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Pay for Nonperformance?

Executive compensation practices won't change until accounting rules for options are fixed.
Andrew Osterland, CFO Magazine
August 1, 2002

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.


Of course, plenty of companies issue restricted stock to their managers and encourage share ownership by key executives. Many even provide loans to purchase company stock, as WorldCom apparently did to disastrous effect with former CEO Bernie Ebbers. For the most part, however executive share ownership is extolled as a virtue, it is rarely mandated in U.S. companies.

The Expense Question
Corporate compensation committees won't scrap options for stock grants anytime soon. For one thing, it would cost too much. More than 90 percent of U.S. public companies use options as the primary long-term incentive for their executives, largely because options are tax deductible and yet don't have to be booked as a compensation expense. Stock grants, on the other hand, do have to be expensed. "Until the accounting [for options] gets fixed, I don't see any great move to change practices," says Peter Clapman, general counsel for pension giant TIAA-CREF.

Clapman's boss, CEO John Biggs, sits on the board of The Boeing Co., which is one of only two companies (Winn-Dixie Stores Inc. is the other) in the S&P 500 that voluntarily expense their option grants on the income statement. The rest disclose the cost (usually using the Black-Scholes options pricing model) in a footnote to the financial statements--their prerogative under the current accounting rule, FAS 123.

Investors don't care about noncash accounting charges, says McGurn, because they don't affect business prospects. Investors want options expensed because they think it would put the brakes on oversized executive compensation. "The companies that make excessive use of options would be punished," he says.

Perverse Accounting
Perhaps the biggest shortcoming of FAS 123 (not FASB's finest effort) is the unfavorable accounting treatment it places on performance-based options. One way to make options a better pay-for-performance tool is to peg them against a benchmark like the S&P 500 or an index of a company's peers. The exercise price of the options would depend on the performance of the shares relative to the benchmark, rewarding executives for outperformance, not merely for a rise in the stock market. Under current rules, however, "variable accounting" has to be applied to indexed options. That means they have to be marked to market every quarter based on the market price of the company stock and the benchmark. Telecommunications provider Level 3 Communications Inc., which declined a request for an interview, is the only public company that uses a pure indexed options scheme, and so has no choice but to expense them.

Many companies evaluate manager and company performance to determine the size of option grants or their vesting schedule. First Data Corp., for example, uses an incentive program, on top of its regular stock option plan, that grants additional options based on how well the company stock performed in the previous two years against the S&P 500. Executives receive the maximum number of options if the company beats 75 percent of its S&P peers. "How we perform versus the S&P determines the available pool of awards," says David Banks, head of corporate communications at First Data. "It gives our incentive plan a relative measure."

The McCain-Levin bill wouldn't resolve the perverse accounting treatment for performance-based options, but it would go a long way to discouraging excessive plain-vanilla option grants. If companies don't expense the grants, they won't be able to deduct them from their tax returns. Some fear it could have the effect of stopping companies from drafting broad-based employee option plans, which most compensation consultants believe foster productivity and reduced turnover. Companies might choose to use option plans only for their senior executives. The bill, however, is still a long way from passage, and given that the business lobby is fighting it tooth and nail, the issue may well end up back in the lap of FASB.

Welcome aboard, Chairman Herz.

Andrew Osterland (andrewosterland@cfo.com) is a senior editor at CFO.

A Better Incentive

A study by compensation experts Clark/Bardes Consulting Inc. finds that common stock ownership is a consistently better performance incentive for management than stock options.

In the software industry, for example, the top three performers in a group of 15 companies were Siebel Systems, Microsoft, and Oracle, based on total shareholder returns over the past five years. The ratios of share ownership to salary of the top executives in those 3 companies were well over 1,000, and the ratios of option holdings to outright share-ownership ranged from less than 0.1 at Microsoft to 1.1 at Siebel Systems (the huge shareholdings of Bill Gates and Larry Ellison skewed the data). The same ratios at the poorest-performing companies--Computer Sciences Corp., Cadence Design, and BMC Software--were markedly different. At Computer Sciences, for example, the top five executives had average shareholdings smaller than their annual salaries. They also held options worth 30 times more than the company stock they owned.

The correlations held true across all 10 industries analyzed by Clark/Bardes principal Jack Dolmat-Connell. He also applied the analysis to acknowledged leaders and laggards in other industries. Southwest Airlines had high stock-ownership levels and good performance, while Delta Airlines had low ownership and poor performance. Likewise, Dell Computer had high ownership and good performance, while Apple Computer (Steve Jobs owns all of two shares in the company) had low ownership and much poorer performance. It also held up for recent flameouts like Tyco and WorldCom--though former WorldCom CEO Bernie Ebbers held large stock holdings. "We ran major regression models with this and got very high correlations," says Dolmat-Connell. --A.O.




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