Now that an underperforming stock market and the excesses of Enron have focused new attention on the use and abuse of stock options as a way to incentivize senior managers, what changes, if any, should companies make in their design of compensation packages?

The short answer: It depends on the philosophy and goals of the company. The long answer: If the purpose of compensation packages is to retain and reward senior executives as well as ally their interests with the interests of shareholders, the package should contain an equity-based element – most likely stock options – perhaps in conjunction with ‘soft’ measures like improving customer satisfaction. In addition, more attention should be given to instituting safeguards to thwart the types of stock price and accounting manipulations that have recently made headlines.

Whatever the answer, it’s clear that effective compensation packages for CEOs and top executives do not come pre-packaged or rubber-stamped. As Wharton accounting professor David Larcker puts it: “A lot of economics drives compensation decisions. But the truth is, much of it remains an art form.”

In his view, a compensation program should be balanced by some base salary, some annual bonus and some stock options or restricted stock, because each of these provides different incentives. “If there is a short-term goal like lowering employee turnover, that is something you can incentivize using the annual bonus,” he says. “If there is a long-term goal such as developing a succession plan, that can be incentivized using the stock options.” Of course this “presumes that stock price is a fair representation of the value of the company, which at any one point in time,” Larcker adds, “can be difficult to determine.”

Stock options came into prominence during the 1980s and 1990s when companies realized that by requiring CEOs and top managers to invest a large portion of their personal wealth in firm equity (stock and stock options), these individuals would have the same objective as the shareholders – maximizing stock price.

Under the old system, popular during the 1970s when stock returns were flat, firms used accounting-based bonus plans to pay executives “even if the stock price wasn’t going up,” notes accounting professor John Core. The upshot was “a lot of executives who were being paid well even though shareholders were not benefiting …The big takeover and LBO wave in the 1980s changed this and forced managers to tie their wealth back to the shareholders.”

$10 Million Jackpots

And for the most part, this approach appears to have worked well. The vast majority of large U.S. firms offer stock options to their CEOs and upper level managers, and in many cases to middle and lower level employees as well. More than half the country’s 200 biggest companies gave their chief executives option packages worth $10 million or more in 2000, according to a study by Pearl Meyer & Partners, an executive compensation consulting firm, that was quoted in the New York Times. In addition, close to 60% of chief executive pay that year was in the form of option grants.

The average executive compensation figure overall for 2001, according to Pearl Meyer, was $10.46 million, down 4% from 2000. Companies continued to increase the options they gave to CEOs, although each option had a lower value because of the stock market’s poor performance, the Times noted, adding that on average, the value of option grants fell seven percent, to $6.02 million.

Part of the appeal of stock options for companies is that they generally aren’t expensed for accounting purposes. And for employees, stock options offer the possibility of eventually making substantial amounts of money (and of course, losing substantial amounts as well, although presumably the incentives to work harder and smarter are now heightened).

Indeed, some observers see stock price as the only means of providing incentives to chief executives. “Most CEOs own so much stock that they do not receive meaningful incentives from variation in their annual pay,” says Core. This makes it unlikely that “anything other than changes in the stock price motivate the executive.

“Even if a CEO’s bonus varies based on accounting or non-financial measures, this variation is small compared to the variation in his or her stock and option portfolio,” Core notes. “For example, if a CEO can make $10 million by increasing the stock price, or he can make $100,000 by increasing some non-financial metric, which will he do? If the right way to increase the stock price is to increase some non-financial metric, then the CEO’s stock ownership will motivate him to increase this metric in order to increase the stock price.”

Management professor Martin Conyon agrees, in general, with the power of stock options, even at a time when the market has suffered through two relatively flat years and the options of many firms are worthless (underwater). “If you tried to think of any other instrument that is better than a stock option, I bet it would have a legion of flaws,” he says. “Throwing away options because you worry that in bear markets they would have some sort of undesirable properties” ignores the fact that they are still a viable form of compensation.

Manipulating Stock Price

Options, however, have recently come under scrutiny for a number of reasons. Some observers point out that options tend to be overused because they receive such favorable accounting treatment, raising the issue of whether firms “should reasonably start considering restricted stock” as a more preferable strategy, says Core.

That issue, however, may well be taken care of by outsiders. According to CFO magazine, The International Accounting Standards Board recently proposed that stock options be expensed. The IASB is responsible for establishing common accounting rules for companies in the European Union by 2005, and eventually for the U.S. and other countries as well. In addition, the magazine reported, starting in April, the SEC is requiring companies to include tables in their 10-K reports disclosing information about all employee stock option plans, not just ones approved by shareholders.

In addition, as noted in a recent New York Times article, due to the large number of option grants made during the stock market bubble, the number of shares outstanding grew sharply, thereby diluting per share earnings growth. The grants, along with the acquisitions and stock splits, have contributed to huge share growth in companies, or what the Times calls ‘share inflation.’ Meanwhile, Berkshire Hathaway chairman Warren Buffett has publicly blasted stock options because, he says, the practice of repricing options for top executives unfairly rewards them at the expense of shareholders.

And then there is the pressure to manipulate stock prices in order to increase the value of the options. “You assume that these performance measures – whether they are stock price or customer satisfaction – have been computed using a known and agreed upon set of rules. Once these are manipulated, all bets are off,” says Larcker.

Every once in a while, Core adds, “there is a failure of internal control systems which allows management to perpetuate a fraud. Through fraud, managers can temporarily manipulate the stock price.” While the fraud allegations at Enron have not yet been proved, he points out, confirmed frauds include CUC International, HBO Inc., Sunbeam and Waste Management. “But these types of frauds are unusual,” Core says, “and the reason they are unusual is that the SEC and U.S. security laws are set up to prevent them.”

Mark Ubelhart, practice leader for value based management at Hewitt Associates in Lincolnshire, Ill., puts it this way: “Most of the available analysis suggests that the capital markets are efficient … and that the human capital markets [CEO and top management level] are somewhat efficient, but not as efficient as the capital markets. So I think there is risk of abuse of stock options.” That risk, he says, “indicates the need in this area for some extra controls or regulation” in addition to the corporate governance controls that already exist.

The big question of course, is just how much stock prices are manipulated and how? “Clearly there is pressure to do this,” says Larcker. For example, “before a big stock option grant CEOs and/or senior executives may try to drive the stock price down. Or right before they exercise their options they may try to drive the stock price up. But ultimately this kind of manipulation gets discovered. Once an executive starts exercising his options and selling the underlying stock, that comes under tremendous scrutiny. Is it reasonable to think that executives, if they have big equity positions, could manipulate the stock up and get the cash out before it catches up with them? Probably not.

“In addition, there are only certain times of year when they can actually engage in sales and exercise of options. If there is any suspicion of manipulation, the penalties can be severe …. What seems to be clear is that while stock fraud can and does exist, it is usually a short-term phenomenon.” If someone within the company decides to commit a fraud, Core adds, he or she can fool the board of directors but it’s usually temporary and comes about because the senior managers at that point in time have “too much power over the board.”

Enron as Cash Cow

Since no one seems to be suggesting that stock options be thrown out as a form of compensation, the question becomes, how big a role should they play and how can abuses of stock options be minimized?

Ubelhart suggests indexing stock options – a concept he first proposed in 1981 and which was also the subject of a Harvard Business Review article last year– so that an executive would gain only if the stock outperforms the market or a peer group. Indexing avoids a situation where an executive profits if the stock price goes up 10% even though the market as a whole goes up 15%.

Some companies, however, will say that if the shareholders benefit, so should their executives, even if the reason is overall aggregate market movements or economic trends over which shareholders and executives have no control. “Compensation philosophy determines the outcome in these situations,” Ubelhart notes. (Because indexed options produce an accounting charge to earnings that does not occur with more traditional stock options, they have yet to become a popular form of compensation.)

The other consideration, Ubelhart adds, is timing. In Enron’s case, “a lot of shareholders got rich temporarily, and the executives got rich temporarily, but many of them cashed out and kept the money. Later on shareholders lost everything. So while there might have been good alignment for a while, that didn’t last. It’s a question of long term vs. short term. How can we be sure that the compensation package is oriented long-term enough so that those kinds of short-term blips – somebody making a lot of money who doesn’t deserve it – don’t happen?” Ubelhart asks.

In designing a compensation program, he says, you can always take steps like stretching out the exercise period of options or granting restricted shares that have long-term vesting. The extreme of this is what often occurs in private companies where compensation packages for executives who are not owners or family members have a very long-term focus that allows them to reap gains only when they retire. Such an approach “ensures that these professional managers think long-term,” Ubelhart notes.

“It gets down to trying to balance the time horizons of the executives with the time horizon of the owners,” he adds. “In a private company there are few owners. In a public company there are multiple owners and they have multiple horizons. Again, there is no single answer.”

For Core, part of the solution lies in prompting the board to better analyze the CEO’s portfolio to ensure that he or she has enough wealth invested in the stock price. “When a CEO has too little wealth in company stock and then is required to increase that wealth, the firms perform better,” he says. On the other hand, having too much wealth in firm stock might make a CEO “very risk averse … For example, research indicates that when CEO wealth is too highly concentrated in stock, CEOs might undertake diversifying acquisitions, which have the effect of lowering the CEO’s risk but also reduces firm value.”

Conyon, like others, suggests looking more closely at the plan’s vesting requirements. “Executives currently have three-year vesting requirements and vesting schedules tend to be linear; a certain percentage vest each year up to four years. One possibility is 25% per year over a four-year period. You could make it stronger by allowing no vesting in the first two years and 50% in years three and four. That makes it much tighter. So rather than delivering plain vanilla contracts, compensation committees and compensation consultants should be more innovative in the contract design.”

Of course what makes incentive packages so complicated, he adds, is that “it isn’t just about options. It’s about the whole gambit of organizational incentives generally, including attraction and retention incentives, incentives generated by career concerns, incentives that have nothing to do with stock or stock options and so forth. All these things have to be worked out simultaneously.”

Larcker points out that many companies have “omnibus plans where they get stockholder approval for a variety of compensation vehicles and at the discretion of the board can either use them or not use them.” But the big push now, he adds, “is to get stockholders to approve the grants on an individual basis rather than give blanket approval for options in general. We will see how this plays out in the case of Hewlett Packard and Compaq. What’s clear is that stockholders no longer give rubber stamp approval for that kind of merger.”

As for shareholders and options holders in companies that have recently hit the skids, Core places the blame, in part, on an unquestioning public. “Anybody who looked carefully at the financial statements of Enron would have never believed the stock should have been as highly valued as it was,” he says. In the late 1990s there was a brief period “when some investors were throwing money at stocks they didn’t understand because they hadn’t bothered to do any analysis of the company. The dot-com bubble is a prime example of this type of behavior, and Enron marketed itself as a ‘New Economy’ company. For some reason, investors never stopped to consider that commodity trading is a very competitive, low-growth business. If a segment of the market place ignores the information the accounting system provides them, better accounting won’t help.”

A Balanced Scorecard

As the merits of stock options continue to be debated, Larcker suggests that some companies are starting to supplement the traditional financial measures used in compensation – such as accounting earnings or stock price – with other ‘softer’ measures, such as increasing customer loyalty, retaining high-level scientific staff or stepping up new product development. “If you believe that stock price is an imprecise measurement, then you should look at other key drivers of value in the company. They help find a balance between hard core financial numbers and things that are expressed in some other kind of unit.”

Ubelhart agrees that soft measures can be a valid part of a compensation package, as long as you can “prove their linkage to long-term value creation.” At Hewitt Associates, for example, the company focuses on “‘engagement of employees,’ meaning how long do employees stay with the company, do they say good things about it and do they strive to go the extra mile. We have a lot of statistics that measure this. So if a company can establish such a metric the board or the board’s compensation committee should think about tying it to compensation … It’s part of the balanced scorecard approach, the idea that results other than purely financial ones are important leading indicators of long-term performance.”

As Ubelhart says, the trick is establishing the importance of the metric to long-term shareholder value. If you don’t, says Conyon, then when you make cash payments “dependent on a metric like customer loyalty, the manager is incented to focus on making that metric rise. That doesn’t necessarily make real customer loyalty rise, however. So these other yardsticks are fraught with measurement problems of their own, perhaps even more so than the metric underlying equity-based compensation.”

Larcker suggests that one somewhat extreme course of action is the adoption of a “completely subjective scheme. The board could write a formula for the CEO that would make his or her bonus dependent on certain specific courses of action and target goals. But problems could arise when the board decides, for example, that certain developments were out of the CEO’s control, or there could be favoritism or sucking up involved. In general this approach places tremendous pressure on the expertise of the board to make performance assessments.”

One other theme in the whole question of compensation is shareholder value creation, an idea that has been evolving in the last two decades and which two years ago inspired a book called The End of Shareholder Value: Corporations at the Crossroads, by Allan Kennedy. “It refers back to some of the dot-com experiences and also is relevant to the Enron situation in the sense of asking, ‘What is shareholder value?’” says Ubelhart. “Is it maximizing stock price next quarter, and if we do that can we only do it by maximizing our earnings next quarter? In other words, it is taking a very short-term myopic perspective. Or does shareholder value mean positioning companies to create long term economic value for years and years?

“A true shareholder value advocate, of which I am one, would say that shareholder value is a long-term concept, not a short-term manipulation of earnings,” says Ubelhart. “Therefore, when you think about compensation plans, pick the metrics and focus the plans so they align themselves with long-term shareholder value creation. In some cases stock options can serve that purpose. In other cases you might need to look at cash flow, return on investment and cash value added – all the better economic measures. This kind of approach has been popular and will become even more so because of the recent criticisms of stock options.”