CEO Options Encourage Sautéing of the Books - Pacific Standard

CEO Options Encourage Sautéing of the Books

Efforts to align the boss and the shareholder prove difficult to master and sometimes create perverse results.
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You might think a corporate CEO's job is to maximize his or her firm's profits and create value for the shareholders, but in practice, say business researchers, it isn't always quite that simple.

Depending on the types of compensation they receive, CEOs often act in ways that run counter to shareholders' interests, taking excessive risks, depressing profits and driving down stock prices. The woes — and horrendous PR — currently afflicting Wall Street may be a case in point. Even President Obama has joined in the chorus decrying executive compensation packages, calling the amounts given in the leadup to the current crisis both in "bad taste" but also "bad strategy."

Stock options, which were dispensed like candy during the dot-com boom of the late 1990s, are particularly fraught with problems, according to a recent study by business professors David B. Farber and Qiang Cheng. Because startup firms often lack cash, they are particularly prone to reward their executives with options, which are basically a promise to sell them shares of stock at a particular price sometime in the future. If at that time the stock price has risen beyond the so-called strike price, the executive can profit handsomely.

Farber and Cheng looked at 289 firms that had filed earnings restatements between 1997 and 2001, looking for links between questionable accounting and option-based chief executive officer compensation. Their study, "Earnings Restatements, Changes in CEO Compensation and Firm Performance," published in The Accounting Review, found that on average, "the proportion of CEOs' compensation in the form of options declines significantly in the two years following the restatement."

This was accompanied by changes in corporate behavior, the pair found. "[T]his reduction is accompanied by a decrease in the riskiness of investments, as reflected in lower stock return volatility and subsequent improvements in operating performance," they write. "Our results suggest that a decrease in option-based compensation reduces CEOs' incentives to take excessively risky investments, resulting in improved profitability."

Firms may suffer a substantial fall in market value following a restatement. They also may be exposed to substantial civil penalties or criminal prosecution, shareholder litigation and damage to their reputations: small wonder that boards wind up reining in their CEOs after the accounting irregularities are brought to light.

A poster child for this would appear to be Stanley O'Neal, who left Merrill Lynch in October 2007 with a $160 million stock option-laden severance package. In a prelude to the current Wall Street crisis, O'Neal presided over an $8.4 billion write-down due to investments in sub-prime mortgages and high-risk collateralized debt securities.

CEOs in particular are also more likely to bail from a company when their options are "under water" — below the strike price —according to a study published in the November issue of Personnel Psychology. Authors Benjamin Dunford, Derek Oler and John Boudreau, who approached this as a retention issue, noted that the further the options fell the greater the likelihood the CEO would quit.

So why reward executives with stock options in the first place?

Farber, who teaches accountancy at the University of Missouri's Robert J. Trulaske Sr. College of Business, said it's a matter of incentives. The logic behind granting options is that they align managers' interests with those of shareholders, he said. Shareholders benefit if the stock price rises, while the executive can exercise the options for a tidy profit.

But the push to boost the stock price means that many CEOs will pursue riskier business strategies than they might otherwise. And when some of these ventures fall short, there is an additional temptation to engage in what is euphemistically called "aggressive" accounting to minimize the damage.

This generally takes the form of exploiting discretionary gray areas in the Generally Accepted Accounting Principles — using liberal interpretations of various rules to allocate earnings and losses to put things in the best possible light. "We found very few cases of egregious manipulation — in other words, fraud," Farber reports. "They weren't just falsifying invoices . . . most of this is within GAAP manipulation." But when the numbers no longer add up, an earnings restatement is sure to follow.

Finding the right mix of salary, stock options and equity grants in the form of shares of stock is tricky, said Michael C. Jensen, an emeritus professor at the Harvard Business School, who has written extensively about CEO compensation.

On the one hand, the practice of simply awarding compensation based on conventional measures of success was sometimes counterproductive, he said. In the 1960s, for example, managers tended to build large, inefficient conglomerates through mergers because their interests diverged from those of shareholders.

"They were putting money into expansion, because executives got paid on the size of the firm in those days," Jensen said. "That destroyed huge amounts of value. That's why in the era of hostile takeovers, there was so much money in breaking these firms up. Now the managers had the incentives to make better decisions."

But stock option grants are no panacea.

"When it's all said and done, I do believe we'll wind up concluding the very large executive stock options of the old type that they got for free has indeed created incentives for executives to manipulate results," Jensen said.

The practice rests in part on a fundamental misunderstanding, he said.

"I don't have any doubt that a major contributor to the huge awards of stock options had to do with the fact that managers and boards and compensation committees — and this is going to sound a little crazy — thought it had no cost."

In fact, he said, options are only free to the executives, who are making a "heads-I-win, tails-you-lose bet" because they lose nothing out of pocket if stock prices fall. What can happen, though, is that a CEO may succeed in raising a firm's stock share price and so turn a profit on his or her options, but not by enough to offset the cost of equity capital — the rate of return on investment that will fulfill commitments to the corporation's shareholders.

"They are confusing value accumulation with value creation," he said. "An enormous amount of wealth was destroyed in corporate America through exactly this kind of fallacious reasoning."

One solution is to get executives to pay something for their stock options. "When I pay you $10 for it and the stock price falls, I lose," Jensen said. "So there's some risk." Another is to adjust the option exercise price to match the rate of the cost of equity capital.

"There's a lot of emotion and a lot of vested interests around this," said Jensen, who has served on corporate boards. While boards in the United Kingdom tend to see themselves as playing an active oversight role in corporate management, "American boards basically see themselves as the supporters of the CEO," he said. "The culture is if you aren't supportive of the CEO, you should resign."

Jensen is a fierce critic of the kind of plush executive employment contracts that are really "unemployment contracts." Even if the CEO does a bad job, he's guaranteed all his pay and bonuses, Jensen said. "There's no risk there."

He touts the idea of a "bonus bank," where a pot of money is set aside for the CEO to draw from in yearly increments. If the company suffers a loss, the remainder in the bank is adjusted downward. "That gives people more incentive to pay attention not just to this year's pay-off, but next year's," he said.

Not surprisingly, Jensen said, CEOs hate the idea.

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