One Way to Settle the Controversy over Stock Options: Eliminate Them

On August 28, Cendant announced that it would soon begin to expense stock option grants. In doing so, the company joined a long list of businesses that were breaking with the traditional way of reporting a type of compensation. But on the same day, Cendant also made another announcement: It expected to reduce the issuance of employee stock options and instead utilize grants of restricted stock (securities that are granted subject to certain voting and transfer rules, time constraints or other limitations). That decision has placed Cendant – a New York-based real estate and travel conglomerate with revenues last year of $8.9 billion – in the vanguard of a movement to reject option-based incentives and return to a more traditional way of rewarding performance.

 

Some Wharton professors, however, question this approach, warning that abandoning stock options altogether could ultimately hurt a company’s performance. They say that despite recent allegations of abuse, stock options remain a valuable way to get managers to perform at their peak level. Yet they also add that the current model of awarding stock options should be tweaked to help ensure that top-level executives concentrate on turning in meaningful long-term performance rather than attempting to simply dress up short-term numbers.

 

For the most part, recent news stories about stock options have focused on the pressure that investors, politicians and board members like Warren Buffett have brought to bear on companies to reflect the value of compensation-based stock options on their income statement. Typically the disclosure has been relegated to footnotes which can be easily overlooked by users of financial statements.

 

Responding to that pressure, companies – ranging from Allstate and General Electric to General Motors and the Washington Post – have indicated they will now record the value of compensation-based stock options on their income statements.

 

Cendant’s announcement – that it would reduce the use of options – apparently didn’t get much exposure in the media. But that doesn’t mean the movement away from stock options has no supporters. For example, Charles Peck, compensation specialist at The Conference Board, sees an emphasis among businesses and investors on returning to what he calls real financial performance. “There’s a move to get away from the short term vagaries of the stock market and stock option-based compensation,” he says. “It should be replaced with a bonus or other incentive payment that consists of money or equivalents.”

 

James A. Knight, a senior executive compensation consultant with Mercer Human Resource Consulting, argues that stock options encourage stock performance, which may not always be driven by operating performance. In a recent issue of the Journal of Business Strategy, Knight observed that “Shareholders want executives to continue to drive operating performance, regardless of what the stock price does.”

 

He says that while stock options are “performance pay” (in that if the stock performs, the executive will be paid), a different model consisting of pay based on operating performance “may provide better opportunities to align executive interests with shareholders’ interests. Does this mean executives will be paid less? No, but the way in which they are paid will change. Pay for performance is pay directly tied to operating performance” and can be delivered in multiple forms, “including stock, options, and/or cash.”

 

Operating performance refers to the financial activity (typically some measure of income or loss) posted by a company. In contrast, the rise or fall of a company’s stock price – which could be influenced by external considerations, future expectations and other factors – may therefore not always move in tandem with the company’s underlying operating performance. By moving to a compensation structure that relies more on stock grants and less on stock options, Cendant appears to be adopting a strategy that is at least similar to the one that Knight has championed. But will other companies fall into line?

 

Peck says he can’t answer that question yet. “It’s too early to tell if Cendant is a leader or if it is unique,” he reports. “It wouldn’t surprise me if other companies follow the example, though. Part of the push is the pressure to expense stock options, which may equalize, on financial statements, with other forms of compensation. Also, although troubles at companies like Enron and Worldcom were not directly tied to options, there is an air of disenchantment with options that appears to be traced to the publicity generated by” what went on at these companies.

 

Incentives to reduce the reliance on options also may get a boost from reports like the one carried recently at CFO.com, which quoted Bill Miller, manager of Legg Mason’s flagship Value Trust fund, urging the total elimination of employee stock options. Saying it would improve investor trust, the publication noted that Miller supported a ban on stock options, “because anything that can be accomplished with options can be accomplished by giving stock directly. And it has none of the downsides of options.”

 

The billions of dollars under Miller’s management, and the fund’s reputation as the only one to beat the S&P 500 for each of the past 11 years through 2001, add considerable weight to his statements. Despite this, John Percival, an adjunct finance professor at Wharton, disagrees. In his view, stock options – when structured and utilized appropriately – are an effective way to compensate managers. “Stock grants reward managers no matter what happens to stock price because the stock is worth something,” he says. “Options, if they are indexed properly, reward managers only for value creation.”

 

He does say, however, that unlimited stock- and option-based compensation could lead to ineffective behavior on the part of management. “Managers who have lots of stock and lots of options are not diversified and therefore do not think like shareholders who are diversified,” explains Percival. “There are certain risks that diversified shareholders would want managers to take that they will not take if all of their wealth (human capital and other) is tied up in one company.”

 

Similarly, Wharton accounting professor David F. Larcker believes it would be a mistake to eliminate stock options as a form of compensation. However, he believes that the current practice of granting stock options that are intrinsically valuable because they are “in the money” (i.e. the market price of the underlying security is above the “buy” price of the option), will eventually be replaced by a different model.

 

“Simply eliminating stock options as a form of compensation is a naive idea, and is a knee-jerk response to a perceived problem,” he says. “First, improper corporate behavior is not entirely due to stock options. Further, research indicates that options provide important incentives to executives, and are an integral part of the compensation program.” But he does expect a rotation from “in the money” options to ones that are priced at a premium, or are “out of the money” (essentially, options that carry an exercise price that is higher than the current market price).

 

The basic issue, according to Larcker, is to encourage managers to pursue growth. He notes that his recent, on-going research with Wharton accounting professor Richard Lambert indicates that premium options provide a better incentive for executives than in-or-at-the-money options. “Lots of options should be awarded,” he says. “But the exercise price should be well above the current price – higher by 50% or more.”

To realize the benefit of such options, managers would have to make profitable investment decisions and convince the market that the company (and, in turn, its stock) is worth intrinsically more than its current valuation.
 He notes, though, that even if a company’s business model and strategy are solid, a drop in the overall stock market can also drag down the shares of a well-run company. “It would be wise to have a competitive program with lots of incentives to shield against this scenario,” he says. “It’s a good way to discourage financial shenanigans.” The trend toward premium-priced stock compensation is growing, he adds, with about 50 companies including Air Products & Chemicals, Baxter International, Chubb, and Gap adopting this approach.

 

One way or another, a combination of factors – ranging from the shaky post-9/11 economy to recent scandals affecting former corporate icons – appears to be driving a variety of changes in the way that business is conducted and reported. It may be premature to say that stock options will either be eliminated or radically changed, but it also may be safe to say, as Mercer’s Knight did, that “Mega-awards of stock options and special arrangements for executives, as was done at Global Crossing, are a thing of the past.”

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