Dimensions of
the Problem

The growing chorus of dissent among shareholder groups and
regulators about stock options in particular and executive compensation
in general will also be addressed in this chapter. But that is
not where the reform needs to focus. The spotlight should rest
squarely on corporate management and their boards of directors.
Board members in particular must break out of the status quo for
executive compensation and look beyond competitive practice to
consider their own policies on pay and performance. Today and
in the future board members are the crucial players in the stock
options game—and on the broader playing field of executive
compensation.

THE PROBLEM WITH OPTIONS

Executive stock options are a problem for two reasons. First companies
have granted too many of them. Second they are ineffective
incentives and rewards at most companies. This has been exacerbated
by accounting rules that contributed directly to the untenable
mess that all of us involved in executive compensation, including
executives, board members, and compensation consultants, must
address.
Let’s look at the facts. Under current accounting a very narrow
definition of a derivative security—specifically an at-the-money call
option granted to an executive or other employee—receives a very
special accounting treatment. These options have no expense whatsoever
associated with them, no matter how many are exercised and
no matter how much money executives make from them. Through
this strange but very tempting little loophole, truckloads of options
grants have been delivered to executives with no expense to the
companies granting them. Because of this same loophole, hundreds
of billions of dollars of shareholder value have been transferred to
executives with virtually no controls or limitations. But this is only
part of the story.
More importantly because of this loophole, approximately 95
percent of public companies pay their executives in exactly the same
way, using exactly the same specific derivative security. And they
have blindly granted them in substantial and ever-increasing num-
6 PART ONE The Stock Option Problem
bers. I refuse to believe that large quantities of at-the-money call
options are the best incentive for virtually every public company.
There is no way that if every company in America started with a
blank sheet of paper, virtually all of them would simultaneously
conclude that this particular form of incentive is precisely the best
one for them. That is absurd.
This might not be a problem if we knew that options were (A)
an effective incentive and (B) a cost-effective way to deliver that
incentive, but we do not. Because there is no expense, companies
have never been forced to make this determination. They just keep
granting these narrowly defined derivative securities in increasingly
larger quantities, as illustrated in Figure 1-2. All the while 10
to 15 percent or more of the increase in value of the entire stock market
is being “transferred” from the pockets of shareholders into the
pockets of employees—and mostly into the pockets of executives.
As I will discuss in the latter chapters, options are not effective
as incentives for a variety of reasons (see Chapters 6 and 7). The
point is that increasingly larger option grants by virtually all companies
are likely a misuse of corporate resources. In a few companies
options have contributed to some highly dysfunctional and
overly risky behavior. In the majority of companies, they have been


THE CURRENT SITUATION

Despite the decline in corporate performance since 2000, total executive
compensation packages have remained very generous, particularly
when it comes to stock options, according to an April 2002
Wall Street Journal special report. Total direct compensation for
CEOs fell 0.9 percent; the first downturn since the newspaper began
tracking this data in 1989.2 Total direct compensation includes
salary, bonus, restricted stock value at the time of the grant, gains
from exercising options, and other long-term incentive payouts.
While this reported compensation has declined slightly, many
executives have more than made up for any drop in cash compensation
with substantial additional stock option grants. According to
the Journal article, top executives of 111 of the 350 firms surveyed
received mega option grants in 2001, up from 85 in 2000. A mega
grant has a face value of at least eight times an individual’s salary
and bonus. (The face value is the number of options granted times
the exercise price per option.)
As long as options grants were “free” with no required
expense, executive compensation never really declined. Even in a
bad year, when CEO salary and bonuses decreased due to poor corporate
performance, companies made up the difference with even
larger option grants. For example, a CEO who received a $900,000
base salary and a $500,000 bonus also received a mega grant of
options on $11.2 million in stock. This means the CEO has been
given the right to the increase in value on $11.2 million in stock for
the next 10 years. If the company’s shares go up only 10 percent in
value, when he exercises his options from the mega grant, he will
make $1.12 million. This profit would be in addition to the options
he normally receives annually on $2 million to $3 million in stock.

EXECUTIVE WEALTH AND THE POSITIVE
POWER OF GREED

News stories have illustrated the magnitude of the wealth that executives
can reap through the receipt of stock options. In the New York
Times Magazine article “Heads I Win, Tails I Win,” Roger Lowenstein
examined the pay of the top executive of SBC Communications, a
company he chose “for its unspectacular qualities.”3 Lowenstein
wrote: “It is profitable and professionally managed, and its CEO is
well regarded in his industry. Like many CEOs he pursued a bold
growth strategy for much of the 90’s, had some good early years
and more recently gave back much of his gains. In the last three
years, his stock has fallen 27 percent—more than either the Standard
& Poor’s 500 or the stock of his Baby Bell peers.” Nonetheless CEO
Edward E. Whitacre, Jr., received the “largest pay package of his
career—one with a present value of $82 million,” Lowenstein wrote.
Stock options are the backbone of Whitacre’s compensation package,
which included a grant of 3.6 million options with an estimated
value of $61 million.
It comes as no surprise that CEOs and top executives want to
be rewarded for their efforts—and the greater the results, the greater
the reward. Greed is a natural force that drives capitalism. But just
like steam power and electricity, which have to be harnessed and
directed with capacitors and resistors in order to be used productively,
so do the innate desires for bigger, better, and more. Executive
compensation policies must provide the methods and systems
to effectively harness and focus these powerful forces that drive
companies and, in fact, the entire U.S. economy. Greed itself is not
the problem. The fault lies with the lack of limits and effective controls
to manage it.
Acknowledging the basic human desire to acquire and amass
more, companies can motivate executives and employees to perform
better, produce high-quality sustainable results, and do more
for the good of the company and themselves. Many companies,
however, have not effectively harnessed the power of greed and
have largely given in to this executive appetite.
As Federal Reserve Board Chairman Alan Greenspan observed
in his July 2002 testimony on monetary policy to Congress, “Why
did corporate governance checks and balances that served us reasonably
well in the past break down?