Level 3 Communications Inc., a $4 billion fiber-optic network operator, is one of the few longtime users of performance-based options. According to CFO Sunit Patel, the company's program, which he helped design, grew out of a desire to create a shareholder-friendly option program. "Our feeling was that while regular stock options are good, they can amount to essentially offering employees a free ride," he says. The solution was to create an option that would have value only if the company outperformed the S&P 500. Because payout is less likely with this plan, Level 3 applies a sliding multiplier to any performance better than the index. The options rapidly become more valuable as the share price outperforms the S&P 500.
Performance options aren't a panacea, though. One problem is that if the requirements are too rigorous, they may not be much of a motivator. "At the end of the day, if your options are very rigid from a value standpoint, people will look at it and say, 'I'll never get this,'" says John Moyer, a partner with Ernst & Young's human-capital practice. "You run the risk of having an incentive plan that's not an incentive plan." And since, like regular stock options, performance shares reward only an increase in the stock price, they do a lousy job of retaining employees when the options are underwater.
One way to address the problem is by moving to a broader portfolio of compensation tools. "You need a portfolio, because generally the same incentives can't be both retentive and performance-based," says Ira Kay, an executive-compensation consultant with Watson Wyatt in New York. He recommends that companies consider plans that include restricted stock (for retention), as well as some regular stock options and performance-vesting shares (for motivation). Our survey shows that many companies will take this approach: stock options won't disappear from compensation plans, but they will become less important relative to other kinds of compensation.
Expensing of options will have one other effect: as opponents of the new rule have argued, it will cause many companies to dump their broad-based employee stock option plans. Companies expect that during the next two years, the percentage offering options to junior executives will drop from 67 percent today to 34 percent. The percentage granting options to nonmanagerial employees will fall from 27 percent to 10 percent.
Why Expensing Won't Fix Everything
But there's a limit to how much these changes will improve matters. That's because despite recent governance reforms requiring compensation committees to consist of independent directors, executives still wield considerable influence over their pay. As Jesse Fried of Berkeley and Lucian Arye Bebchuk of Harvard argue in a summer 2003 paper, "Executive Compensation as an Agency Problem," compensation committees are often reluctant to drive a hard bargain with the CEO. That's because CEOs play too big a role in the renomination of board members, board members are insulated from shareholder wrath, and directors generally have little to lose in salary negotiations, while the CEO has a great deal to gain.
This helps explain the massive option payouts some boards have made for mediocre performance, and could lead to similar abuses with other forms of compensation, such as large grants of restricted stock or performance shares with low hurdles. "It's very likely that boards will not be as tough with performance requirements as they would if it were their own company and they had hired managers to make value for them," says Fried.
This could be the explanation for last year's award of performance shares to Danaher Corp. president and CEO H. Lawrence Culp Jr. The company, a Washington, D.C.-based tool and scientific-instrument maker, granted Culp $35.7 million in restricted stock in 2003, which will vest if he is still CEO by the end of 2009 and if Danaher has four consecutive quarters during which its diluted EPS is at least 10 percent higher than it was for the four quarters ending March 31, 2003. Given that the company's diluted EPS has risen an average 34 percent annually since 1993, this looks more like pay for attendance than for performance.
Still, those who work with compensation committees report that, on the whole, committee members are far more serious about their jobs today than they were in the 1990s. "The level of scrutiny is much more intense today than a couple of years ago, and as a result there's a new level of care and detail," says Claude Johnston, managing director of Pearl Meyer Partners, an executive-compensation consulting firm. "Many directors are truly concerned about reputational risk. They don't want their names splashed across the papers."
The real test will come when the market stages a sustained recovery. Shareholder hand-wringing over executive pay can turn to apathy when profits soar. Executives will once again compare their pay packages to those of their peers and demand similar conditions, whether that means larger grants of stock or easier benchmarks.
If companies start implementing some basic governance changes, such as separating the CEO and chairman's roles or requiring board members to hold a certain amount of company stock, the recent changes could stick. If not, this could be a short-lived revolution.
Don Durfee is research editor at CFO.
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