Pay for Nonperformance?

In the mid-1990s, when the Financial Accounting Standards Board proposed that the cost of employee stock options be reflected on corporate income statements, the accounting standards-setting body nearly had its head handed to it.

Business leaders and Washington politicians like Sen. Joseph Lieberman (D­Conn.) called the proposal blasphemous and threatened to cut FASB's funding if it didn't relent--which it did. Options, after all, were the fuel of the New Economy--a tool to align the interests of managers and shareholders and foster productivity and entrepreneurship in new and established companies alike. FASB's initiative would prevent start-ups from attracting the best management talent and generally stifle innovation in the economy.

Well, the options debate is back, and the talk of interest alignment is wearing a little thin. Like every other element of U.S. business practices, executive stock option plans have fallen under the skeptical eye of an investor community that has been burned by a growing incidence of accounting fraud and near-fraud. Regulators and prosecutors have largely focused on the conflicts of interest at Wall Street investment houses, at auditing firms, and on corporate boards.

But there is a growing sense that New Economy­style compensation practices (read: huge option grants) are a major part of the problem. Changing the accounting treatment for these options doesn't resolve the problem, but it's a start. "Accounting, not business strategy, drives compensation plans in the U.S.," says Patrick McGurn, a vice president at proxy advisory services firm Institutional Shareholder Services Inc. (ISS). "We have a once-in-a-lifetime opportunity to improve the accounting rules for options." ISS, along with the Council of Institutional Investors, advocates expensing options on corporate income statements.

Whether it comes from Congress--where the McCain-Levin bill in the Senate would disallow tax deductions for companies that fail to reflect option grants in their financial statements--or from FASB, where incoming chairman Bob Herz may soon have to take up the issue again, change is in the air. And this time around the business lobby will be facing more adversaries than just FASB.

Options Versus Stock
If the object is to increase the transparency and clarity of financial statements, expensing options is not the answer, say business leaders. Frederick Smith, CEO of FedEx Corp., argues that it would actually distort financial statements and confuse investors. Given that option grants are already reflected in fully diluted earnings-per-share figures, expensing them would amount to double-counting, Smith wrote in an April 5 editorial in the New York Times. The article, co-written with Silicon Valley venture capitalist John Doerr of Kleiner Perkins Caufield Byers, called on Congress to leave options alone. "Options embody a principle that the Enron scandal does nothing to diminish: that the financial interests and responsibility of workers, management, and investors be aligned," they wrote. Smith held 2.2 million options on FedEx shares as of May 31, 2001.

Tails, You Lose
If the object is to align management and shareholder interests, the issue is the options themselves. On the one hand, options are valuable to executives only if the share price rises. When shareholders win, so do option holders. On the other hand, options are a one-way street, with upside potential but no downside risk. This can motivate executives to manage companies more aggressively, increase corporate leverage, or undertake risky ventures like acquisitions--and, yes, adopt aggressive accounting practices.

The short-term returns of such activities can be attractive, but they may not be in the long-term interests of shareholders. Indeed, based on the evidence in corporate collapses like Enron's, options have arguably motivated executives to deceive and work against the interests of shareholders, at least for long enough to exercise their options. "If there is only upside potential, executives tend to take inordinate risks," says Jack Dolmat-Connell, a principal at Clark/ Bardes Consulting Inc.

The objective of stock option plans is twofold: (1) to attract and retain talented managers to the company, and (2) to pay executives for performance. On the second count, the plain-vanilla options that U.S. companies grant their executives do a poor job. A McKinsey & Co. study of stock returns shows that more than 40 percent of movements in share prices result from movement in the broader stock market and in a company's specific industry. In other words, even blithering idiots could make a fortune in the late, great bull market--regardless of how well they managed their companies.

The solution, says Dolmat-Connell, is to give them stock, not options to buy stock. Actual share ownership, not potential ownership via stock options, does a better job of aligning managers' interests with those of shareholders and driving long-term performance. In an analysis of corporate stock returns and long-term incentive programs for key executives in 10 different industries, Dolmat-Connell found that companies in which executives had large shareholdings performed significantly better than those in which ownership was small.

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