The Trouble with Stock Options (Digest Summary)

Option grants to executives of S&P 500 Index companies increased from an average of
$22 million per company in 1992 to $238 million in 2000. During the same period, the
average pay of CEOs of those companies grew from $3.5 million to $14.7 million. Most of
this increase stemmed from the rise in stock option grants. Furthermore, between 1993
and 2000, option grants in old economy companies increased 44 percent while grants in
new economy companies increased 75 percent. The data, however, do not reveal the
increased prevalence of broad-based option plans that cover all or most company
employees. The increasing popularity of option grants can be attributed largely to their
favorable tax and accounting treatments, especially tax laws enacted in 1994 that
consider compensation in excess of $1 million paid to proxy-named executives as
unreasonable, thus making it nondeductible as a corporate compensation expense. The law
does not impose limitations on performance-based compensation, including payments from
exercising options.

Typically, options granted to executives can only be exercised over time, are generally
nontradable, and are forfeited if the employee leaves the company before vesting. Most
companies offer cashless exercise programs, in which employees simply receive the value
of the spread between the market price and the exercise price in cash or shares of
company stock. Under U.S. tax rules, options are qualified or nonqualified. For
qualified options, employees pay nothing on exercise but pay capital gains taxes when
the stock is sold. Companies, however, cannot deduct the employee gain on a qualified
option as a compensation expense and require stock recipients to hold the stock for at
least one year after exercise. For nonqualified options, the difference between the
exercise price and the market price on exercise constitutes taxable personal income to
employees and a tax-deductible compensation expense to companies. Most option grants are
thus nonqualified.

In spite of their potential benefits and increasing popularity, stock options are
troubling in five ways. First, compensation in the form of stock options is not entirely
beneficial or efficient. Corporate executives are legally precluded from shorting their
company stock, trading their options on “restricted stock,” or pledging
those securities as collateral. Second, stock options may not necessarily help to
attract high-quality employees. Third, a recent study of new economy companies shows
that companies with greater cash flows use options more extensively. Additionally,
well-known option-intensive companies, such as Microsoft, also pay high cash
compensation. Thus, stock options do not appear to be a substitute for cash compensation
or are not preferred by companies starved for cash. Fourth, the value of stock options
tends to be lowest when a company's stock is “underwater.” In bear markets,
stock prices typically fall below the exercise prices and workers are likely to seek
employment at competitor companies offering fresh compensation packages and more
valuable option grants. And fifth, the number of shares tied to stock option grants is
often a trivial fraction of the outstanding shares of the company. Even if employees
increase the value of the company, their share of the gain through option holdings is
small, thus creating a free-rider problem on top of the risk imposed on employees by
stock-based pay.

Indexed stock options would greatly diminish many of the previously mentioned limitations
of traditional stock options, but they are virtually nonexistent because (1) grants of
indexed options need to be expensed, whereas traditional options do not, and (2)
traditional options have a much higher probability of ending up in the money than
indexed options. Because indexed options are less valuable to executives, they dominate
traditional options only if their exercise prices are well below market prices at the
time of grant.

Restricted stock offers several advantages over stock options. It provides relatively
stable incentives, even when stock prices are lower, and overcomes the pressure for
lowering exercise prices during stock market declines. Executives holding
out-of-the-money options are more likely to engage in riskier investments than
executives holding company stock. Additionally, executives owning restricted stock may
pursue an appropriate dividend policy, whereas those holding stock options may prefer
stock repurchases to cash dividend payments.

Next, the authors present data showing a strong positive association between option
grants and stock market performance. Specifically, CEO cash compensation is weakly
correlated with the DJIA, but CEO total compensation is strongly correlated with the
stock market. Another interesting revelation is that the CEO of the average S&P 500
company earned 30 times the pay of the average production worker in 1970. By 2002, it
was 90 times greater. Explanations include sharp increases in stock prices during the
1990s, renewed focus on shareholder value creation, and fixed-share policies, whereby
the grant size remains constant over time in spite of stock price increases. According
to one hypothesis, executives choose options over cash because options are less
transparent to shareholders, politicians, and the media. Another explanation for the
growth of option granting is that the perceived cost of options is less than the
economic cost because the company receives a tax deduction for the spread between the
stock price and the exercise price.

Proposals for expensing stock options have proliferated. Although this change would not
affect future cash flows of companies, companies would be likely, as a result of better
understanding of the true costs involved, to grant fewer options out of fear of a
backlash in the market.