Commentary: How to Halt the Options Express

By Louis Lavelle

Amid the post-mortems of recent corporate scandals, stock options have not fared well. Indeed, they seem to have replaced money itself as the root of all evil. But lost in the stories of executives hauling home hundreds of millions of dollars thanks to their option grants is the reason for awarding options in the first place: Used with care, they're a good way to encourage innovation, hard work, and productivity. Moreover, options provide an invaluable tool for recruiting talent, especially for cash-poor startups.

But all good things can be overdone, and that's what happened with options. Compensation committees handed out options with abandon in the 1990s, and executives amassed huge option stockpiles. Instead of acting as incentives, they became a risk-free way for CEOs to accumulate massive wealth. It doesn't have to be this way. By adding a few real-world constraints to the way options are awarded and tailoring them so they pay off only if real goals are met, options can once again become a way to reward excellence. Here's how to do it.

-- Enough already. In 1999, in exchange for forgoing four years' worth of salary and bonus, Lawrence J. Ellison, CEO of Oracle Corp., was awarded 10 million options. At the time, the board said the award would "more closely align his compensation with the company's stock performance." In truth, Ellison's pay was already pretty well aligned. After all, he owned nearly 1.4 billion split-adjusted shares at the time--nearly a fourth of the company, a stash worth nearly $10 billion. Last year, Ellison cashed out options to the tune of $706 million.

Piling on options became an annual event for compensation committees in the 1990s. Why? Because options don't have to be accounted for on the income statement, making them an apparently cost-free way to pay managers. But momentum is building to require companies to expense options, with dozens of companies--including Coca Cola (KO ), General Electric (GE ), and Amazon.com (AMZN )--announcing plans to do so voluntarily. When companies have to choose between options and profits, they'll be less likely to make excessive grants to undeserving CEOs.

Still, it's clear that boards will be tempted to ratchet up rewards when times are flush, so it's time for the government to create a few incentives of its own. Tax penalties for companies that make excessive option grants--similar to those in place now for salaries in excess of $1 million--should do the trick. Pay consultants say many companies now hold the line on salaries to avoid the tax penalty, and many will do so on options if given a similar incentive. Says Randolph Ramirez, associate principal at New York-based Buck Consultants Inc.: "There has to be some message that says there's a limitation in terms of what we consider to be excessive compensation."

-- A better option. But just keeping a lid on the number of options doled out is not enough. Boards also need to get smarter about the kinds of options they use. Instead of granting those that reward CEOs for coasting in an up market, directors should replace at least some traditional options with options that reward execs for meeting specific goals.

Indexed options, for example, have an exercise price that fluctuates with the performance of a peer group or market index. If the company's stock fares no better than the index, the options are worthless. Premium-priced options have an exercise price higher than the stock's closing price on the date of grant, so the exec can't cash out until shareholders have seen significant gains. Performance-vesting options can't be exercised until the company meets other specific goals. "The problem with regular options is that they reward all behaviors--good, bad, and indifferent," says Blair N. Jones, senior vice-president at Sibson Consulting, a human-resources consultant in New York. "At least with [alternative] options, you're narrowing it down to an outperforming group."

Some companies have already set higher hurdles for their executives. Last year, Maytag Corp. (MYG ) awarded new CEO Ralph F. Hake 300,000 "premium-priced" options with a strike price as much as 30% higher than the grant-date closing price. Within 10 months, the stock had surged 45% before giving back some gains. "CEOs should get paid for creating value for shareholders," says Hake. "If you're not doing that, why should you get rewarded?" Of course, any time pay is linked to performance, investors have to worry that the goals will be laughably easy to meet. Compensation committees must start by setting the bar reasonably high--and then keeping it there.

-- The ties that bind. Directors also need to be more vigilant about correcting another disadvantage of options. Despite huge option grants, many CEOs have microscopic stakes in their companies. Apple Computer Inc.'s (AAPL ) Steven P. Jobs owns 21.9 million options, but just two shares in the company he co-founded nearly three decades ago. That's a problem because an option, unlike a share, requires no investment on the part of of the holder. Without any of their own money on the line, it's hard to argue that option holders are in the same position as investors. The problem is that few companies have ownership requirements for executives, and those that do often allow execs to meet the hurdle with options instead of shares.

To fix this, boards should require CEOs to exercise most of the in-the-money options they accumulate in the first three years on the job and to hold the shares for as long as they occupy the executive suite--in effect, forcing them to put some of their own wealth at risk. This, in combination with other stock-ownership programs, should help CEOs build a substantial stake in their companies. "Stock-purchase programs create a more direct parallel between the risks the CEO faces and the risks shareholders face," says Ira T. Kay, who heads the compensation-consulting practice at Watson Wyatt Worldwide. "Options don't do that."

Of course, building a stake by exercising options would leave execs with a hefty tax bill without generating any cash to pay it. That's why it's important to let them cash out some of their options in the early years. That way, they won't have an excuse to hit up their companies for tax reimbursements, as many do now. After all, shareholders already pay execs a bundle--they shouldn't have to pay their taxes, too.

-- Stop right there. Still, requiring CEOs to maintain stakes in their companies wouldn't go far enough to stamp out another serious problem. One of the most egregious abuses of the late '90s occurred when execs cashed out big just before their stocks crashed. Enron's Kenneth L. Lay, Global Crossing's Gary Winnick, and Qwest Communications International's (Q ) Joseph P. Nacchio were among dozens of top execs who sold millions of dollars' worth of stock in the months before their companies collapsed, leaving shareholders holding the bag.

In the future, top execs should be required to wait six months after exercising options before selling the shares. The lag time would create an advance-warning system for investors--alerting them to a possible future sale that could signal serious trouble ahead. What's more, the delay would make it difficult for corporate leaders to escape unscathed when their companies go under. Bruce R. Ellig, an authority on executive pay and a compensation-committee member of several pre-initial-public-offering boards, says execs should go down with the ship. "Executives should be put at risk with the shareholders," Ellig says. "Stock options should not be a cash machine."

In the 1990s, many top execs began treating their companies like broken ATMs--making withdrawal after withdrawal without ever depositing cash. And options are what made that possible. Expensing them is a start. But it's time to finish the job by creating real incentives for building shareholder value--not just CEO wealth.

Lavelle covers executive pay from New York.

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