Stock options exaggerate the promise of 'New Economy'

By Christopher Lingle

HONG KONG (JP): While the use of stock options are seen as a key element of the "New Economy", they have also been portrayed as one way to ensure survival of capitalism since they were established in 1950. Intended to induce work and encourage creativity, they have become an important component of pay packages for budding dot.com millionaires.

A more ambitious, if less generous scheme, was the advent of employee stock option plans that were supposed to turn workers into capitalists. However, the reality behind this important tax loophole is more complex than the theory or the hype.

According to a study of company proxy statements filed with the Securities and Exchange Commission between May 31, 1999 and May 31, 2000 by Graef Crystal for Bloomberg, the average total pay was US$12.5 million for the CEOs of the 500 largest U.S. companies with the largest market values.

Included in total pay are base salary, annual bonus, the estimated present value at grant of stock options awarded during the year calculate with the Black-Scholes pricing model, the value at grant of free shares of stock awarded, payouts made under other long-term incentive plans, and "other annual compensation" and "all other compensation" as defined by the Securities and Exchange Commission.

Out of those 500 corporations, eight of their chief executives received pay packages of $100 million or more. Their combined income exceeds $1.5 billion that were mostly derived from stock option grants but also included salary, bonus, free shares and other compensation granted during the latest fiscal year. Charles Wang of Computer Associates International Inc. ranks first on the list with earnings of $511 million.

Many economists dismiss criticisms of executive pay packages of extreme dimensions and proportions by insisting that it is the free market at work. Their retort is that if some executives were overpaid, shareholders would revolt or other investors would shun the offending companies' shares or both. In the end, such punishment on the stock market capitalization would serve as a self-correcting remedy against abuses. At the same time, there is a dominant argument that CEO pay is linked to performance, especially the enhancement of shareholder value.

In the limit, there is some truth to this. Wang's salary is actually down from $655 million after reaching a settlement with shareholders who sued over his remuneration package. And the sacking of "Chainsaw Al" Dunlap by Sunbeam Corporation shows that these high-flyers can lose their jobs. However, the argument that market participants will punish malefactors may assume too much knowledge on the part of investors and too much power in the hands of dissenting shareholders who are likely to be a tiny minority.

Crystal's study also attempted to discover the important determinants of CEO remuneration and, in particular, to match pay with performance. It turns out that the most significant indicator of pay disparity is company size as measured by differences in revenue, invested capital and number of employees.

But an examination of shareholder performance over three-, two-and one-year returns (measured by the sum of stock price appreciation and reinvested dividends) explained only 2 percent of the CEO's variation in their pay packets.

Interestingly, the principal source of the disparities in incomes was the issuance of stock options. The present value of all the options granted to CEOs of all 500 companies during 1999 totaled $3.9 billion. As it turns out, a favorable tax treatment insures that the cost of such options is not charged off on the companies' earnings. Consequently, there is little discipline exercised in this practice so that issuing options does not have to reflect performance.

Besides CEO compensation, there are other problems arising from stock options. For example, Microsoft Corporation's recent sharp drop in market valuation induced it to double the grants of annual stock options for full-time employees to halt defections of key developers and managers. Like most hi-tech companies, Microsoft offsets relatively low salaries by offering stock options with heavy discounts from current market prices. Yet these option-linked compensation packages distort the accounting reports of most of these companies.

Whatever the intent behind their use, the use of option packages tends to overstate profits. This should be of considerable interest when considering dot.com companies that traditionally show low or no profits.

As indicated in a report by ABN Amro, current accounting practices inflate operating income of these companies by including the "earnings" from the sale of options to their employees. At the same time, a tax credit linked to option allows companies to deduct from their earnings the taxable gain that employees incur when exercising their options.

Taking the impact of options into account would mean that these companies would show decidedly lower profits or perhaps bigger losses. The recent plummet in Amazon.com's stock valuation may be seen as a result of the growing awareness of this problem.

Regardless of the intentions or the hype behind them, stock options are not a silver bullet that will preserve or promote capitalism. Indeed, there are good reasons to worry that the growing use of stock options as a component of remuneration may have the opposite effect.

For it is the use of stock options that has created such great disparities between compensation for workers and executives. By exceeding historical and international norms, this practice has incited worker discontent. Perhaps worse, stock options have also been the source of distortions that contributed to the speculative mania that has afflicted stock markets.

The writer is Global Strategist for eConoLytics.com and author of The Rise and Decline of the Asian Century (CLINGLE@eConoLytics.com.)