The Folly Of Jumbo Stock Options

Huge grants don't always work as incentives

On Dec. 3, Walt Disney Co. Chairman and CEO Michael D. Eisner cashed in options he received in 1989 on 7.3 million shares of Disney stock--taking home more than $100 million even after paying taxes, giving to charity, and upping his Disney holdings. He also issued a statement that day saying that the exercise of his options would "provoke much discussion." Investors knocked the stock down $2 on the news, but there wasn't the kind of outcry that accompanied his award of options on 8 million shares in 1996.

That may be because the mania for mega-grants is catching--and Eisner's pay packet, while gargantuan, no longer stands alone. In recent years, the princely sums chief executives have garnered from stock-option grants have gone from gasp-provoking to commonplace. Notable recent grants include 2 million options to IBM's Louis V. Gerstner Jr. and 4.12 million to Oracle Corp. Chief Operating Officer Raymond J. Lane.

DIMINISHING RETURNS. The rationale for such huge grants is simple: By tying the CEO's interests to those of shareholders, execs will be motivated to work extra hard. "Greed is certainly good," says Gregg S. Tenser, director of research at Federated Investors, a $135 billion money manager.

But is it good enough? According to a new study of shareholder returns, the mega-grants don't necessarily lead to mega-results. Compensation expert Graef Crystal tracked the 20 companies in which CEOs received the most valuable option grants in 1995 and again in 1996. He found that they beat the Standard & Poor's 500-stock index by an underwhelming 4 percentage points through July 29, 1997. "If you're trying to retail the notion that huge grants should give you tremendous motivation," says Crystal, "you haven't proved very much."

Certainly, there are superstars such as Eisner, Travelers Group's Sanford I. Weill, and HFS's Henry R. Silverman, all of whom have left rivals--and all pay norms--in the dust. But for every master of the universe, there are many masters of the mundane making pots of profits as their company's stock lags the market.

The reason, of course, is the sheer volume of grants. According to an analysis of 1997 proxies by Pearl Meyer & Partners, 27% of CEOs at the largest 200 companies were awarded grants worth $10 million or more, up from 17% the previous year. Today, the number of options in a grant commonly runs to six figures--and often tops 1 million. It's most breathtaking at the top: In 1995, Crystal points out, the 20th-largest grant was worth $10.8 million; one year later, the figure was $26 million.

DISINCENTIVE? As mega-grants reach mega-proportions, a slight blip can add millions to an exec's nest egg. After all, if a stock goes up a buck, that's worth more to the CEO with 2 million options than the one with 200,000. Some fear such giant awards can be demotivating. "What they are doing is fostering not poor performance but mediocrity," says Patrick S. McGurn, director of corporate programs at Institutional Shareholder Services, a proxy advisory service.

King World Productions Inc. is just one example. Since CEO Michael King was granted options for 1.5 million shares on Dec. 20, 1995, the media company's stock has risen 41%, to 55 13/16. That's well under the S&P 500's 61% gain over the same time. Yet because King's numerous options were granted at the then-market price of $39.50, he's worth $24.5 million more than he was on grant day. Steven A. LoCascio, CFO of King World, says the shares are now on the move.

Another beneficiary of mega-mania is Stephen A. Wynn, CEO and chairman of Mirage Resorts Inc. Since Aug. 16, 1995, the date he was awarded 1 million options, Mirage's split-adjusted stock has risen 46%, far below the S&P's 74% gain. That's boosted his paper trove by $15 million. Another example is Warnaco Group Inc.'s Linda J. Wachner, now worth an extra $7.5 million.

Stock options do carry more risk than most other forms of compensation. If the stock falls in value, the grant becomes worthless or "under water." Among top optionees now under water are the CEOs of Green Tree Financial, Circus Circus, Kmart, and Viacom.

UNCONSCIONABLE. Still, mega-grant recipients can sometimes make sure they don't suffer along with ordinary shareholders when things go badly. Take Lyle Berman, CEO and chairman of Grand Casinos Inc. He received a grant of 1 million shares on May 6, 1996, when the stock price was $32. Trouble with projects such as the now-bankrupt Stratosphere casino, in which Grand had a 42% stake, caused the stock to fall 59%, to its current 13 5/16. But while ordinary shareholders have gotten hammered, Berman hasn't. Grand's board repriced his options last February at $11. So the 21% rise in the stock since then has padded Berman's net worth by some $2.1 million.

That, not surprisingly, has drawn the wrath of investors such as Federated's Tenser. "Put the carrot on the stick, not in his mouth," he says. "I approve of CEOs making a lot of money, but I want them to have their ass on the line the way I do. I think repricing is unconscionable." Says a Grand spokeswoman: "Since he got that repricing, the company has turned around."

Investor reaction has done little to discourage repricings, however. Indeed, ISS's McGurn expects the recent market volatility to result in more of them.

There's another, less controversial method to keep CEOs from losing out. Companies with underwater options issue a new grant at the new, lower stock price. It happened at Reader's Digest Association Inc. in November, when the board canceled a plan approved in October--including options on 212,000 shares for CEO George V. Grune at a then-market price of $27.03. In its place came a new plan at $21.47. The stock is now trading at 23 15/16.

What to do? Most corporate-governance experts would require that a stock significantly outperform its peers or the market before the options have a value. Says Nell Minow, a principal at LENS Inc., an activist investment fund: "No options grant has any credibility unless it's indexed." Such plans, while on the rise, are still rare. The same, it appears, is true of CEOs who get a windfall only when they've done more for shareholders than simply ride a bull market.

Before it's here, it's on the Bloomberg Terminal.