Executive Options about to Hit the Wall?

By Kahn, Sharon | Global Finance, November 1997 | Go to article overview

Executive Options about to Hit the Wall?


Kahn, Sharon, Global Finance


AS USE OF OPTIONS DILUTES SHAREHOLDINGS. INVESTORS ARE RETHINKING EQUITY

COMPENSATION.

It's a classic case of "be careful what you wish for." Institutional investors who argued that US executive pay should be tied to performance complained that managers didn't have significant stakes in the companies they ran. Now shareholders have a whole new worry: dilution of their shares by executives who had been granted stock options. "Options are like arsenic poisoning," insists Graef Crystal, publisher of The Crystal Report, an executive pay newsletter. "You can take tiny doses for years, and it has no effect. The last dose, though, kills you."

That, in fact, is a massive overstatementmost shareholders ap prove of stock options in moderation. "Noncash incentives are a time-proven weapon to increase shareholder value," says a spokesman for the State of Wisconsin Investment Board, probably the most vocal critic of executive compensation among large pension funds in the United States. But the use of options has undergone spiraling inflation in the past half-dozen years, seriously diluting existing shareholdings and leading institutional investors to rethink the equity compensation strategy. "When companies set aside 20, 30, and 40% of shares as a form of compensation," says the Wisconsin pension manager, "shareholders are starting to say enough is enough."

According to consultant Pearl Meyer & Partners, the 200 largest US companies by market capitalization reserved nearly 12% of outstanding shares for management and employee equity incentives in 1996. That was up from 10.96% in 1995, and an amazing 71% increase since the 1989 proxy season when corporate America allocated less than 7% of shares for employees. Further, 23 companies in the group had set aside more than one-fifth of their outstanding shares as equity incentives. Five of these -Morgan Stanley, Merrill Lynch, Travelers, Warner-Lambert, and Microsoft-had allocated more than 30%.

Most shareholder groups seem to settle on 10% executive ownership through stock options as the magic acceptable figure for mature corporations, although high-growth companies can get away with 15% executive ownership. "With so many companies right at or exceeding limits," says Patrick McGurn, vice president of Institutional Shareholder Services (ISS), a Bethesda, Maryland, firm that counsels institutional shareholders, "votes against compensation plans are rising." ISS, for example, recommended that its clients vote against 20% of the plans that came up for approval this season. In fact, the average shareholder opposition to all new executive stock option plans, as a percentage of votes cast, climbed to a record 19% in 1996, up from 18% in 1995, according to the Investor Responsibility Research Center, a Washington group that tracks shareholder issues.

The growth in options use is largely a result of Internal Revenue Service Rule 162(m), adopted in 1994. The IRS requires US public companies to tie compensation of their five highest-paid officers to performance or lose the corporate tax deduction on pay above $1 million. A simple way to comply is to pay executives in stock options, which, after all, requires shares to rise in value before they are worth anything. With the prolonged bull market, neither executives nor shareholders have complained-until lately.

Stock options also caught on because they incur no charge to earnings, and therefore don't reduce corporate income. That accounting procedure, which the Federal Accounting Standards Board considered changing until companies threatened to do away with FASB, tends to artificially ratchet up corporate earnings. It also leads companies to view options as "anti-gravity devices," says compensation critic Crystal. "In the early days CEO Charlie would ask for two million options, pointing out he wouldn't get a nickel unless the stock went up. Compensation boards would end up saying, hell, that's `risk compensation,' and that's good. …

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