To avoid future Enrons, cut out stock options
By CARMEN R. THOMPSON
The Houston Chronicle
Jan. 29, 2002, 6:14PM
So far overlooked, but fundamental to the discovery of the truth surrounding Enron's collapse and Arthur Andersen's alleged culpability, is the usefulness of compensating certain key executives with stock options.
The pros and cons of extraordinary compensation given to top corporate executives have been written about and debated ad nauseam, but the components, methodology and motivations that underlie such compensation schemes are rarely examined. How should executives be compensated? Do stock options give management appropriate incentive? If so, are more options better than fewer? Should executive compensation be limited in some way?
Stock-option grants are supposed to align management's interests with the interests of shareholders; i.e., if executives are shareholders, they will be more inclined to make decisions that benefit all shareholders. What this theory misses is the fact that investors actually put money on the line while executives with stock-option grants do not.
Most executives see stock options as a form of compensation -- and importantly, compensation for work already performed. After all, stock options vest over a period of time. This view is in direct contrast to an investor's hope that future performance will cause his investment to rise in value. (If an investor doesn't anticipate good future performance, he sells his investment.) Investing involves risk, whereas stock options are riskless.
Some executives would argue that stock options can comprise a significant amount of compensation and are, therefore, a significant source of risk. However, executives are also paid significant salaries and bonuses in cash, mitigating much of their personal financial risk should stock options prove ultimately worthless. Investors in common stock are (usually) not paid partially in cash, but instead, have their entire investment riding on future capital appreciation.
Stock-option plans, or SOPs, can also be manipulated (and often are) by management teams to compensate executives even if the stock price falls. Most SOPs allow managers to grant themselves stock options at any time, for almost any reason. If the stock price falls significantly, management can grant itself options at the new, lower price. Because management usually has sole discretion (with a wink and a nod from the company's board) as to when stock options are granted, executives can take advantage of dips in stock price to grant themselves options on the day the stock hits an all-time low. If you think this is a rare occurrence, ask yourself how many times you've seen a company publish, in advance, the dates it plans to issue stock options. Wouldn't investors be more confident that management was taking a long-term view if a company published the dates of planned stock-option grants one, two, three, five or 10 years in advance?
Investors believe that management has ultimate control over the stock price, and therefore, ultimate control over the value of stock options. This is a long-term view, however, and executives are more short-term in outlook. Experienced management teams know that they can make all the right decisions and still have a stock price that isn't very high due to, among other things, general market conditions. Therefore, to management, stock price cannot be controlled. However, the number of stock options can. For executives, it is better to issue lots of stock options that ultimately have a little value each than it is to issue a few stock options and wait for higher long-term value to be realized.
The common sense of good public policy does not allow accounting and audit firms to be paid with company stock or stock options because doing so creates a conflict of interest and compromises the integrity of the data these entities provide to the public. However, the same standard is not applied to individuals inside public companies who ostensibly have the same duty to the public, such as the chief financial officer, chief accounting officer, general counsel and other employees responsible for preparing documents filed with the Securities and Exchange Commission. Logic dictates that these individuals should be held to the same standard, given that the same conflicts of interest can (and, in the case of Enron, do) arise. Wouldn't it be better for investors to be able to ask the CFO questions regarding the finances of a company and know that the CFO has no (or at least, less) incentive to hide material facts?
Material financial facts would also become more visible if the CFO of a public company reported to the company's board of directors instead of to the CEO. Direct reporting to the board would almost certainly result in better disclosure and more unbiased reporting of an entity's financial situation because the CFO would no longer have to traverse political waters involving his or her own boss.
Most investors believe that directors ask the right questions and make decisions based on all available information. Investors believe this because, theoretically, the board has ultimate responsibility to the investing public; but a board is only as good as the inquisitiveness of its members and the information it receives from management. Since most chief executive officers sit on the boards of their companies and most CFOs do not, the information a board receives regarding financial matters has usually been filtered by the CEO (usually to fit the CEO's agenda). By having the CFO report directly to the board, the board would gain insurance that they were receiving an unbiased assessment of material financial details.
The healthy debate this arrangement would foster regarding a company's potential acquisitions/investments would undoubtedly result in better allocation of capital across the company, and would better balance the power between CEOs (the keepers of the vision) and CFOs (the keepers of the financial facts).
The benefits of such a reporting arrangement can easily be seen by examining Enron's situation. If Enron's CFO, Andrew Fastow, had reported directly to Enron's board and been compensated with cash only (not stock options), would he have taken the financial risks he took with shareholder money? If Enron's lead auditor, Arthur Andersen, had had a closer relationship with Enron's directors instead of with Ken Lay and Andrew Fastow, would Andersen have stretched the rules as far as they allegedly did? The answers are obvious. A better balance of power should (and can) exist in America's public corporations.
Unfortunately, we are all investors in Enron now, given the amount of taxpayer dollars being spent by chest-beating public officials vowing to "uncover the truth." Enron should serve as the warning, as well as the catalyst, for much-needed change in the rest of corporate America.
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Thompson, who lives in Sugar Land, is a chartered financial analyst and a consultant to institutional investors. |
