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Jul 31, 2002

Options... for a price

They love them! They hate them! They can't stop talking about them! Stock options are being debated like never before

'The ability to say no is a tremendous advantage for an investor'
- Warren Buffett


Are these corporate executives worth what they're paid? Every day investors ask the same question. And very often the answer is a resounding no. When it comes to executive remuneration, there is a lot to debate. The debate sells newspapers. It fuels chat rooms. It prompts e-mail to flood IR mailboxes. It provokes down-home investors to get in their cars and drive 500 miles to an annual meeting. At the center of this debate is the issue of stock options. How much is too much? Are these guys worth it?

The collapse of Enron did wonders to bring the stock option debate back from the dead. Enron executives cashed in millions of dollars in options while steering the company towards bankruptcy. This sad story seemed to confirm popular paranoia that many (most? all?) corporate execs play by their own rules; that company performance has no bearing on executive compensation; and that corporate brass gets rich while everyone else gets duped.

Yet while the Enrons and WorldComs of the world may come and go, the rest of us are left trying to figure out what level of compensation is appropriate. And this against a backdrop of a record number of options held by corporate executives, a record number of employees holding options, and a record number of investors believing options programs need reform.

The traditional attitude has been that if the stock price goes up, executives should be given a chunk of equity. Unfortunately, somewhere along the line that attitude changed to the belief that if the stock price goes down, executives should be given a chunk of equity to keep them from leaving.

Options under fire

The Corporate Library is beta-testing a product that ranks compensation levels in the S&P 500. The goal is to find a correlation between CEO compensation - among other key metrics - and investment risk. The rationale: companies with overcompensated CEOs may also have weak boards that cannot stand up against management's proposals. This suggests weak governance and, in turn, represents greater risk for investors.

'A lot of CEOs have made a lot of money on stock options while their stock prices have fallen by 50-60 percent,' notes the Corporate Library's senior research analyst for CEO compensation, Paul Hodgson, who has tracked compensation practices of every company in the S&P 500. 'And people are thinking, How can that happen?'

Hodgson concedes that in some situations options rewards can give executives a powerful incentive. For instance, a new CEO may be brought in to a lagging company and granted equity incentives to get the stock price up to premium levels. 'I can't think of a better incentive than that,' Hodgson admits.

No performance conditions

The problem is that while a great number of companies across all industries award stock options to their executives and directors, 90 percent of the option schemes at S&P 500 companies have no performance restrictions whatsoever. According to the Corporate Library, only 50 of the 500 have granted performance-related stock options in the last two years.

The situation is somewhat better in the UK, where nearly all companies that offer executive option awards have performance conditions, though the hurdles are often low. The London Stock Exchange's Yellow Book rules require companies to apply performance conditions to all stock option grants, or to give detailed explanation of why they don't. When the exchange introduced these rules, most companies adapted their compensation schemes. True, the rules also prompted some to drop their schemes altogether, but the net result is now a performance-related compensation standard.

Meanwhile, US investors are left to wonder why US companies don't more frequently peg options to performance. The answers have left many institutions bitterly opposed to current practices. For one, companies are reluctant to introduce performance restrictions for fear of the effect on executive retention. After all, why should executives work for a company that rewards them only for superior performance, when they can work elsewhere and be rewarded regardless of their performance?

Ironically, as the managing director of the Council of Institutional Investors (CII), Peg O'Hara, points out, options plans originally proliferated in the US as a means of attracting talent: 'In the beginning they were used by companies that didn't have money to pay people. You took a risk when you signed on with this kind of company, and you worked your butt off, and if you made it, you made it well. Whereas now many of these companies have perfectly fine paychecks and bonuses and everything, but they still give stock options out the door. It's gotten so that the total compensation just doesn't make sense.'

According to Hodgson, 'To a certain extent [options] have lost their incentive ability because they are now a standard, accepted element for executives as part of their compensation package. It would be almost unthinkable for an executive not to receive any stock options.' His research found that of all the S&P 500 companies, those that do not give their executives stock options 'could be counted on the fingers of one hand.'

Hodgson wonders if US compensation committees believe that stock options are inherently performance-related, even though stock price is a relatively clumsy measure of performance: 'If there's a bear market and all the stock prices are going down, you could still be outperforming your industry, and giving a better return to stockholders. Surely that is a reason to reward a board and the executives who are running the company and doing a good job at it. Instead, they find themselves with underwater options like everybody else.'

Perhaps the main reason Corporate America has omitted performance triggers for options is that, unlike the UK system, no regulatory body or group of institutions has mandated them.

Fuzzy math

The fuzzy options issue gets even fuzzier when accountants enter the picture. When testifying before Congress this year, Enron's former chief executive, Jeffrey Skilling, admitted that stock options give companies a way to inflate reported earnings: 'Essentially what you do is you issue stock options to reduce compensation expense, and therefore increase your profitability.'

The CII's executive director, Sarah Teslik, agrees that stock options can be used to grossly overstate a company's balance sheet. As she summarizes, 'They turn companies into Ponzi schemes.'

Almost without exception, US corporate accountants have agreed not to subtract the cost of stock options from corporate earnings - at least not on their balance sheets. While companies may pretend the options they award are free, their investors certainly do not. Expensing of options would lower earnings of nearly every major US corporation. For some, the difference would only be slight. For others, it would cause earnings to completely evaporate. Take Yahoo, for example. Had the company expensed options for fiscal 2000, its operating income would have changed from $21 mn, as reported, to minus $1.9 bn, according to Bear Sterns. Broadcom's income would have gone from $4 mn to negative $685 mn. The list goes on. Companies in options-heavy industries such as technology and telecoms stand to lose the most from the expensing of options - at least on paper.

A decade ago it was these industries that lobbied to uphold stock option accounting practices when the Financial Accounting Standards Board (FASB) threatened to change them. The argument rose to a fever pitch when FASB recommended options be expensed and thousands of tech company employees and executives staged rallies across the US and marched on Capitol Hill in protest.

High-tech companies, which made particularly liberal use of options, were frightened that charges against earnings would seriously detract from their ability to attract and retain capital. The FASB rule could cause significant damage to the market as a whole, they argued. Even the CII sided with the business lobby and most of Washington and decided the FASB recommendation was heavy-handed and should be rejected.

Policy reversal

Things have changed since then. Companies across all sectors began using options programs and ever more aggressive accounting. This year the Council decided to reverse its policy because, O'Hara says, it found 'a lot of things to worry about with stock options. Disclosure is not sufficient. The use of stock options has absolutely magnified many times over. Nobody could have dreamed how much of our stock would be given away in options. Compensation packages have gone out of bounds.'

And now the opposition to options accounting practices has many more voices, including media favorites like Alan Greenspan, Warren Buffett and TIAA-Cref. Moreover, the International Accounting Standards Board (IASB) is mounting a campaign to establish common global accounting standards that may require companies to treat stock options as an expense.

On top of all this, Standard & Poor's says the cost of options must be subtracted in order to get a true picture of what it calls core earnings. 'This piece of information is of some significance and should be available. We're trying to keep it pretty simple because we think at the end of the day it is pretty simple,' says David Blitzer, S&P's managing director and chief investment strategist.

Investor relations officers are on the front line of the options debate. They are the proverbial messengers linking investors and senior management. As the options debate heats up, companies that are proactive in tailoring their compensation practices now have the opportunity to boost their corporate image.

Human resource consultancy William H Mercer advises companies to reassess the objectives of options and redesign new programs along those lines. They should choose effective performance measures and link their rewards programs to the achievement of them. Executives should work to balance the emphasis between internal incentives and shareholder value creation.

As Hodgson affirms, it's important for companies to deal with underwater options first. He says they are good for neither the company nor the employees who hold them. He suggests granting additional options at the current reduced value, rather than replacing existing options.

There is no one-size-fits-all solution. Ultimately, Hodgson adds, companies must break the cycle of creating incentives that focus on quarterly or even fiscal results, incentivizing them for the long term instead. 'The way forward is for companies to try and adopt best practice without some agency having to force it down their throat. Then they are going to look good. And they are going to improve their corporate image immeasurably.'


The cost of options
Among S&P 500 companies, there are only two - Boeing and Winn-Dixie - that currently expense options. In Boeing's case, compensation is tied to performance shares that trigger when the company's stock price reaches specified levels. 'Once the stock price hits the threshold price in these increments, a corresponding percentage of the shares automatically vest,' explains Boeing spokesman John Morrocco. 'We adopted the accounting method because it adds predictability to earnings as you accrue the cost of these performance shares over the life of their maturity, versus having to accrue them when they vest or are exercised, which is less predictable.'

Voting rights
Over the past several quarters institutional investors have seen their investments decline while executive compensation in their portfolio companies has continued to increase. Moreover, many companies have removed compensation issues from their proxy ballots, so shareholders have little say in the matter.

This year the CII, TIAA-Cref and others launched campaigns to re-establish shareholder voting rights for compensation issues. Carol Bowie, director of governance research services at the Investor Responsibility Research Center (IRRC), believes most institutional investors support these voting rights. 'There is some concern, especially in the tech industry, that too many restrictions on a company's ability to grant stock options will have a negative impact on its growth prospects. But I haven't heard of any investors complaining about having to vote on all plans,' she says.

Through heavy lobbying, investors have made progress recently. First, the SEC ruled that all plans - approved and non-approved - must be disclosed. Then the New York Stock Exchange proposed new listing rules requiring companies to get approval for all plans, including broad-based plans designed for employees.

'There's a lot of sentiment to restore that right to vote, and we think with some of the scandals, that may happen,' the CII's Peg O'Hara believes.

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