Options: Too Much of a Good Incentive?

These symbols of a compensation system gone haywire are coming under new scrutiny

Stock options. The very term conjures up the promise of the heady 1990s. They were the juice that helped fuel what was then called the dot-com revolution. They were a powerful magnet that few could resist: Remember the torrent of seasoned executives at old-line companies who left solid career tracks for giant slugs of stock options at tiny, unproven entrepreneurial companies? Large corporations, too, doled out options in ever-increasing quantities to keep their bright execs from fleeing to greener pastures. For a time, with the bull market raging, everyone, it seemed, was either getting options or trying to.

The craze seemed to validate some basic tenets of a newly energized economy: Executives and, later, workers of all levels, were all too eager to accept options in lieu of raises, cash bonuses, or even salaries. The theory was that by taking such a risk, managers and workers alike would work harder, achieve superior performance, and strike it rich when options soared well past their strike prices to dizzying heights. Economists and corporate governance experts also embraced the concept: Since options only pay off big if a stock rises, the interests of managers who receive options grants would be more closely aligned with shareholders' interests, and they would be motivated to do whatever it took to boost productivity, profits, and shareholder return.

Overall, what the U.S. got in the '90s is exactly what options promised: faster productivity growth, a sharp focus on innovation, and higher share prices. Even with the market slide of the last two years, the S&P 500-stock index has roughly tripled since the beginning of the '90s. It's impossible to gauge how much of those gains can be attributed to the use of options. Still, there's little doubt that options played a huge role. "On average, stock options were good for the typical American company and the U.S. economy," says Ira T. Kay, compensation practice director at Watson Wyatt & Co.

Despite their benefits, stock options are coming under new scrutiny, causing companies, investors, and regulators to rethink how, when, and in what quantities they should be doled out in the future. The punishing bear market, along with accounting scandals at Enron, Global Crossing, and a host of other companies, are transforming the once-blessed stock options into potent symbols of executive abuse and a compensation system gone haywire.

As the excesses of the '90s are laid bare, it's becoming clear that options played a central role at numerous companies. Options grants that promised to turn caretaker corporate managers into multimillionaires in just a few years encouraged some to ignore the basics in favor of pumping up stock prices.

Add to that the controversy over the way options are accounted for on corporate income statements--and treated by Uncle Sam. Under current accounting rules, companies are not required to record any expense when they pay their execs and employees with options, unlike other forms of compensation like salary or stock grants. At the same time, when employees exercise options, companies derive huge tax benefits. The combination of those benefits skews the corporate incentives towards offering up oodles of options to executives, well past the point where new grants are needed to motivate better performance--and even further past the point where outside shareholders suffer serious dilution.

Now, as one former highflier after another comes tumbling down to earth, there is a growing chorus in Washington and among shareholder activists to introduce new regulations or tighten up loose rules now governing options grants. On Feb. 13, Senator Carl Levin (D-Mich.) and Senator John McCain (R-Ariz.) introduced a bill that would close an accounting loophole that lets business deduct the cost of employee stock options from corporate taxes. If successful, the new push for regulation could rewrite the '90s playbook for compensation that virtually all S&P companies now follow. And while such changes would iron out some of the abuses, if taken too far, they also threaten to weaken options' powerful lure to motivate managers and workers alike.

The issues swirling around options are complex and there appear to be no easy answers. One question that investors and governance experts are asking is just how many options CEOs and top managers should be able to pocket. Today, the 200 biggest companies by revenue allocate more than 16% of their outstanding shares for options, with the heaviest ownership at the top, according to Pearl Meyer & Partners. That's double the percentage allocated a decade ago. Moreover, CEOs now get about 60% of their total pay from stock options--with only minimal performance standards for most. Executives often stand to make a fortune so long as they provide steady earnings growth. And that encourages gaming the system through accounting gimmicks. "It's really very easy to abuse," says Chris Wiles, president of Pittsburgh-based mutual-fund managers Rockhaven Asset Management.

That tendency may get worse. With the market no longer moving ever upward, many CEOs seem to be trying to compensate by demanding even bigger grants for the next year. So, even smaller rises in share price will provide equally huge rewards. Today, too many companies hand out options like "candy kisses," says compensation expert Pearl Meyer of New York. "We overdosed."

When the market was soaring, concerns about the downside of options were dismissed. The truth is there has always been a cost for issuing options. When options are exercised, they add to the shares outstanding. That dilution drives down earnings per share. To combat dilution, many companies buy back large numbers of shares that their execs have exercised. That means companies have to lay out cold cash that then isn't available for investing in research and development and marketing.

That's why many shareholder activists and some investors want options expensed as a current cost, when they are granted. The impact would be huge; only two S&P 500 companies, Boeing (BA ) and Winn-Dixie (WIN ), reduce reported earnings by their expense. Indeed, one study estimates that AOL Time Warner's (AOL ) earnings would have been reduced as much as 75% over five years if options were expensed.

Critics insist companies that dole out big lumps of options are having their cake and eating it, too. Why? Because not only can they avoid expensing the costs, they get huge tax deductions when employees exercise options. Cisco (CSCO ) has gotten tax breaks sometimes exceeding its reported net income, while Microsoft (MSFT ) got a $2.1 billion tax break as a result of exercised options, according to a Credit Suisse First Boston study. Critics say that's just one more corporate giveaway.

With reform in the air, some companies aren't waiting for Congress and the accounting rulemakers to rethink their options programs. Boeing not only counts its options expenses against earnings, but the aerospace company has gone an important step further, crafting an additional plan to more carefully align employee and shareholder interests over the long term. Boeing issues "performance share" units that are convertible to common stock only if its stock appreciates 10% annually for five years.

Other companies are also making big changes. Niall FitzGerald, co-chairman of Unilever, the Anglo-Dutch consumer products company, has created a system in which options do not vest unless Unilever achieves total shareholder returns over a rolling three-year period that are above the median for a group of 20 peer companies, including Coca-Cola (KO ), Nestlé (NSRGY ), and Procter & Gamble (PG ). If returns are in the top third of the group, the options vest in full. "Our philosophy," says FitzGerald, "is if we are capable of beating them in the marketplace, then we are capable of beating them in shareholder value and you will be rewarded accordingly."

Similarly, General Mills Inc. (GIS ) links its grants, as well as bonuses and matches to 401(k)s, to the prior year's performance. "We're constantly rethinking all of this," says Mike Davis, General Mills vice-president of compensation. No doubt General Mills will have plenty of company as Corporate America starts to reconsider its compensation incentives-- before the government and investor activists do it for them.

By David Henry and Michelle Conlin in New York, with Nanette Byrnes and Michael Mandel, Stanley Holmes in Seattle, and Stanley Reed in London

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