Quite a while ago my brother Chris pointed out to me that stock options do not align the interests of executives with those of shareholders. Options, he said, make the top executives want as much volatility in the company's stock price as possible.
Now this point is becoming the conventional wisdom. I think this is healthy.
...The theory is that the huge amounts of stock options dished out to executives in the 1990s encouraged them to behave badly. Unlike stock itself, a stock option has no downside: the owner might gain a lot of money if his company's share price rises, but he loses only the cost of the option if the share price falls (and nothing at all if the option is given to him). That might have encouraged excessive risk-taking at the top--a willingness, as Ira Kay of Watson Wyatt, a pay consultancy, puts it, to "roll the dice". Combined with the freedom to sell the company's stock once the option is exercised, stock options might also have encouraged short-term business strategies, or even fraud. By fiddling with their accounts, company bosses could hope to drive up the share price, cash in their options, and set sail in their yachts. Stock options are indeed becoming less popular in the boardroom. Mr Kay sees a gradual switch from options to outright share-ownership plans. So does Peter Chingos of William Mercer, another consultancy. Mr Chingos says that efforts to make bosses hold on to their companies' shares are also gaining ground. New share-ownership plans, for instance, might typically prevent the boss from selling his shares for five years...
Corporate reform
Clambering back up
From The Economist print edition
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Can Americans trust their business leaders to do the right thing?
AFTER the race to the bottom, a race back up to the top. Claiming a desire to “help restore confidence in corporate America”, on July 14th Coca-Cola announced that it would begin recording employee stock options as an expense on its income statement. A day later, the Washington Post Company said that it too would make the change. AMB Property, a hitherto obscure real-estate investment firm, said that it had been expensing options for a whole week already, throwing doubt on Coca-Cola's stated willingness to “take the lead on this issue”. More firms might follow these pioneers, including Heinz, a food group, and Delta Air Lines.
Give Coca-Cola its due: its timing is spot on. Twice in two weeks, President George Bush has demanded that corporate America put its house in order. On July 16th Alan Greenspan took his turn to wag his finger at America's bosses. Too many of them, said Mr Greenspan, had sought ways to “harvest” the booming stockmarket of the late 1990s. The investments of ordinary Americans, meanwhile, keep wilting. Since the start of the year, the S&P 500 index has fallen by over 20%.
Coca-Cola's choice of reform is also clever. Although other initiatives are beginning to take shape in Congress, efforts to make it compulsory to charge the cost of stock options as an expense have fallen foul of the high-tech business lobby. That has turned options-expensing into a pressing issue among those Americans who feel their government is doing too little.
The willingness of companies to embrace this accounting change voluntarily, meanwhile, cheers free marketeers. They urge caution in new rule-making and claim that the system can, by and large, be relied upon to fix itself.
On the evidence so far, who is right? One place to look for the answer is bosses' pay. The theory is that the huge amounts of stock options dished out to executives in the 1990s encouraged them to behave badly. Unlike stock itself, a stock option has no downside: the owner might gain a lot of money if his company's share price rises, but he loses only the cost of the option if the share price falls (and nothing at all if the option is given to him). That might have encouraged excessive risk-taking at the top—a willingness, as Ira Kay of Watson Wyatt, a pay consultancy, puts it, to “roll the dice”.
Combined with the freedom to sell the company's stock once the option is exercised, stock options might also have encouraged short-term business strategies, or even fraud. By fiddling with their accounts, company bosses could hope to drive up the share price, cash in their options, and set sail in their yachts.
Stock options are indeed becoming less popular in the boardroom. Mr Kay sees a gradual switch from options to outright share-ownership plans. So does Peter Chingos of William Mercer, another consultancy. Mr Chingos says that efforts to make bosses hold on to their companies' shares are also gaining ground. New share-ownership plans, for instance, might typically prevent the boss from selling his shares for five years. Sanford Weill, the boss of Citigroup, boasts of the “blood oath” that he and the company's other executives must take. As long as they run the company, Citi's top dogs must keep three-quarters of any shares or options that they receive. Between them, Citigroup's board of directors and senior managers own 85m shares, worth a staggering $3.2 billion.
There is a happy coincidence at work here. Because of the slumping stockmarket, options were in any case becoming less popular. Chief executives already have their drawers full of worthless options. Increasingly, they prefer straight shares, says Mr Chingos, because even if the market falls, shares are still worth something.
Stock-holding restrictions, meanwhile, typically lack bite. Few companies can match Mr Weill's blood oath. Much more typical are rules requiring chief executives to own company shares worth, say, six times their annual salary.
Another test of reform is the way companies choose to present their accounts. Here, shareholders are demanding more “honest” numbers, designed to illuminate, rather than disguise, the profitability of businesses. The decision by Coca-Cola, AMB and others to expense stock options is the first big sign that companies are beginning to take these calls seriously.
Employee stock options are not a huge cost at Coca-Cola, however. By the company's own calculation, expensing them would have knocked just $200m off its profits in 2001. West-coast technology companies, such as Microsoft and Cisco, will find it harder to follow suit. Cisco, for instance, calculates that the options it dished out to its employees last year had a value of $1.7 billion. The Business Roundtable, a trade organisation for chief executives, remains opposed to options-expensing, on the dubious argument that there are so many ways to calculate their cost. Elsewhere, “pro forma” accounting—the selective (and usually flattering) removal of certain costs in calculating “core” profits—remains far too common.
A final test of reform is change in the boardroom. One effort has been to strengthen outside directors as a counterweight to over-mighty bosses. As part of the proposed changes to its listing requirements, the New York Stock Exchange (NYSE) wants to make boardroom “executive sessions” without the chief executive compulsory, a change that corporate-governance activists think might help to restore some balance to the board.
It was thought that these executive sessions would arouse controversy. As it turns out, chief executives have put up little resistance, says Leon Panetta, a former White House chief of staff who sits on the NYSE's board. Given the news, he chuckles, bosses are not in much of a position to complain. David Nygren of Mercer Delta, a consultancy, thinks this change could help to entrench the role of a “lead” independent director, America's answer to the separation of the role of chairman and chief executive that has already happened in many British companies.
Supporters of greater government intervention might argue that these achievements are slender. But several points are worth bearing in mind. It is still too early to tell how far companies are willing to go. Cynics will say they are playing the same waiting game as the politicians. The economy could recover, the markets might bounce back and America might invade Iraq. All three events would lessen the impetus for reform. But America's capricious shareholders, whom bosses serve, might also change their minds, and once again stop caring about greedy bosses. After all, a couple of years ago, none of this mattered to them. “We have sought leadership in corporate governance for years,” says Hamid Moghadam, the boss of AMB. “Nobody noticed until a month or two ago. All of a sudden, everybody cares.”
Posted by DeLong at July 22, 2002 10:35 AM | Trackback