell, the options would be worthless -- "underwater," in the argot of Wall Street.

Options became particularly popular with emerging high-tech companies that were short on cash but could use options to attract and retain not just top executives, but also young programmers and hotshot sales representatives. And with the support of institutional investors and shareholder-rights groups, the high-tech community won tax breaks that made it cheaper to use options than cash and accounting rules that made it appear as if option grants cost the company nothing.

With these incentives and the bull market of the 1990s, the use of options soared. Over the decade, options went from representing 5 percent of outstanding shares to 15 percent. And while high-tech companies tended to spread them widely through the organization, "old economy" companies began using them to sweeten pay packages of their top executives. By last year, options accounted for 60 percent of the pay package for the typical corporate CEO, helping to drive the average compensation package above $10 million, according to Pearl Meyer Partners, a compensation consultancy in New York.

Options have accomplished one purpose -- a recent study by Brian Hall of the Harvard Business School says the sensitivity of CEO pay to shareholder return has increased tenfold since Jensen did his study more than a decade ago. But there is a growing consensus among academics and practitioners that corporate America "overdosed on stock options," as Ed Archer of Pearl Meyer put it last week.

Not only have options contributed to a backlash against what many people view as excessive CEO pay, but many experts have concluded that options have the effect of disconnecting the interests of executives and long-term investors.

"There is a misconception that stock options align the interests of executives with the interests of shareholders," said Allen at NYU. "In fact, they align executives with the interests of short-term speculators and other option holders."

Allen and others argue that stock options are essentially a one-way bet for executives that encourages them to take more risk than would a real owner. If they take a risk and it works out, they gain as much as any stockholder. But if it doesn't work out, the worst that happens is the option becomes worthless. Stockholders, however, suffer a decline in wealth.

The structure of most option packages also rewards executives for taking actions that boost stock prices over a three-to-five-year horizon, but not beyond. According to Lawrence Mitchell, director of the Sloan Program for the Study of Business and Society at George Washington University, that means a CEO would do better using his tenure buying and selling divisions, laying off workers, ignoring environmental cleanups, and delaying investments in training, research and development.

"If you're going to create incentives to manage for the long term, giving them options to buy gobs of stock that they can dump the next day, the next quarter or the next year isn't a very good idea," Mitchell said.

The turn away from stock options has already begun, according to compensation consultants such as Archer, who now recommends that options account for only 30 percent of top executives' pay. Along with a number of academic experts, he recommends greater reliance on stock grants and bonus pay tied to achievement of a broader array of long-term corporate goals.

"With the environment out there now, I can tell you every single compensation committee is reevaluating their option program," Archer said.

Options are also losing support here in Washington, where House and Senate Democrats now favor the elimination of accounting and tax rules that favor stock options over other forms of incentive pay. They are likely to get support this week from the Council of Institutional Investors, a former champion of options that is now having second thoughts.