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Why stock ownership for managers doesn't always have the intended effect.
Ian Springsteel, CFO Magazine
April 1, 2000
When industry deregulation reared its competitive head in the mid- 1990s, the board of San Francisco based Pacific Gas & Electric Co. looked for a way to refocus the priorities of executives and senior managers.
"The company needed to change the game, from climbing the corporate ladder to creating wealth over the long term for shareholders," says recently installed CFO Peter Darbee.
So the renamed PG&E Corp. set up a plan in 1998 to require executive stock ownership. The program, typical in design, required the CEO and chairman to own three times their salaries in stock, CEOs of the company's business lines to own twice their salaries, and all executives at the vice president level and above to hold one and a half times their salaries.
PG&E has been far from alone in requiring, or at least encouraging, such ownership. Roughly a decade ago, when the last recession walloped corporate earnings and share prices, shareholders and corporate-governance activists began pushing for adoption of such a requirement. As a result, many of the largest companies now embrace the idea. At last count, 178 of the Standard & Poor's 500 required some degree of stock ownership, up from 30 in 1993.
But as PG&E's experience also attests, implementing stock ownership requirements doesn't guarantee superior performance, as its stock went south last year. To be sure, a recent study by CFO magazine suggests that, as a group, companies opting for holding requirements performed better in the years after adoption, on an absolute basis. But compared with companies that skipped such programs, adopters still underperformed.
Those results don't come entirely as a surprise. Companies often adopt stock-ownership plans only after underperforming, so they're starting out from behind. "When companies are doing badly, that's when they have been most open to doing new things, such as adopting ownership guidelines," says Nell Minow, former principal at activist investment firm Lens Inc., and now editor of TheCorporateLibrary.com, an Internet site that compiles information on corporate best practices.
This may help explain why the movement toward holding requirements has recently tapered off, with just one company in the S&P 500 introducing an ownership requirement in 1999. With the rising tide of the bull market lifting a lot of boats, pressure on companies to adopt ownership requirements has abated. Anecdotal information from consultants and corporate executives also suggests that more executive teams are taking advantage of ownership opportunities of their own free will.
But that could change if the recent downturn in much of the stock market continues. "Choosing to increase or require executive ownership has always been a great signal to investors that management is bullish on the company's prospects, and that they will put their money where their convictions are," says Minow.
Much, however, depends on how these programs are designed. In fact, both consultants and shareholder activists have criticized some plan designs as defeating their stated purpose, in essence creating empty initiatives meant to wow impressionable investors. These plans typically pay only lip service to the idea that management is putting its own money on the line.
One of the key tests is the manner and levels of ownership required. When these plans were first introduced, nearly all used a multiple-of-base-salary formula to determine the value of stock that various executives should hold. For CEOs, the multiple ranged from 2 to 10 times salary. American Home Products Corp. (AHP), for example, requires its chairman and CEO, John Stafford, to own 8 times his salary; his direct reports must hold 6 times their base pay. Champion International Corp., on the other hand, asks its CEO, Richard Olson, to maintain only 3 times his salary, while other executives hold 1 to 2 times their pay.
Although it's impossible to determine how much of a company's performance is attributable to executive stock ownership, it looks as if AHP's plan has been far more effective than Champion's. AHP's stock spiked 47 percent in 1988, though by the end of 1999 its stock had declined to 1997 levels, for a total 200 percent return from 1990 to 1999. This compared with 142 percent for other companies that adopted such plans between 1990 and 1999. In contrast, Champion has returned only as much as the overall group.
Certainly, these requirements vary between industries, with higher- growth, higher-pay companies often requiring higher levels of ownership commitment. But requirements should be changed over time to make them more meaningful to executives if initial levels don't sustain their attention. At American Express Corp., for instance, the board instituted a 2-to-5-times-salary requirement in 1993. Last year, the board revisited its requirements, and as of last April, requires top managers to hold a minimum of 3 times salary, up to 20 times the salary for the CEO, Harvey Golub. As is typical with most plans, executives will have several years to comply with the new requirements, as they did with the initial requirements.
In the early 1990s, before Amex adopted the plan, its stock suffered along with that of other financial services firms, gaining only 21 percent from 1990 to 1992. But after the Amex board adopted ownership guidelines, the stock took off, soaring 312 percent during the next six years. All but 15 percent of that increase, however, took place during the first five years. After revising the ownership requirements, the stock took off again, returning 62 percent from the end of 1998 to the end of last year.
Twists And Returns
Experts also say that plans should set an absolute percentage or number of shares to be owned instead of a dollar value based on a salary multiple. The problem with salary- multiple programs, advisers find, is that one or two years of strong performance can significantly reduce the amount of their own cash executives have to invest in order to meet their targets.
Citigroup and General Mills, for example, now require top managers to hold a substantial majority of the shares and options granted to them, for the duration of their employment. At Citigroup, the commitment extends only to the board, the executive committee, and the operations committees, the members of which are required to hold 75 percent of all granted and optioned shares. General Mills, on the other hand, asks a broader tier of managers and all executives to hold 80 percent of all their optioned and granted shares.
Generally speaking, consultants say flat requirements may be more appropriate in cyclical industries, where stock market performance often has little to do with individual management decisions, and a decline in value would otherwise force executives to buy more shares to maintain their required targets. But consultants say flat requirements are less justifiable at faster- growing companies.
Another cause for concern is how shares are counted toward the total requirement. Some companies allow executives to count only shares actually purchased with cash, whether on the open market or through option programs, as well as those held in qualified retirement and deferred compensation plans. Others allow options to be counted; some just those in the money; some just vested options and some any option at all.
PG&E, for one, goes so far as to include the cash payout value of the company's performance unit plan--an incentive tool that pays out when target shareholder returns are reached. In addition, deferred compensation plan amounts invested in stock are counted, as are 401(k) balances invested in company stock and all in-the-money amounts of vested options held by an executive.
While critics say such plans lack teeth, Darbee strongly defends PG&E's arrangement. "Executives have many ways to hold value at risk in the company, so we try to count all of them," he says.
Forgive and Forget?
"While the concept of ownership is laudatory, it can wreak havoc on executive decision making and focus when executives have significant wealth at risk and little control over their short- to medium-term results," says Judith Fischer, managing director of Executive Compensation Advisory Services, in Alexandria, Virginia.
In the end, ownership requirements are unlikely to be effective unless companies are prepared to see management suffer along with shareholders. So it seems with PG&E, even after the company's stock declined last year. "Investors aren't happy with our performance, and that's no surprise," says Darbee. "But they know that everyone in senior management here is a significant owner, and that we took the hit, too. We feel their pain." Or at least those who paid with their own money do.
Ian Springsteel is a freelance writer in Weston, Massachusetts.
Poorly conceived stock ownership requirements can pose big risks, as Conseco Inc. found out the hard way.
See "A Good Deal Too Much" for a look at how the formerly high-flying insurer's program has backfired on managers and shareholders alike.
Where Their Mouths Are
To gauge what difference, if any, stock ownership requirements make on performance, CFO magazine took a look at the 437 companies that have been part of the S&P 500 since 1990, and divided them into three groups: (1) those 77 companies that adopted ownership guidelines by the end of 1995; (2) the 67 companies that have adopted guidelines since 1995; and (3) the remaining 293 companies that have never adopted ownership programs. Each group was measured using year-end stock prices, equally weighted (one share per company, regardless of capitalization), at the close of 1990, 1995, and 1999.
Returns for the first group confirm the widely held belief that ownership requirements enhance the performance of laggard companies. During the 1990 to 1995 period, when they opted to implement their ownership guideline programs, the companies in group 1 returned an average of 40.8 percent, compared with a 53.5 percent return for group 3 companies, which have never adopted such a plan. After implementing ownership plans, the adopters of stock-ownership plans returned 105 percent between 1995 and 1999, compared with nearly a 120 percent gain by companies without such plans, significantly closing the gap.
The second wave of adopters (group 2), which implemented ownership plans between 1996 and 1999, produced returns in the first period that were barely better than the early adopters--42.3 percent for five years ending last year. As the decade progressed, these companies lagged far behind the Joneses, turning in a 70.2 percent share price return between 1995 and 1999. But if the first wave's experience is any indication, the second wave should approach the performance of nonadopters in the coming years. I.S.