Options: Middle Managers Will Take the Hit

Executive stock options have become a flash point across Corporate America in the past year or so. The scandals at Enron Corp., WorldCom Inc., and elsewhere showed investors how imperial CEOs appeared to have cooked the books to pump their stock and cash in on lucrative options. The continuing stock market woes have tainted nonscandal executives, too, given how many profited by returns that have now evaporated.

The result has been tremendous pressure on companies to cut back on options. The battle will break out in the open during next spring's proxy season, when companies are likely to find it "a lot harder to get options plans [approved]," says Paula Todd, an executive-compensation expert at consultant Towers Perrin.

So, many companies are rushing to head off wrathful shareholders. Compensation consultants say the broad outlines of their plans have been laid out: Companies by and large intend to slash options awards--but mostly by reducing them for lower-ranking managers. Many top execs will stay on the gravy train, either by getting just as many options as before or by taking more pay in stock and cash bonuses. "Every single one of my clients is going to cut back on their option grants," says Michael S. Kesner, a partner in Deloitte & Touche LLP's executive-compensation unit. "The brunt of it will fall on middle managers, I hate to say. Now, most of what's spent will go to the top people."

Companies that do so will only harm shareholders all the more. Already, most top execs can't justify the huge sums they have taken. To grab even more only demonstrates again how little control most boards exercise over CEOs, who basically set their own salaries. Shareholders would be better served if companies cut outsize grants at the top and maintained them for employees down the ranks. The more modest option rewards middle managers get--which research shows lift motivation and productivity--are more likely to fulfill the original idea of aligning the interests of employees and stockholders.

Even a cursory look at corporate chieftains' option winnings shows how far out of whack they are. The top five executive officers of the 1,500 largest U.S. companies take about 30% of all options issued every year, according to an analysis of Securities & Exchange Commission filings done for an upcoming book co-authored by this writer. From 1992 to the peak of the market in 2000, this corporate elite saw a 1,000% increase in the paper value of their unexercised options, to a collective $80 billion. Over that same period, the Standard & Poor's 500-stock index rose 350%, which means execs gained nearly three times as much as the shareholders they serve.

Swapping options for stock or bonuses won't solve the problem, either. Many companies plan to use them to ensure that the top guys lose nothing, says June Anne Burke, who heads the global stock plan group in the U.S. at Mercer Human Resource Consulting LLC. This ignores the real issue, which is that executives take too much from shareholders. For example, incoming WorldCom CEO Michael Capellas is due severance of some $14 million from his old post at Hewlett-Packard Co. (HPQ ), plus millions more at his new job. Similarly, Tyco International Ltd.'s (TYC ) new CEO, Edward D. Breen, got stock and options that could be worth more than $50 million.

Targeting only lower-level managers for options cutbacks "runs counter to the concern that huge options [packages] for key executives motivate them to make decisions in their own interests, not in the interests of the company," says Burke. Investors should take heed as the proxies start to roll in with revamped compensation plans.

Commentary by Aaron Bernstein

Bernstein co-wrote with Rutgers professors Joseph Blasi and Douglas Kruse In The Company of Owners: The Truth About Stock Options (And Why Everybody Should Have Them), to be published in January by Basic Books

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