Since coming into vogue in the mid 1990s stock options have been a boon for CEOs but an expensive extravagance for shareholders. The US Securities and Exchange Commission is currently investigating “dozens” of companies for allegedly backdating options. The man who discovered the backdating scandal, Erik Lie, estimated that of the 7,774 firms sampled, it was found that as many as 29% had manipulated or backdated options between 1996 and 2002.

Some companies didn’t even bother backdating options, rather, like Fannie Mae, they just rigged corporate earnings so that executives could cash in options worth millions.

While the situation has never been so dire in Australia, we have not been without scandal. Just yesterday, The Age reported a “gulf between reported pay and actual benefits received results from accounting treatment [because] the reported pay totals include an actuarial assessment of the value of options when they are granted. But this valuation is not updated when the options are exercised.”

Further, many executives enter into derivative arrangements (typically cap and collar deals) which allow them to “cash out” their options. So much for linking executive compensation with shareholder returns. Executives get all the return but none of the associated risk.

While there is nothing wrong with options if they are correctly used, as Warren Buffett notes, options are “more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders”.

If not options – how should companies incentivise executives? The most logical way is to truly align executives and their shareholders. That is, give executives base pay plus a loan to acquire shares in the company (this is different from giving Telstra-style performance rights which in effect amount to free shares). The company could pay the interests costs associated with the loan – that amount (which is far easier to calculate than the value of an option) would be considered as remuneration to the executive. The executive would not be able to “cash” in their shares for a significant period after grant so as to encourage long-term wealth creation (executives would however, receive the dividends on those shares, encouraging the most effective use of capital).

For example, an executive might receive $1 million in base compensation, with perhaps the company paying $560,000 of interest on a loan to purchase say $7 million worth of shares. (See how much an executive would make if they can deliver 20% share increases per year for ten years, below). By contrast, if the executive performs badly, they may “lose” money (but only in proportion to shareholders’ loss of value).

The benefits of giving executives shares rather than options include:

  • ease of calculation (and by implication, clearer disclosure to shareholders);
  • a “true” alignment of executives and shareholders; and
  • reduced costs of paying remuneration consultants.

Unlike with options, executives receiving shares would not tempted to maximise the short-term share price to the long term detriment of shareholders. (Perhaps as a failsafe, executives could be protected from capital loss by the company if the value of their shareholding falls, but by a lesser amount than the market as a whole).

While banning options is a draconian suggestion, it comes after years of misuse of options. While options have been a boon for executives, they have been horrible for shareholders. In case you are worried that banning options would inhibit the best executives from working in Australia, that is not necessarily the case (although it probably would stop the greedy) – Warren Buffett has never received options and works for $100,000 per annum.

By the way, returning to the above example, if an executive were able to deliver 20% per year share price growth, after ten years, their holding would be worth $43 million – and shareholders would be duly enriched.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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