VideoExpecting a revolution in long-term incentive pay? Don't hold your breath.
Change, to be sure, is occurring. And more is inevitable, if the Financial Accounting Standards Board finally succeeds in requiring the expensing of at least some employee stock options, as a rule it has proposed would do beginning in 2005. Although they agree on little else, advocates and opponents of expensing do agree on one thing: if companies have to expense options, most will use fewer of them. In fact, companies have already curtailed their use of options, partly because boards are anticipating the new rule and partly because the recent stock-market slump made options far less attractive to managers.
Expensing should also prompt companies to look seriously at ways to link long-term incentives to performance goals. Companies currently have to expense performance shares, since the exemption applies only to options whose exercise price and quantity are fixed on the grant date. Require the expensing of all compensation, though, and boards will no longer have an accounting reason to dismiss options with a performance component. Expecting that the expensing rule will take effect next year, a number of companies have already started using performance-based options.
A survey by CFO magazine of 131 companies suggests that these changes will accelerate if FASB gets its way. This is good news for those who think that options contributed to the excesses of the 1990s. But there are reasons to doubt that expensing of options will magically produce better alignment between executive pay and shareholder wealth. That is because the basic governance problems that allowed compensation committees to dole out questionable incentives to managers still exist. Unless boards show true independence, there's a good chance that top managers will continue to receive pay that isn't tightly hitched to performance, and that shareholders will once again be left paying the consequences.
The Trouble with Options
When stock options first took off in the early 1990s, many investors greeted them as the answer to a long-standing problem: how to make managers act like owners without rewarding them even if they botched the job. Compensation committees embraced options for another reason: granting them incurred no charge to earnings.
But fixed-price options created perverse incentives. Because there are no restrictions on when an executive can unload options upon vesting, they invite steps to fuel a short-term rise in stock price, even if the decision doesn't make long-term sense. CFO found that 23 percent of finance executives at public companies think stock options have led to such actions at their companies.
A number of academic studies have established a link between options and earnings manipulation. One new paper, by Jap Efendi, Anup Srivastava, and Edward P. Swanson of Texas A&M University, shows that the likelihood of an accounting restatement is higher at companies where CEOs have large holdings of in-the-money options. The study also found that these CEOs realized more cash from their options in the two years preceding a restatement than did their counterparts in other firms.
Options are also inefficient. Research shows that employees value options at a small fraction of their Black-Scholes value, because of the possibility that they will vest underwater. "You might have to give managers a lot of options to make them feel as well off as they would if they were paid in cash or stock," says Jesse M. Fried, a professor of law at the University of California, Berkeley. "From the board's perspective, these options might seem free, but you're actually taking a lot of money out of shareholders' pockets to pay employees."
Change Is Coming
By taking some of the luster off options, the expensing rule will help alleviate these problems. Our survey shows that under expensing, companies would continue to move away from options and increase their use of virtually all other forms of compensation.
For example, while the proportion of companies granting options would drop from 87 percent to 71 percent, the percentage using performance-vesting equity would rise from 35 percent to 47 percent, and the proportion using restricted stock would go from 66 percent to 75 percent. Companies also expect to use more stock-option substitutes, such as stock appreciation rights (SARs) and phantom stock. One reason: both pay executives for stock-price appreciation without causing as much dilution. If an employee has 100 options and the share price rises from $5 to $10, he'll make $500. With an SAR or a phantom stock, the company would just settle that spread by giving the employee 50 shares of stock — 50 fewer than would be needed with options.
Performance shares have long been a favorite of shareholder activists. More often discussed than actually used, this is a type of equity that vests only when the company has achieved certain goals. While companies are generally secretive about their long-term hurdles, our survey shows that internal measures of financial performance — including profits, revenue, and return on capital employed — are the most common. Others require that the company's share price outperform some benchmark, such as a peer-group index or the S&P 500.
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