The latest spate of executive-pay roundups is dribbling out, and once again the news is great for CEOs. A recent New York Times report says that in 2000, chief executives saw an average salary and bonus increase of 22 percent. (Compared to 4 percent for salaried employees and 3 percent for hourly workers.) They also got 14 percent more in the form of stock grants than the prior year and 50 percent more stock options.
This last point is the most interesting because for the last few years much has been made of the benefits of aligning the interests of top management with those of shareholders. Or rather, of boiling all the interests of both to one thing: a rising share price.
Cynics have all along pointed out that there was little wonder why top executives would bear-hug this particular concept in recent years: Shares were going through the roof all over the place. CEOs wanted a bigger piece of that action. No surprise there.
One of the more interesting and iconoclastic reactions to this trend was a plan championed by James Crowe, founder of the fiber-optic network company Level 3 Communications. Usually, stock options have an exercise price fixed to a particular date, often the date of issue. So if a CEO gets an option on 200,000 shares priced at $10, and shares have risen to $15 by the time the executive is allowed to exercise them, then he or she pockets $1 million. Seems reasonable since the share price rose 50 percent—that executive must be doing a good job. Unless of course the S&P 500 doubled over the same period (remember the bull market?), in which case a 50 percent rise seems like no great favor to shareholders. In other words, a CEO could get a free ride and rack up massive compensation gains even as his (or her) company’s stock performance badly lagged a benchmark like the S&P. In a March 2000 Forbes article, Crowe referred to this as “the Lake Wobegon effect.”
It’s a good point, and that Forbes story included several real-world examples of CEOs whose options packages grew by millions of dollars even as their company share price trailed the S&P by 10, 20, even 30 percent. “All kinds of companies have hurt their investors,” Crowe complained, “yet managements are getting enormous payoffs.”
Crowe’s idea was to tie the exercise price to the S&P 500. If Level 3 shares outperform the index, then the options are worth something. If not, they aren’t. (An interesting side effect is that the options could be worth something even if the company’s share price fell—provided, of course, that the benchmark was falling even harder at the same time.) Other companies expressed polite interest in the scheme—then of course continued on with what they were doing.
A lot has changed in the intervening year. If you signed on with Level 3 shortly after that Forbes article, you probably wouldn’t be too excited about your options package today—LVLT was flying high back then but has been slaughtered in the last 12 months and, as it happens, positively crushed by the S&P over that period (even though the S&P has not exactly been the turbo-charged benchmark of the recent past).
When I learned of Crowe’s ideas back then, I thought they were great. (He also champions the notion that the value of options should be charged to earnings when they’re issued and believes that insiders should disclose their stock sales before the fact; he does so in letters to shareholders like this one.) I later had some second thoughts about the aggressive options-pricing scheme, which I’ll get to in a minute, but what I still like about it is the attempt to minimize the ability of mediocre executives to make massive options scores behind a smokescreen of pro-shareholder rhetoric.
The big theme of last year’s compensation stories was a scramble for options by CEOs jealous of the enormous stock payouts going to dot-com chiefs. This year, not surprisingly, the theme is backpedaling. Cash payments are up. Options are being repriced. Special compensation awards are going even to CEOs who did not meet financial goals. This is par for the course: Executives who were perfectly willing to take full advantage of obviously inflated share prices suddenly discover the market’s imperfections when confronted with the downside. Maximum reward, no risk at all. (And just to keep Crowe’s bravery in perspective, his 1999 base salary was $350,000, and he got a $1 million bonus; the 2000 figures aren’t out yet.)
So far there’s been little sign that shareholder disgust with all of this will have any effect on the corporate boards that actually approve executive compensation deals. Perhaps that will change. If so, the spirit of Level 3’s idea is worth holding on to: An “enormous payoff” should result from an above-average performance, period.
What’s the problem with the rest of the Level 3 solution, then? What gives me pause is the possibility that such a scheme merely exacerbates the tendency of management to obsess over share prices, especially in the short term. An extra incentive to add juice to shares to push them past some benchmark at least has the potential to serve as an incentive for accounting gimmicks, too. When the bull market was truly on fire, it became a truism that share price is the only worthwhile proxy for corporate performance. It was hard to convince anyone—investors or managers—that there can be long stretches when stock prices are actually a rather imperfect gauge and that other measures like earnings and return on equity might be worth a little more attention. In a down market, of course, executives are likely to be much more sympathetic to that point. Would they be willing to put a greater share of their compensation at risk as a result? Well, don’t bet your bonus on it.