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Executive Stock Option Plans
"If the company does not do better than its competitors, but the stock market goes up, executives do very well from their stock options. This makes no sense." Discuss viewpoint. Can you think of alternatives to the usual executive option plan that take the viewpoint into account?
Executive stock options are performance-based incentive plans that became popular in the 1950s and 1960s. They declined due to the stock market crash of the 1970s, but returned aggressively returned in the 1990s (Kole, 1997). Today, most companies grant stock options to their top officers as part of executive compensation, along with salary and bonuses. Options that are awarded as part of a compensation package can be very valuable to executives when stocks are performing well. The challenge comes in when stock value is realized for executives even when a company is not faring well at all. This is problematic.
In general, long-term incentive compensation for executives may include basic stock option rights, restricted stock grants, and cash payouts from long-term incentive plans (Parrish, 2008). An option award is basically the right to purchase company shares at a fixed price. Most vest over a 3-5-year period. Restricted stock awards for executives involve the restricted resale or transfer of a fixed quantity of shares that have forfeiture clauses invalidating the award if the executive voluntarily or involuntarily leaves an organization before the restrictions lapse. General stock options are much more flexible; restricted stock award redemption has greater constraints and as a result, less incentive value to the executive.
In the mid-1990s, nearly one-third of executive compensation was in the form of basic stock option awards vs. one-fifth during the 1980s (Kole, 1997). In recent years, stock-based remuneration has come to comprise the most profitable portion of executive pay. The original idea was that the value of options would rise parallel to stock market price increases. In most cases, the options have no value if there is no rise in share price. Hence, many publicly traded companies and investors regard options as one of the best compensation strategies for attracting top talent and incentivizing executives to perform well, aligning their interests with those of shareholders (Hess, 2012). However, this interest alignment does not always occur.
There is much debate regarding the ethics and ultimate value of stock-based remuneration for CEOs and other corporate executives. In particular, many investors, politicians and academics have grown critical of this form of compensation when executives are able to walk away with large stock awards in underperforming companies (Hamilton & Wise, 2008). They cite this as reward for mediocre performance. Defenders of options argue that most companies grant options judiciously and that it is the most effective means of attracting top managers and leaders (Wade et al., 1997). With aggressive competition for talent, executive salaries continue to rise across industries. Stock options, advocates say, is the best way for more cash strapped organizations to lure in highly qualified executives.
One serious criticism however, is that stock option grants can incite executives to engage in actions that ultimately provide a short-term boost in company stock. Public corporations make it more enticing for CEO's to seek short-term gains that produce stock price spikes (Wyld, 2010). This can be detrimental to an organization in the long run. Corporate scandals such as the Enron incident have brought executive compensation and stock options under the microscope. According to Cicero (2009), "...the scandals at Enron, Tyco and other corporations have alerted investors...to how severely [executive] stock option plans can dilute both their stakes and their companies' earnings." The Sarbanes-Oxley Act of 2002 was created to ensure ethical accounting practice and improve regulation of corporate governance. Compliance is mandatory for all firms, both large and small. Yet, despite the presence of such new regulation and penalties executives may still manipulate the exercise of options to their personal benefit based on their personal knowledge of the organization (Collins et al., 2009). Many executives exercising stock options often avoid selling shares on the open market. They may utilize other alternatives such as selling the shares back to the company or holding them for the long-term (Cicero, 2009).. The assumption that stock options will be sold in the open market may skew interpretations about the practice and cost of options as part of total executive compensation.
Many firms are forced to address such concerns by including executive stock options on corporate financial statements because of the potential impact they can have to the financial health and prosperity of an organization (Parrish, 2008). Stock option awards are now subject to valuation and representation on a firm's balance sheet. This practice, however, did not become standard until June 2005. Before this, stock options were touted as being an inexpensive form of compensation for top talent. Now that options are subject to expensing, the idea of executives receiving hefty options in underperforming companies is receiving much more scrutiny.
Executive stock options result in higher total compensation typically only if the stock price increases between the grant date and the exercise date, providing executives with an incentive to participate in behaviors and activities that increase the market value of the firm (Wade et al., 1997). Defenders also offer that due to the vesting requirement associated with stock options, their use decreases the likelihood that executives will voluntarily leave an organization resulting in high executive turnover. Corporate proxy statements often contain such justifications for the compensation scheme of a particular company. A 1992 study analyzed proxy statements across a sample of companies and revealed that total compensation does not correlate with executive level loyalty to a company (Murphy & Zimmerman, 1993). The study refutes the claim that high CEO compensation is a tool to retain managerial talent.
Another debatable element of executive pay practices is that of board selection. In many organizations, CEOs choose board members, and in most instances they select those whom they can count on to support large bonuses and stock-option plans for top level management (Hamilton & Wise, 2008). In a perfect world, boards of directors would simply seek the most viable candidate for an executive role and pay them a competitive wage. However, when CEOs influence board selection, board members are faced with a conflict of interest.
Opting not to pay predominant CEO rates and simply hire other qualified executives can be risky. The end consequence may be less than optimal business results due to the output of a less-qualified candidate. In addition, over 70% of CEOs also serve as Chairman of the Board (Wyld, 2010). This raises certain ethical questions regarding management of the interests of the shareholders, employees, and other stakeholders when the compensation arrangements between executives and their respective boards are self-managed. Sadly, if board members fail to "play along," they often risk losing their positions, fees, and the prestige and power that comes along with board membership (Cicero, 2009). Despite a less than stellar performance, CEOs and other executives can still manipulate the system to take advantage of stock options.
There are many cases where when stock prices have fallen, boards of directors have simply changed the rules. Known as "repricing" this practice is one way in which an organization can move the goal post so that existing "underwater" option prices are lowered or backdated (Collins et al., 2009). Sometimes newer options are issued with a lower strike price. It is the board of director's job to govern these options, which is why it is so important for a compensation committee to be completely separate from management (Parrish, 2008).
The intent of repricing, according to defenders, is to help in the retention of valuable executives (Wade et al., 1997). It is supposed to encourage them to improve their performance when stock values erode. However, three separate studies have indicated that over a two-year period after repricing, CEO turnover was approximately twice as high for repricing firms compared to a matched group of firms that did not reprice (Murphy & Zimmerman, 1993). Critics refute that backdating stock encourages the retention of executive level talent. They argue that repricing "alienates shareholders and other workers of the company who are left unprotected from the adverse economic consequences of a stock price decline" (Wyld, 2010). Adding additional shares into an already depressed market contributes to increased dilution of shareholder value.
Another consideration is that repricing transfers wealth from shareholders to executives, which raises ethical questions regarding the redistribution of wealth during business downturns. The practice seems contrary to the original goal of aligning managers' and shareholders' interests. Critics posit that it is unethical to allow executives to receive a refund for fallen stock when companies are not performing well while other shareholders lose money (Cicero, 2009). In short, executives get paid no matter what. Even if their performance has been lackluster (which may be the reason for the low stock price in the first place), repricing will still provide them with rewards.
It is estimated that about 11% of companies repriced stock options between…[continue]
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