The Hindu Business Line : Manipulating stock options for personal gain

Under the garb of designing a motivational compensation package intended to spur the executive to higher performance, the concept of granting stock options to CEOs has been hijacked by those in power to award themselves corporate funds.

The US Securities and Exchange Commission has been digging around corporate records the last few months and is said to be investigating about twenty companies with regard to the procedures followed on granting stock options. Senior executives of some of these companies have been sacked, others have resigned, and the probing is said to be on. The issue is one of timing the option allotment.

In theory, stock options are granted to the CEO and other senior executives by the board to motivate their performance. The process is as follows: An individual is granted the right to buy a specified amount of stock at a `strike' price, that is, the market price at the time of award of the stock. He or she has to have held it for a given period, say, a year, and can then sell it at the ruling market price. So, if the stock price has risen, the difference between the strike price and the sale price is the bonus the individual receives because the company's performance (as revealed by the stock price) has improved.

Our current notions of corporate governance rest on the principal-agent model. The manager is the agent of the principal, the owners (stockholders). So the board of directors, representing the stockholders, would like to design the compensation of the manager in such a manner that it is aligned with the interests of the owners.

Without proper controls, the managers may act in a manner that only benefits them and not generates profits for the owners. Therefore, theoretically, when the compensation of the top management team (and that includes the CEO) is in some manner tied to the stock price, it brings the owners and agents interests in line.

Incentive or compensation

Reality has been something else. The problem that has now been found in many companies hinges on the fact that soon after the grant of the options, the stock price has risen sharply. Inherently, there is nothing illegal in this. It could, hypothetically, be just good fortune, or genuinely the result of the performance of the managers.

On the other hand, it could also be that the directors, knowing from inside information that the stock is going to do better in the near future, give the executives the options. Then, one can consider it an immoral use of inside information that has put the executive in a better position than an outsider who owns or wishes to buy stock. It is also wrong from the perspective of compensation theory since the award of the option has not been to motivate improved performance. By careful timing, the incentive has been transformed into deferred compensation.

Not too long ago, companies got away with offering these options at below market price. This made it even more clear that the options were not an incentive but only a form of current compensation. The regulators plugged the loophole by requiring that the difference be treated as a compensation expense, thereby reducing the company's net income. This led many companies to restate their annual statements.

The hitch

What makes the current cases illegal from the regulator's point of view is that vesting of the option appears to have been backdated. Namely, after the stock price has risen, the company backdates the issue of the option to precede the rise in the stock price. Academic researchers who have studied this issue by analysing large databases believe that the problem is more widespread than the current investigation suggests.

In essence, under the garb of designing a motivational compensation package intended to spur the executive to higher performance, the concept has been hijacked by those in power to award themselves corporate funds.

In many of the companies now under scrutiny, the CEO and others receiving these options are also the founders, and often among the directors on the board granting the options. Thus, the system of compensation has been manipulated so that it has cheated other owners (stockholders) and other managers (those not eligible for options) in favour of owner-managers who had the power to allot themselves the option. Grant of options requires approval by the board, and this whole practice also casts doubts on the role of the directors of the company.

Sky-rocketing salaries

CEO compensation in the US has been growing seemingly without limit for many years now. In 1980, the CEO of top companies made 42 times the average worker. Now, the multiple is around 420 and growing. Stockholders have tried in vain to propose resolutions at annual meetings to limit such runaway compensation. Regular newspaper reports reveal that apart from such excessive compensation, top managements negotiate unbelievable packages for their retirement. The ethics of many of those compensation packages are highly questionable. The CEO and two other executives of North Fork Bancorp., a regional bank, had included in their contracts restricted stock that they would receive if the firm was taken over, or when they retired. So they negotiated its sale to Capital One Financial Corp., and pocketed about $288 million (Rs 1,296 crore) in the process. Mr James Kilts, CEO of Gillette, similarly received substantial sums to compensate him personally from having sold his company to Proctor & Gamble.

All of this suggests that the issues of stock timing, CEO compensation, and so on are not minor aberrations in a corporate system that only needs more regulations to fix them. Every time there is a new regulation, another way out is discovered. The problem is that the form of capitalism practiced in the US does not put any moral limit on accumulation of capital and the means adopted to do so. It is a winner-takes-all society.

The winner is the one who holds the power and can take what he or she can. It is common to find a leading player in a professional sports team to be compensated many hundred times more than the rest of the team. And they still call it a team!

Growing divide

That such behaviour has skewed income distribution in society has become increasingly clear in national (US) statistics. The Federal Reserve conducts a survey of consumer finances and estimates the net worth of families, that is, the difference between the assets and liabilities.

These triennial surveys show that the share of the net worth of the top 1 per cent of families in the country has increased from 30.1 per cent in 1989, to 32.7 per cent in 2001 and to 33.4 per cent in 2004.

Comparable figures for the bottom half of the families in the country show a fall of their share of net worth from 3 per cent in 1989 to 2.8 per cent in 2001 and to 2.5 per cent in 2004. A clear illustration of the expression, `the rich are getting richer while the poor are getting poorer.' Recently, in an initiative heavily promoted by the President, the Congress voted a further set of tax cuts for the higher income tax brackets!

A driving force of capitalism is the right to property and the freedom to accumulate wealth. When the property is accumulated by justifiable means, it is a glorious reflection of the individual's skills and capabilities.

The history of nations has shown that this is a more powerful motivator for economic growth of a nation than the tired communist philosophy of restricting accumulation in favour of equity in distribution.

But if the accumulation is through use of power and position and not through performance, then it is a corruption of the system. Leaders of corporate America need to think about this carefully before they write themselves their next cheque.

(The author is professor of international business and strategic management at Suffolk University, Boston, US. His Internet address is cgopinat@suffolk.edu)

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