An Overdose of Options

Depressed stock prices are prompting companies to issue more options than ever

Stock options were supposed to be the great motivator, letting top management reap a share of the gains they produced for shareholders. They certainly enriched smart execs who cashed them in before the stock market tanked. But investors are getting poorer, not richer, as company after company shatters on the rocks of executive fraud, greed, and incompetence.

Worse may be yet to come. Companies are still issuing options at a furious clip. In fact, 200 of the largest companies are handing them out in amounts approaching 3% of their outstanding shares every year, more than double the pace of a decade ago. The grant rate is headed yet higher as companies try to compensate executives for the lost value of options they received before stock prices fell. Moreover, with shares down sharply, the standard models used to price options show that companies will have to issue more of them to give executives the same dollar value each year.

Though the 3% annual average of option grants may look like peanuts, it could become a large and permanent drag on future share prices. In fact, if the market returns to its historical rate of return of about 10% a year, options will siphon off nearly one-third of company profits by the time they expire in 10 years. Investors will have their pockets picked either by having earnings per share watered down by the additional stock or by corporate spending on share buybacks to control dilution.

With a big transfer of wealth to management on the horizon, a shareholder backlash is gathering force. Institutional investors have declared war on runaway option grants and the outsize goodies they bestow on corporate insiders. "The trend is really bad," says Patrick McGurn, director of corporate programs at Institutional Shareholder Services, a proxy-vote advisory firm. It comes when many money managers are bracing for a long period of investment returns well below the 18%-plus levels of the 1990s. Says Lisa Rapuano, a mutual-fund manager at Legg Mason Inc., "There is a smaller pie, and executives continue to ask for more of it. We have to work on making their share smaller."

That's starting to happen. Investors are voting down a record 23.4% of options plans vs. 16.2% five years ago, according to the Investor Responsibility Research Center. Some companies are taking the hint: Jones Apparel Group, facing a shareholder rebellion, withdrew its plan in May before it came to a vote. But most aren't going to give up without a fight. Companies like options because they appear to be a costless way of paying employees: Unlike bonuses or salaries, most options don't have to be deducted from company earnings as an expense.

The way the conflict plays out could have a big impact on stock prices, investor trust, and companies' ability to reward innovation. If companies voluntarily pare down their compensation schemes to better align the interests of investors and executives, confidence will rebound and so should performance. But if the drive to improve the system fails, investors may become even more disillusioned with Corporate America.

Even as the fight unfolds, shareholders are seeing more and more of the value of their companies slip through their fingers. On average, stock equal to 16.3% of large U.S. companies' outstanding shares has been earmarked for employee options, nearly double the 8.3% average a decade ago, according to a survey by executive compensation consultants Pearl Meyer & Partners. Starting with fiscal years beginning after Mar. 14, 2002, a new Securities & Exchange Commission rule will require companies to disclose details of their options overhang more clearly.

Because of the bear market, of course, some existing options seem unlikely ever to be turned into shares because their strike prices are far above today's market. But since almost all options have 10-year terms, they could spring back to life in years to come. "As companies recover and their stock prices start to improve, these underwater options will come back in the money and automatically dilute earnings," says McGurn.

The existence of so many options waiting to be converted into shares weighs on the markets, acting as a brake on any potential stock price rises. And the overhang is building. Undeterred by poor results, companies keep issuing larger amounts to compensate top brass for the weakness in stocks. The average "burn rate"--options jargon for the pace at which companies issue the securities--is now 2.6% of outstanding shares a year, more than double the 1.08% rate in 1991, according to Pearl Meyer.

The trend will burn investors in coming years as companies turn over a growing share of their returns to insiders. Take a company with a price-earnings ratio of 25 and earnings and stock prices growing at 9.4% a year, the historical return on stocks at constant price-earnings ratios as calculated by Ibbotson Associates. Assume the company grants options representing 3% of its stock in 2002. According to BusinessWeek calculations, if executives then exercised all those options in 2012, it would have to pay out 27% of its income that year just to mop up the new stock. And that's after allowing for the tax break the company obtains--equal to the difference between the price executives pay them for the stock and what the stock is worth when the options are cashed. Without that benefit, the exercise would swallow up 44% of 2012 earnings.

Repeat the math over a full decade to capture the impact on each year's profits, and the result is worse (table). Management would skim off 46% of earnings added over the 10 years even though most of the gains resulted from little more than keeping pace with the economy. So much for proponents' arguments that options reward outstanding performance.

Institutional investors are hoping that major changes may now occur in executive pay. They'd like to see compensation plans that reward executives for doing more than showing up for work and simply matching broad economic trends. Peter T. Chingos, head of the compensation practice at Mercer Human Resource Consulting, expects companies to begin shifting away from options--for example, to bonuses for growth in earnings per share and return on capital that beat industry benchmarks.

But change is likely to remain modest until the big roadblock of inconsistent accounting standards is removed. Current rules effectively penalize most ways of linking pay to exceptional performance. For example, companies must treat options as an expense if their exercise price varies, perhaps rising with an index of the stocks of a peer group. By contrast, the classic fixed-price option is not an expense.

Likewise, when companies pay with restricted shares which executives must hold for a number of years, they must count them as an expense when they're issued. Despite that, employees love them because they are worth something, even if the stock falls. "In a down market, restricted shares are far more motivating and can retain a person better than stock options will," says Richard H. Wagner, a principal at Strategic Compensation Research Associates.

Indeed, if accounting rules treated all options equally with other forms of pay, companies would be free to choose compensation methods based on how well they motivate execs, not what they do to reported earnings. "In exchange for that accounting, we would get a program that is more effective in motivating people and getting financial results," says Wagner.

Perhaps if enough investors convince executives that they are paying attention to the cost of stock options, corporations will quit blocking a new accounting standard and get on with finding the compensation tools that work best. But until then, the friction over options is only likely to keep growing.

By David Henry in New York

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