New York Times - April 2, 2000
REPORT ON EXECUTIVE PAY Will Today's Huge Rewards Devour Tomorrow's Earnings?
By DAVID LEONHARDT
Over the last 15 years, as executive pay has soared and each new plateau has met with something of a public outcry, America's business leaders and their supporters have had a ready answer for the critics: Look at the stock market.
In 1988, when the average pay of chief executives at large companies first topped $2 million, the Dow Jones industrial average ended the year at 2,168. By 1995, when average pay hit $5.8 million, the Dow had reached 5,117. On Dec. 31, 1999, the end of a year in which the average pay package reached $11.9 million, the index closed at 11,497.
The two numbers have enjoyed a symbiotic relationship, the executives argue, as the promise of wealth, in the form of stock options, has inspired them to create efficient companies that are driving the longest economic expansion in American history.
To a large extent, the debate is over, and the executives have won.
Companies in Europe and Asia are starting to mimic the American system by raising salaries and awarding more stock. Dot-com billionaires have made the fortunes of some old-line executives look moderate. And eight years after Bill Clinton made exorbitant executive pay an issue in his first presidential campaign, the topic has disappeared from the political scene.
Yet at this moment of triumph -- when nine-digit packages are a reality and eight-digit annual pay is the norm -- there is a rising undercurrent of concern over the very thing that executives credit with helping motivate the country's stunning growth: the tremendous boom in stock options.
Over the last five years, America's companies have handed over a large portion of themselves to the executives who run them. That has aligned management's interests with investors, delighting those who advocate tying executive pay to performance.
But a growing number of analysts warn that it has also created the potential for a host of long-term problems that could undercut economic growth.
As top executives (and other employees) continue to exercise their rising pile of options over the next decade, other stockholders will see their stakes watered down. It seems unavoidable. Already, companies have spent billions of dollars in recent years -- and taken on rising levels of debt -- buying back shares to minimize the dilution. For the repurchasing to continue at its current pace, a recent Federal Reserve study warned, companies would have to devote virtually all of their future earnings to buybacks.
In essence, the skeptics worry, corporate America is using stock options like a credit card without a spending limit. While every penny in salary is recorded as a cost on company books, hundreds of billions of dollars in stock options aren't counted at all. To the fire of a blazing stock market, companies add the fuel of overly rosy earnings reports, unencumbered by off-the-books promises of future pay.
In a speech last summer, Alan Greenspan, the Fed chairman, said stock options helped "impede judgments about prospective earnings" and, over the last five years, had caused companies to overstate profit growth by one to two percentage points each year.
The level of exaggeration is on the rise, doubling between 1997 and 1998, according to a study by Bear Stearns. At some companies -- including Cisco Systems, a new-economy stalwart that briefly last week boasted the highest market capitalization in the world -- earnings would be more than 20 percent lower if stock options were accounted for.
"The dilution is a serious financial problem, and it ought to be getting a lot of attention," said John C. Bogle, the founder and former chairman of the Vanguard Group, the big mutual fund company.
Not everyone agrees, to be sure. By attracting and motivating the best workers and managers, stock options spur long-term growth at a faster rate than they dilute a company's shares, many executives argue, giving stockholders better net returns than they would have received otherwise.
"I'm a great believer in stock options," said Dennis Powell, the controller of Cisco, one of the stock market's best performers over the last decade.
In addition, companies publish their level of "overhang" -- the percentage of the company that options would represent if all were exercised -- allowing investors to factor it into their decisions. And widely published statistics on diluted earnings per share take into account any options that currently have value.
But a growing number of investors remain skittish. Fund managers at T.I.A.A.-C.R.E.F., a $288 billion pension and mutual fund company, are more often using their proxies to vote against executive pay plans. Over all, the proportion of such plans that meet tough resistance is up. And a New York Stock Exchange task force has recommended tightening guidelines to force companies to seek shareholder approval of almost all options plans.
"For the first time, you're starting to see mainstream institutional investors become concerned that the decade-long stock-option binge has left companies with serious, structural earnings problems," said Patrick S. McGurn, the director of corporate programs at Institutional Shareholder Services, a Rockville, Md., group that advises large investors.
Even some of the consultants paid to design executives' contracts -- who have been some of the loudest defenders of the pay explosion -- have grown concerned.
"We're giving away more and more of the future value of the company," said Richard H. Wagner, president of Strategic Compensation Research Associates.
Corporate debt, rising in large part to pay for options plans, "is the dirty little secret of corporate America," added Ira T. Kay, the head of the pay practice at Watson Wyatt Worldwide.
Just a few years ago, boards of directors were hesitant to set aside more than 1 percent of a company's equity for stock options in any given year; they generally kept the overall level of outstanding options below 10 percent.
But just as technology companies have transformed attitudes about stock price valuations and the track record that a company should have before going public, so have they blown through the old guidelines on options.
"The dot-com and new economy companies have rewritten all the rules," said Gary Locke, head of Towers Perrin's executive compensation practice.
The rising use of stock options predates the Internet, but the remarkable success of technology firms over the last five years has helped to rapidly accelerate the trend. The number of millionaires, and mega-millionaires, that technology companies have created has put the rest of corporate America on the defensive. One response has been to ply executives with even more options.
Last year, the nation's 200 largest public companies handed out options that represented the equivalent of 2.1 percent of their outstanding shares, up from 1.2 percent in 1994, according to Pearl Meyer & Partners, a pay consulting firm in New York. As a result, the average overhang reached 13.7 percent in 1999, well above the old 10 percent ceiling.
Since 1996, the Financial Accounting Standards Board has required companies to include a footnote in their annual reports disclosing what options would cost, using one or another widely accepted formula, if they were charged as an employment expense.
Why is there a cost? In granting options, companies are allowing employees to buy stock in the future at today's (presumably lower) price. To make up for the discount, the companies either forgo issuing shares for which they could have received full price, or they buy back existing shares and forfeit the difference.
"You're buying high and selling low," Mr. McGurn said.
Of course, if a company's stock price has fallen below the exercise price when its executives become eligible to cash them in, the executives will not exercise them, and other investors' shares will not be diluted. But that is hardly a trade-off most companies would welcome. When options are under water -- as is the case at so many old-economy companies today -- many executives either flee or demand other payments to make up for money they had expected to get.
To date, few companies appear to have suffered from the options boom. Strong profits have given many of them enough cash to pay for their growth and to repurchase millions of shares. Among other things, the buybacks have generally prevented options granted in the early 1990's and exercised over the last few years from diluting earnings per share -- though, of course, the money used to buy the shares could have been deployed to other ends.
From 1994 to 1998, the amount that companies in the Standard & Poor's 500 spent each year on stock repurchases more than tripled, to almost $150 billion, according to a Fed analysis of Compustat data. Together, buybacks over that period accounted for about 2 percent of all outstanding shares.
But the pace of option grants has accelerated rapidly in the last few years, and the number of exercisable options will be far greater in five years than it is now. As a result, the Fed study found, companies would have no money for investments or dividends if they tried to keep up their pace of buybacks. On the other hand, the study's authors warned, slowing the pace of buybacks "could have a negative effect on equity valuations."
Of course, companies could borrow to buy back stock -- a strategy for which they have already shown a fondness. Corporate debt has risen by 45 percent over the last five years, and much of the increase is a result of share repurchases, said John Lonski, the chief economist at Moody's Investor Services.
Defenders of the current level of option grants point out that the growth of the stock market has kept debt-to-equity ratios at levels that are of little concern. Skeptics note that the ratios have risen in recent years despite the long bull market, leaving companies vulnerable to a correction.
The central question, though, may be whether investors have taken into account the rising level of overhang when valuing today's market.
On one hand, the footnotes in companies' annual reports tell investors the degree to which options could dilute their shares and offer an estimate of the options' cost. "There is full disclosure," said Rick Escherich, a managing director at J. P. Morgan, "and I assume it is something that gets factored into every company."
On the other hand, the information is buried inside a document issued once a year, in an era when the smallest bit of news about a company can instantly alter its stock price. "We all know companies' stock price moves on quarterly earnings numbers, not annual reports," said Pat McConnell, a senior managing director at Bear Stearns and one of the authors of the study that found options' true effect on earnings to be rising (though still smaller than in some earlier estimates).
Some analysts are not even sure that individual investors find the annual footnotes. "You've got to be pretty sophisticated to sort it all out," said Paula Todd, who manages the executive compensation research division at Towers Perrin. "My grandmother isn't going to figure out the overhang."
A further question is what companies are getting for their largess. Numerous studies in recent years have shown that companies with high levels of executive stock ownership have outperformed companies with low levels. Few of the studies, however, asked what the ideal level of ownership was: Do companies get an extra bang from making their chief executives centimillionaires, for instance, rather than mere decimillionaires?
Noting the void, three Columbia Business School professors undertook a study of 600 companies, examining their performance over the last 20 years. Their results, published late last year in the Journal of Financial Economics, showed that increasing an executive's stakes in a company did not cause stronger earnings or a higher stock price. Instead, it appears to be other factors, like research spending, that cause a company to perform well.
"A lot of the evidence people have cited for the link between ownership and performance is flawed," said Charles P. Himmelberg, one of the authors.
Another, R. Glenn Hubbard, added, "There's not much extra kick from higher managerial ownership." The ideal level of ownership appears to vary by company, they said.
A recent Salomon Smith Barney study, meanwhile, found that most of the heaviest users of options in the S. & P. 500 actually underperformed the index.
Such findings can only fuel the skepticism that already has companies working harder to win shareholder approval of proposals for new option plans. Fourteen such proposals, including one at Ben & Jerry's, the ice cream maker, failed last year. More significant, one out of every seven proposals received at least 30 percent negative votes last year, according to Strategic Compensation Research Associates, which advises companies on getting such plans approved. Three years ago, only one of every 12 plans met that level of opposition.
ecause many of the yes votes represent bulk votes by brokers, on behalf of individuals who do not return their ballots, anything but a landslide often means that executives had to lobby large investors or revise parts of their proposals.
"It used to be that you just put your plan in your proxy," Ms. Todd said. "Now that period when the proxy is out on the street is hell for a lot of companies."
Even Microsoft, with years of stellar returns, saw 27 percent of its shares vote against a small option plan for board members in November.
It would be an exaggeration, however, to suggest that investors no longer believe in options, analysts say. "There's a general consensus that stock options have been very beneficial to the performance of U.S. companies," said Mr. Escherich of J. P. Morgan. "The question is: What is the right level?"