(art) Options and Execuitve compensation;
nytimes.com
April 2, 2000
REPORT ON EXECUTIVE PAY
Will Today's Huge Rewards Devour
Tomorrow's Earnings?
By DAVID LEONHARDT
Over the last 15 years, as executive pay has soared and each new
plateau has met with something of a public outcry, America's
business leaders and their supporters have had a ready answer for the
critics: Look at the stock market.
In 1988, when the average pay of chief executives at large companies
first topped $2 million, the Dow Jones industrial average ended the year
at 2,168. By 1995, when average pay hit $5.8 million, the Dow had
reached 5,117. On Dec. 31, 1999, the end of a year in which the
average pay package reached $11.9 million, the index closed at 11,497.
The two numbers have enjoyed a
symbiotic relationship, the
executives argue, as the promise
of wealth, in the form of stock
options, has inspired them to
create efficient companies that
are driving the longest economic
expansion in American history.
To a large extent, the debate is
over, and the executives have
won.
Companies in Europe and Asia
are starting to mimic the
American system by raising
salaries and awarding more
stock. Dot-com billionaires have
made the fortunes of some
old-line executives look
moderate. And eight years after
Bill Clinton made exorbitant
executive pay an issue in his first
presidential campaign, the topic
has disappeared from the
political scene.
Yet at this moment of triumph -- when nine-digit packages are a reality
and eight-digit annual pay is the norm -- there is a rising undercurrent of
concern over the very thing that executives credit with helping motivate
the country's stunning growth: the tremendous boom in stock options.
Over the last five years, America's companies have handed over a large
portion of themselves to the executives who run them. That has aligned
management's interests with investors, delighting those who advocate
tying executive pay to performance.
But a growing number of analysts warn that it has also created the
potential for a host of long-term problems that could undercut economic
growth.
As top executives (and other employees) continue to exercise their rising
pile of options over the next decade, other stockholders will see their
stakes watered down. It seems unavoidable. Already, companies have
spent billions of dollars in recent years -- and taken on rising levels of
debt -- buying back shares to minimize the dilution. For the repurchasing
to continue at its current pace, a recent Federal Reserve study warned,
companies would have to devote virtually all of their future earnings to
buybacks.
In essence, the skeptics worry,
corporate America is using stock
options like a credit card without
a spending limit. While every
penny in salary is recorded as a
cost on company books,
hundreds of billions of dollars in
stock options aren't counted at
all. To the fire of a blazing stock
market, companies add the fuel
of overly rosy earnings reports,
unencumbered by off-the-books
promises of future pay.
In a speech last summer, Alan
Greenspan, the Fed
chairman, said stock options
helped "impede judgments about
prospective earnings" and, over
the last five years, had caused
companies to overstate profit
growth by one to two percentage
points each year.
The level of exaggeration is on
the rise, doubling between 1997
and 1998, according to a study
by Bear Stearns. At some
companies -- including Cisco
Systems, a new-economy
stalwart that briefly last week
boasted the highest market
capitalization in the world --
earnings would be more than 20
percent lower if stock options
were accounted for.
"The dilution is a serious financial
problem, and it ought to be
getting a lot of attention," said
John C. Bogle, the founder and
former chairman of the Vanguard
Group, the big mutual fund
company.
Not everyone agrees, to be sure.
By attracting and motivating the
best workers and managers, stock options spur long-term growth at a
faster rate than they dilute a company's shares, many executives argue,
giving stockholders better net returns than they would have received
otherwise.
"I'm a great believer in stock options," said Dennis Powell, the controller
of Cisco, one of the stock market's best performers over the last decade.
In addition, companies publish their level of "overhang" -- the percentage
of the company that options would represent if all were exercised --
allowing investors to factor it into their decisions. And widely published
statistics on diluted earnings per share take into account any options that
currently have value.
But a growing number of investors remain skittish. Fund managers at
T.I.A.A.-C.R.E.F., a $288 billion pension and mutual fund company,
are more often using their proxies to vote against executive pay plans.
Over all, the proportion of such plans that meet tough resistance is up.
And a New York Stock Exchange task force has recommended
tightening guidelines to force companies to seek shareholder approval of
almost all options plans.
"For the first time, you're starting to see mainstream institutional investors
become concerned that the decade-long stock-option binge has left
companies with serious, structural earnings problems," said Patrick S.
McGurn, the director of corporate programs at Institutional Shareholder
Services, a Rockville, Md., group that advises large investors.
Even some of the consultants paid to design executives' contracts -- who
have been some of the loudest defenders of the pay explosion -- have
grown concerned.
"We're giving away more and more of the future value of the company,"
said Richard H. Wagner, president of Strategic Compensation Research
Associates.
Corporate debt, rising in large part to pay for options plans, "is the dirty
little secret of corporate America," added Ira T. Kay, the head of the pay
practice at Watson Wyatt Worldwide.
Just a few years ago, boards of directors were hesitant to set aside more
than 1 percent of a company's equity for stock options in any given year;
they generally kept the overall level of outstanding options below 10
percent.
But just as technology companies have transformed attitudes about stock
price valuations and the track record that a company should have before
going public, so have they blown through the old guidelines on options.
"The dot-com and new economy companies have rewritten all the rules,"
said Gary Locke, head of Towers Perrin's executive compensation
practice.
The rising use of stock options predates the Internet, but the remarkable
success of technology firms over the last five years has helped to rapidly
accelerate the trend. The number of millionaires, and mega-millionaires,
that technology companies have created has put the rest of corporate
America on the defensive. One response has been to ply executives with
even more options.
Last year, the nation's 200 largest public companies handed out options
that represented the equivalent of 2.1 percent of their outstanding shares,
up from 1.2 percent in 1994, according to Pearl Meyer & Partners, a
pay consulting firm in New York. As a result, the average overhang
reached 13.7 percent in 1999, well above the old 10 percent ceiling.
Since 1996, the Financial Accounting Standards Board has required
companies to include a footnote in their annual reports disclosing what
options would cost, using one or another widely accepted formula, if they
were charged as an employment expense.
Why is there a cost? In granting options, companies are allowing
employees to buy stock in the future at today's (presumably lower) price.
To make up for the discount, the companies either forgo issuing shares
for which they could have received full price, or they buy back existing
shares and forfeit the difference.
"You're buying high and selling low," Mr. McGurn said.
Of course, if a company's stock price has fallen below the exercise price
when its executives become eligible to cash them in, the executives will
not exercise them, and other investors' shares will not be diluted. But that
is hardly a trade-off most companies would welcome. When options are
under water -- as is the case at so many old-economy companies today
-- many executives either flee or demand other payments to make up for
money they had expected to get.
To date, few companies appear to have suffered from the options boom.
Strong profits have given many of them enough cash to pay for their
growth and to repurchase millions of shares. Among other things, the
buybacks have generally prevented options granted in the early 1990's
and exercised over the last few years from diluting earnings per share --
though, of course, the money used to buy the shares could have been
deployed to other ends.
From 1994 to 1998, the amount that companies in the Standard &
Poor's 500 spent each year on stock repurchases more than tripled, to
almost $150 billion, according to a Fed analysis of Compustat data.
Together, buybacks over that period accounted for about 2 percent of all
outstanding shares.
But the pace of option grants has accelerated rapidly in the last few
years, and the number of exercisable options will be far greater in
five years than it is now. As a result, the Fed study found, companies
would have no money for investments or dividends if they tried to keep
up their pace of buybacks. On the other hand, the study's authors
warned, slowing the pace of buybacks "could have a negative effect on
equity valuations."
Of course, companies could borrow to buy back stock -- a strategy for
which they have already shown a fondness. Corporate debt has risen by
45 percent over the last five years, and much of the increase is a result of
share repurchases, said John Lonski, the chief economist at Moody's
Investor Services.
Defenders of the current level of option grants point out that the growth
of the stock market has kept debt-to-equity ratios at levels that are of
little concern. Skeptics note that the ratios have risen in recent years
despite the long bull market, leaving companies vulnerable to a
correction.
The central question, though, may be whether investors have taken into
account the rising level of overhang when valuing today's market.
On one hand, the footnotes in companies' annual reports tell investors the
degree to which options could dilute their shares and offer an estimate of
the options' cost. "There is full disclosure," said Rick Escherich, a
managing director at J. P. Morgan, "and I assume it is something that gets
factored into every company."
On the other hand, the information is buried inside a document issued
once a year, in an era when the smallest bit of news about a company
can instantly alter its stock price. "We all know companies' stock price
moves on quarterly earnings numbers, not annual reports," said Pat
McConnell, a senior managing director at Bear Stearns and one of the
authors of the study that found options' true effect on earnings to be rising
(though still smaller than in some earlier estimates).
Some analysts are not even sure that individual investors find the annual
footnotes. "You've got to be pretty sophisticated to sort it all out," said
Paula Todd, who manages the executive compensation research division
at Towers Perrin. "My grandmother isn't going to figure out the
overhang."
A further question is what companies are getting for their largess.
Numerous studies in recent years have shown that companies with high
levels of executive stock ownership have outperformed companies with
low levels. Few of the studies, however, asked what the ideal level of
ownership was: Do companies get an extra bang from making their chief
executives centimillionaires, for instance, rather than mere
decimillionaires?
Noting the void, three Columbia Business School professors undertook a
study of 600 companies, examining their performance over the last 20
years. Their results, published late last year in the Journal of Financial
Economics, showed that increasing an executive's stakes in a company
did not cause stronger earnings or a higher stock price. Instead, it
appears to be other factors, like research spending, that cause a
company to perform well.
"A lot of the evidence people have cited for the link between ownership
and performance is flawed," said Charles P. Himmelberg, one of the
authors.
Another, R. Glenn Hubbard, added, "There's not much extra kick from
higher managerial ownership." The ideal level of ownership appears to
vary by company, they said.
A recent Salomon Smith Barney study, meanwhile, found that most of the
heaviest users of options in the S. & P. 500 actually underperformed the
index.
Such findings can only fuel the skepticism that already has companies
working harder to win shareholder approval of proposals for new option
plans. Fourteen such proposals, including one at Ben & Jerry's, the ice
cream maker, failed last year. More significant, one out of every seven
proposals received at least 30 percent negative votes last year, according
to Strategic Compensation Research Associates, which advises
companies on getting such plans approved. Three years ago, only one of
every 12 plans met that level of opposition.
Because many of the yes votes represent bulk votes by brokers, on
behalf of individuals who do not return their ballots, anything but a
landslide often means that executives had to lobby large investors or
revise parts of their proposals.
"It used to be that you just put your plan in your proxy," Ms. Todd said.
"Now that period when the proxy is out on the street is hell for a lot of
companies."
Even Microsoft, with years of stellar returns, saw 27 percent of its
shares vote against a small option plan for board members in November.
It would be an exaggeration, however, to suggest that investors no longer
believe in options, analysts say. "There's a general consensus that stock
options have been very beneficial to the performance of U.S.
companies," said Mr. Escherich of J. P. Morgan. "The question is: What
is the right level?" |
