Stock options for executives carry unintended consequences

If you are Rip Van Winkle awakening from a 20-year slumber, you might not know about America’s outrageous compensation for chief executive officers. But almost everyone else does. The flow of most income and wealth gains to the few highest earners comes at the expense of everyone else.

Let’s not forget that Americans’ real median incomes have been stagnant. Annual U.S. household income reached $57,263 this past March but is still below the $57,342 median in January 2000, according to Sentier Research. Any wonder why Americans are angry?

In contrast, a recent AFL-CIO study found that heads of the Standard & Poor’s 500 companies are paid about 330 times as much, on average, as production and non-supervisory employees.

CEO compensation took off in the 1990s because activist shareholders, board members and academics, all mating like alley cats, pushed to better align management’s interests with those of shareholders. So corporations began to award stock options to senior managers

Executive stock options have been a controversial topic for some time because of the fortunes executives have made under these programs. Stock options come in several forms. In the most common, executives granted stock options have the right but not the obligation to purchase shares of their company’s stock at a favorable set price within a specified time period.

Stock options are often used in lieu of signing bonuses as a tool to attract talented executives. In theory, they also align shareholder and management interests. The idea is that granting stock options gives executives skin in the game and creates incentives for them to make decisions that lead to higher stock prices. Vesting periods for options give current managers incentives to remain with the firm.

While beneficial in some ways, this formulation has its downsides. It tempts executives to focus on the short term at the expense of long-term shareholder value. Let the next guy worry about the Ohio factory whose leaky roof should have been replaced years ago while management focuses on managing quarterly earnings figures to meet investor expectations and lift stock prices. Management may decide not to invest in research and development on projects whose payoff is down the road.

Recent revelations about Valeant Pharmaceuticals International offer a treasure trove of teachable moments. Conventional pharmaceutical companies spend about 20 percent of sales on R&D for new drugs. Valeant executives devoted only 3 percent to R&D. The firm also had to restate its 2014 and 2015 earnings because millions in sales had been recognized during the wrong period and an array of costs excluded to allow it to report fantasy earnings of $2.74 a share when each Valeant share earned 14 cents.

But wait, there’s more. While CEO Michael Pearson received a base salary of $2 million, his executive pay was tied to Valeant’ s stock price. He owned stock and options worth more than $3 billion, putting him on the Forbes billionaire list before the recent scandal crushed the stock.

Today’s business world is a playground for feckless conduct that pats you on the back for behaving badly. Maybe it is time to put an end to that by prohibiting hired gun managers from buying and selling stock in their companies, just like we bar professional athletes from betting on their own games. In lieu of stock options, give them big cash salaries plus generous bonuses linked to how profitable their companies are over several years as an incentive for them to manage for the long term.

When future historians look whether stock options are an effective way to align the interests of managers and shareholders, they will ask some basic questions: Do they motivate executives to act in the best interest of shareholders? What costs do stock options impose on the company and its shareholders?

The answer is that they may indeed accomplish those things, but with a lot of unintended consequences.

Originally published: May 14, 2016

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