Executive Privilege?

"I was wrong about options," acknowledged Nell Minow, editor of the Corporate Library and a leading shareholder activist. "It proved too easy to game the system."

Institutional investors are also concerned that the pool of employee options has become so large it threatens to seriously dilute the share of the company owned by current investors. They propose that shareholders, not just directors, vote on future option plans, an idea hotly opposed by the business community.

Although Securities and Exchange Commission Chairman Harvey L. Pitt has come out against changes in the accounting treatment of options, he has vowed to use existing law to force executives to give back option profits gained through accounting fraud.

And one of Pitt's predecessors, Richard C. Breeden, has recently wondered aloud whether the agency should go one step further and seek disgorgement for all option profits earned by executives in the year preceding a bankruptcy filing.

Legal Liability

In trying to influence corporate behavior, stock options are the carrot of choice. Threats of lawsuits by unhappy shareholders are the stick.

Corporations routinely buy insurance for their directors and officers that shield them from any personal liability for their actions, except when they or the company commit outright fraud. Fraud is notoriously difficult to prove and doesn't cover sins of omission, such as failing to properly supervise employees who engage in fraud or other misdeeds.

After the Enron scandal broke, Treasury Secretary Paul H. O'Neill and others floated the idea that lowering the threshold of legal liability might make directors and officers more vigilant in exercising their fiduciary responsibilities. O'Neill suggested that chief executives be held personally responsible for financial statements that do not reflect a true picture of the firm's condition. Others suggested that insurance policies include exemptions for negligence or be subject to a deductible on the insurance if there are any court judgments against them.

"Directors need some downside risk," said one Fortune 500 CEO and corporate director. "They need some exposure so they don't fall asleep at the switch."

So far, however, such ideas have been hooted down by the corporate community as well as the Bush administration. In presenting his package of post-Enron reforms, President Bush said he didn't think any problem could be solved through increased litigation. And a number of well-known directors warned that any such move would lead them to stay away from boards completely.

Instead, Bush proposed that the SEC consider setting tougher standards for directors and executives, particularly in the area of full and accurate accounting disclosure. Breaking such rules could subject them to fines or disbarment from holding positions in public companies. But the SEC is unlikely to impose sanctions against directors for being merely "asleep at the switch," according to one administration official, out of fear that having such a standard would open the door to shareholder suits.

Wall Street's Myopia

To hear it from corporate executives and those who study them, stock options are not the only factor driving the relentless focus on the short term. Many also fear the damage to their reputation, employee morale and the company's cost of capital if they refuse to play the quarterly numbers game that Wall Street demands.

Such fears are not fanciful: Companies that miss their earnings target by even a penny per share can see their stock price plunge 25 percent in a day. Many blame the overreaction on Wall Street analysts who prize the kind of steady, predictable increase in quarterly earnings that make them look smart in recommending a stock. Others point to money managers, who themselves are rated and compensated every quarter on the basis of how much their portfolio has gone up and down.

In a recent paper, Harvard's Jensen and colleague Joseph Fuller argue that this "dysfunctional conversation" between Wall Street and and the executive suite has poisoned the corporate environment. It forces executives to take bad risks and adopt questionable practices to maintain the fiction that their business is predictable and profits will rise uninterruptedly.

Their advice: Executives should follow Buffett's lead and "just say no to Wall Street," even if it means taking a hit to the stock price.

But as Yale's Garten points out, Wall Street does not operate in a vacuum. It dances to the tune of investors who move trillions of dollars around every week on the basis of short-term swings in stock prices. And it responds to the fickleness of the financial media, where there is no shame in lionizing executives, money managers and analysts one quarter and burying them the next.

"I don't blame it all on the CEOs or Wall Street," Garten said. "It's the broader society that has brought on this focus on money-in-the-pocket-now and forget the long term. The nature of capitalism has been transformed and the whole society is now complicit. Frankly, I'm not sure how you change that."