Video"I'm willing to lay it all on the line in terms of performance." Four years ago, that was what WorldCom's Scott Sullivan — at the time the highest-paid CFO in our compensation survey — told us when he chose a cash bonus over a base-pay increase. Two years later, our biennial survey showed that CFOs were enjoying the fruits of new, CEO-style compensation packages laden with stock options, but also that the booming stock market was rewarding leaders and laggards alike.
How times change. Both Sullivan, now under indictment for securities fraud, and the market have since gone seriously awry. Thanks to the havoc wreaked by both, corporate boards are once again pursuing the elusive goal of tying executive pay more closely to individual company performance. Much of the consequent reshuffling of CFO pay packages will likely involve rethinking the use of stock options, which have become a singular focus of reform efforts.
Much of the consequent reshuffling of CFO pay packages will likely involve rethinking the use of stock options, which have become a singular focus of reform efforts. But CFOs have already felt the pain of the bear market in their short-term pay, according to the 2002 compensation survey, conducted by Mercer Human Resource Consulting. Total CFO cash compensation (salary and paid bonuses) stayed flat this year, averaging $432,400. The lack of growth — a sharp contrast with the 9.6 percent increase the previous year — is testament to frozen salaries and lower or unpaid bonuses, even as other finance functions saw their pay go up. And as the stock market has gone south, "options have also shown significant erosion in value to executives," says Mercer analyst Lee McCullough.
To Have and to Hold
It isn't just the market that is eroding the value of options. The features that made them so wildly popular — grants don't affect earnings, and companies get a tax deduction when they're exercised — are under heavy fire. Many companies have already opted to expense them under FAS 123, and the Financial Accounting Standards Board (FASB) now may have the moral clout to win a rematch with Congress, which killed its 1995 effort to require expensing of options. And should expensing become mandatory, options will lose a key advantage over other forms of incentive-based compensation.
None of this suggests that options are going away. Indeed, the survey shows that a slightly higher percentage of CFOs were eligible for stock options this year than last. Options have the benefit of being exempt from Section 162(m) of the Internal Revenue Code, which limits the tax deductibility of cash compensation over $1 million. And serious issues still stand in the way of a universal expensing requirement. In October, FASB issued a draft of rules meant to clarify the process for companies making a transition to expensing from footnote disclosure. But that's an administrative fix that ignores, or at least lags, growing questions among businesses about the accounting problems inherent in expensing options. Without a provision for truing up the estimated "fair-value" expense of options with the actual expense when they are exercised, option expensing in a down economy could ultimately skew the bottom line in much the same way pension gains did during the boom.
Until the accounting and tax-treatment changes, options still carry hefty advantages over stock and cash, argues Jack Dolmat-Connell, vice president of Clark/Bardes Consulting, an executive compensation and benefits consulting firm based in North Barrington, Illinois. And although they are no longer perceived to have unlimited upside, options doled out in a bear market have room to grow. "People say options are dead, cash is king," he says. "That's bunk. Companies aren't in the position these days to give lots of cash."
But turning options into cash may get harder for CFOs. Already it is nominally more expensive. Until the Securities and Exchange Commission clarifies the rules for the Sarbanes-Oxley Act prohibition on corporate loans to executives, most companies have suspended cashless exercise programs, forcing executives to pay the strike price out of pocket or seek financing.
And reforms aimed at the perceived failure of options to act as long-term incentives could also hit CFOs in the wallet. A report on executive compensation released by The Conference Board's Commission on Public Trust and Private Enterprise suggested "substantial minimum holding periods for equity received as compensation." Similarly, a cross-industry study of 100 proxy statements by Clark/Bardes found strong correlations between "real" beneficial ownership — that is, actual shares held by executives — and five-year total shareholder return. "The inverse held as well: companies whose executives held the most options were the lowest performers," says Dolmat-Connell.
Clark/Bardes now recommends requiring executives to hold some multiple of their salary in actual stock. Since stock grants have to be expensed, and option grants — so far — don't, the end result is likely to be that finance chiefs exercising options will have to hold at least a portion of any stock bought with options.
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