When a record $4.9 billion in punitive damages was awarded in July to a family that was severely injured in a fire caused by a poorly designed General Motors automobile, the jury said it was "sending a message" to GM's management about consumer safety and corporate responsibility. Too bad the senior executives at GM don't have to listen. As is true of most American high-level managers, their compensation isn't tied to what most of us would consider good performance.
For example, most investors, if not most Americans, would probably expect GM executives to feel some pain because 1) Chevrolet made the irresponsible decision to risk lives in order to save a few dollars on each car; 2) although the judge quickly reduced the award to a still-considerable $1.09 billion, GM's penny-wise, pound-foolish decision earned the company a major lawsuit and bad publicity; and 3) GM's stock could be adversely affected by the award--and GM is already a chronic under-performer, not only in comparison with the broad Standard & Poor's 500 market index but relative to other companies in its peer group, such as Ford and DaimlerChrysler.
But it is hard to see how GM's management will pay much of a financial price for any of these failures. The reason is that at GM, as at many other large companies, a substantial portion of top managers' long-term compensation takes the form of stock options--in essence, vouchers that let executives buy company stock at a certain price during a set period of time. In theory, stock options are supposed to improve corporate profitability and therefore the firm's stock price, by making managers think more like long-term shareholders. In other words, managers are supposed to make decisions that enhance their company's efficiency and market share--and thus maximize the value of its stock over the long haul. All too often, however, it doesn't work that way.
Last year, for example, GM awarded options to purchase 300,000 shares at the then-current market price to Jack Smith, who has been its CEO since 1992 and chairman since 1996. Because these options don't expire for another 10 years, Smith has plenty of time to accumulate significant capital gains as GM's stock rises through his efforts, or simply because the rising tide of a bull market lifts all boats. When this new award is combined with prior ones, Smith's total holdings of options amounted to about $18 million as of Dec. 31, 1998.
It is not clear, however, that GM's shareholders have benefited from the corporate largess available to Smith. Between January 1994 and December 1998, GM stock generated cumulative returns of only 57 percent, compared with almost 200 percent for the S&P 500. Indeed, GM's stockholders would have been better off investing in rival auto makers, such as Ford (which returned 234 percent over the same period) or DaimlerChrysler and its predecessor, Chrysler (169 percent return).
And unfortunately for investors, this obvious disconnect between what stock options were supposed to do and what they actually accomplished is not unique to GM. These days, almost every large corporation in America--up from around half of them a decade ago--uses equity as a management incentive. Senior executives at America's major firms had a claim on more than 13 percent of their companies' equity at the end of 1998. The Economist magazine estimates that in 1998 options awards accounted for a record 53.3 percent of the compensation given by America's top 100 companies to their chief executives.
The reason for this popularity is simple: Accounting rules and the tax code make stock options a cheap way to pay executives. When the options are awarded, they are not charged against corporate income. In fact, they don't show up on the company's balance sheet at all. Instead, they are disclosed only in a footnote to the company's financial statements. It is only when these options are exercised in the future that their cost is charged against income as a business expense, lowering the company's tax bill at that time.
The link between stock options and improved corporate performance--however one defines it--is tenuous at best. Take financial profits, for example. It is true that, on average, companies in the S&P 500 index had profits in 1998 that were double what they had been in 1990. However, these profits do not for the most part include the cost of executive options because, as mentioned earlier, they are not recorded on balance sheets. According to Smithers & Co., a British research firm, U.S. companies overstated their profits by as much as 50 percent in 1998, once the cost of these footnoted options was deducted. Of course, this raises the question of just how much of the past decade's spectacular rise in stock prices--the S&P 500 index is now nearly four times higher than it was 10 years ago--is attributable to real value added by managers with stock options.
If there is some causal relationship between stock option schemes and corporate profitability, reams of academic research have failed to find it. Part of the reason may be that those schemes are being increasingly used not as a performance incentive--their original purpose--but as a way to attract and retain managerial talent.
This shift from incentive to entitlement is most clearly illustrated by the growing practice of repricing options if the market value of the underlying stock declines. For example, the board of Cendant Corp., a hotel-franchising and direct-marketing company, reduced the purchase price on stock options held by its chairman, Henry Silverman, after the company's stock price fell 76 percent following revelations of massive accounting fraud at the firm. The value of this repricing amounted to about $50 million, which grew to $75 million after the stock finished the year down 44 percent.
Some consolation may be taken in the fact that the Financial Accounting Standards Board (a private-sector entity authorized by the Securities and Exchange Commission to formulate accounting standards) is now considering a rule change that would charge the cost of repriced options against company profits. But this better accountability does nothing to penalize poor managerial performance. Thus, managers gain when stock prices rise and are often protected when prices fall.
There are other, often insidious, effects. For example, as more and more companies feel pressured to offer stock options so that their compensation plans are competitive, executive compensation is ratcheted up to levels that seem beyond any reason or merit. As a result, income disparities between the rich and poor have dramatically worsened. The AFL-CIO estimates that, because of stock options, the average U.S. chief executive now makes 419 times what the average factory worker does. Back in 1980, he or she made only 42 times as much.
And while America's admiration for entrepreneurial superstars such as Microsoft's Bill Gates probably means that this tremendous income gap won't foment social revolution here any time soon, it does lead citizens to behave in ways that many would consider socially unproductive. The trend toward excessive compensation probably helps explain the growing national obsession with day trading, as well as young people's lack of interest in low-paying public service jobs.
Option schemes have also caused further inflation in an already frothy stock market, as companies buy shares at historically high prices and sell them at a loss to managers choosing to cash out. (See the accompanying boxed article.) And the number of executives selling has been increasing, with many of them unloading a portion of their stock awards every quarter. Not surprisingly, firms repurchased about $220 billion worth of shares in 1998, compared with $20 billion worth in 1991. Worse, many companies have had to finance these buybacks by borrowing money in the bond market.
As a result, corporate assets are being dissipated for the short-term benefit of executives. Such companies are more vulnerable in the event of an economic downturn.
While there is no foolproof way to make sure that managers' short-term financial interests coincide with shareholders' long-term concerns, action should be taken to curb, if not eliminate, abuses within prevailing stock option schemes.
First, distorted incentive schemes exist because shareholders allow them to. Shareholders need to be more aggressive in examining and challenging the incentive plans approved by compensation committees. After all, shareholders are the ones who ultimately pay for these schemes when exercised options dilute their ownership stake, or when the company saddles itself with debt to pay off mediocre managers. And shareholders who do scrutinize proposed option schemes should do so with a healthy dose of skepticism, even when plans are endorsed by auditing firms or compensation consultants. Such firms have a natural reluctance to offend the companies paying their fees, or from whom they hope to receive repeat business.
Furthermore, although institutional investors such as pension funds and insurance companies have a fiduciary duty to veto stock option schemes that endanger the investments of their constituencies, few actually do so. The beneficiaries of these funds should therefore pay more attention to how these institutions vote and hold them accountable.
In addition, institutional investors should use their considerable clout to encourage the adoption of "benchmark" plans: plans that reward only performance that beats the market as a whole, or that is above-average when compared to a suitable peer group of companies in the same industry. In contrast, prevailing "straight option" plans reward managers simply because their company's share prices rise in line with the rest of the market--quite an easy accomplishment when the bulls are running!
To facilitate this shift, the tax code should be changed so that the cost of benchmark option plans is allowable as a business expense, while the cost of straight option plans is not. In any case, the fair value of option plans should be periodically charged against income so that a company's financial statements more accurately reflect its profitability. When options are exercised, charges to the company should be adjusted to show the expense of selling stock at below-market prices to managers who choose to cash out.
America's CEOs certainly deserve some of the credit for what has been the longest economic expansion in U.S. history, but they don't deserve as much as most stock option schemes give them. By making sure that credit is given only where it is due, shareholders can help keep the expansion going.
Teresa Wyszomierski is a lawyer and former investment manager. Pieter Bierkens is an economist and securities dealer. Both are based in New York.