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Strategies & Market Trends : Zeev's Turnips - No Politics -- Ignore unavailable to you. Want to Upgrade?

To: Timothy Liu who wrote (98561)	8/26/2002 6:30:58 PM
From: Don Green	Read Replies (1) \| Respond to of 99280

If Stock-Options Grants Didn't Work, What Will? By MICHAEL CASEY DOW JONES NEWSWIRES Aug 26,2002 Until recently, conventional Wall Street wisdom held that stock-option grants were the most effective compensation tool available for aligning top management's interests with those of shareholders. It took the painful bursting of the stock-market bubble and a slew of corporate scandals for investors to learn that this idea was way off the mark. "Some of the things that people held as basic truths are being questioned, and rightfully so," says Raymond Miles, an expert in organizational behavior who is professor emeritus and a former dean of the University of California at Berkeley's Haas School of Business. But does that mean executives should be discouraged from holding large equity stakes in the companies they manage? At universities around the country, economists and business-administration professors have been debating this question for decades and have produced reams of research, most of which show no clear correlation between corporate performance and big stock-option grants. Nevertheless, some of the most prolific economic researchers on the subject still believe that ownership incentives, although not necessarily options per se, are a useful tool. One common explanation for why options haven't lived up to their promise is that they don't work in a falling market. Options may encourage executives to shoot for ever-bigger gains when they are priced profitably, critics say, but they offer no incentive to limit losses when share-price declines drive them "underwater." In fact, according to Brian Hall, an associate professor of economics at Harvard Business School who has written extensively on incentive plans, this "fragility" of the options incentive model has had the perverse effect of fueling bigger options grants. He notes that many companies whose shares fell below option exercise prices in the 1990s would typically give much larger grants in subsequent years to restore the incentive power of their executives' portfolios. Mr. Hall still believes equity-based pay plans of all stripes are superior to cash-only compensation programs, whose limitations were exposed when leveraged buyouts in the 1980s showed that managers with an ownership stake could aggressively turn failing companies around. But he argues that the establishment of ownership incentives should be handled with stock grants, not options. Indeed, it is widely acknowledged that options have been favored not because of their superiority as an incentive tool but because, unlike stock grants, they don't have to be expensed. This special accounting treatment has made them only more complex and harder to understand, a feature that Mr. Hall says executives have exploited. How else, he asks, to explain why Apple Computer's board agreed one year to an options grant in excess of $500 million for Chief Executive Steve Jobs? "Try telling me a convincing story about why such a package was needed for attraction, retention or motivation and you can't do it," he says. "That looks like a board that was asleep." Apple declined to comment. The accounting exemption that Washington lobbyists have fought well to retain is an example of what economists such as Mr. Hall would call an "externality," an outside factor that creates a market inefficiency. In this case, the distortion boosts the attractiveness of options over other forms of compensation, even though these may offer more powerful performance incentives. Meanwhile, an inefficiency that has always plagued financial markets -- an inequitable distribution of access to information -- has also undermined options' effectiveness. Corporate executives have always been the ones with the most privileged information; what the options revolution of the early 1990s did was to give them the wherewithal to exploit it. After that, courtesy of ill-informed shareholders once again, another market inefficiency emerged that gave them an incentive to do so: the stock-market bubble. Since then, proposals to avoid creating such temptations have abounded. Among the more draconian is one supported by Ira Kay, a compensation consultant at Watson Wyatt. "We think that creating more direct stock ownership, where executives would be required to buy shares and hold, perhaps on favorable terms, is the way to go," Mr. Kay says. That a large management-consulting firm is floating such a radical idea, one that treats executive share ownership as a duty, not a right, shows how far the pendulum of opinion has swung against options. After all, many compensation consultants were among the strongest promoters, and beneficiaries, of options-based pay schemes.