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Jan 19, 2009

Deacons wrong on performance rights

According to a study by mid-tier law firm Deacons, almost three-quarters of employee share options plans issued since 2003 are worthless, writes Adam Schwab.


“Share option plans worthless”, screamed the Financial Review last Friday. According to a study by mid-tier law firm Deacons, almost three-quarters of employee share options plans issued since 2003 are worthless. Deacons also noted that “S&P/ASX 50 companies learnt a lesson from the dot-com crash and moved to performance rights schemes rather than employee option schemes to ensure that their incentive schemes continued to motivate their employees during downturns in the market.”

The Deacons study’s fawning admiration of performance rights is certainly not a good thing for shareholders.

While premium or market price options can lead to a significant transfer of wealth from shareholders to management, at least they require some sort of share price appreciation (along with satisfaction of usually easily passable hurdles like earnings-per-share). The same cannot be said for performance rights, which are essentially free shares given to executives, in most instances, exercisable if the company is able to achieve an “earnings per share” target.

It is no coincidence that most performance rights plans utilise an absolute “earnings per share” hurdle. This is because, unlike a relative hurdle such as “total shareholder return”, absolute EPS targets are relatively easy to achieve (especially in a rising market). The “earnings” part of “earning per share” is a pliable accounting value, which can be manipulated by executives. Further, paying executives based on EPS can encourage short-term thinking, such as reduction in research or marketing expenditure. This leads to a brief increase in earnings but is detrimental to shareholders in the longer term (by then, the culpable and recently wealthy executive has long since departed, performance rights in tow).

The ostensible authors of the Deacons study, Andrew Spalding and Shane Bilardi, took a different view, claiming:

While a performance rights plan cannot replace options that will expire in the near future, it may provide a better mechanism for motivating employees in the future. Performance rights plans arguably promote better alignment between the interests of employees and shareholders and operate more effectively in a downturn.

With friends like Deacons, shareholders hardly need enemies.

Deacons appear to confuse “motivation” with “giving executives money to perform badly”. The fact that “options issued under those plans since 2003 are on average 48% out-of-the-money” shows that premium-price options may be the one small way for companies to achieve any sort of correlation between shareholder and executive returns. The alignment is of course virtually irrelevant — in most instances, where options fall out of the money, directors (like those at United Group and Asciano) reward executives with vast increases in fixed pay and short-term cash bonuses, which are completely independent of flailing shareholder returns.

Just in case you were in any doubt as to where Deacon’s real motivations lie, the firm provided a helpful reminder:

Employers considering ways to reinstate the value of their employee option plans should be aware that there are a number of different methods that can be used which have varying implications under the Corporations Act, ASX Listing Rules and income tax legislation.

Some would suggest that instead of counseling executives and directors on how to “reinstate their pay”, Deacons should be instructing executives and directors to spend more time reinstating the company’s share price.

The attitude of firms like Deacons (and to be fair, Deacons are certainly not alone, companies would hear similar views from the vast majority of remuneration consultants, accounting and law firms) is exactly why top 100 executive remuneration has skyrocketed from 30 times average earnings in the 1970s to around 90 times average earnings today. It is also why despite the All Ordinaries Index dropping by more than 40 percent of their equity investment value last year, executives who oversaw the loss actually increased their earnings rise by one percent to $2.97 million.

The services of firms like Deacons or the faceless remuneration consultants are chosen by executives (and their patsy directors) but paid for by shareholders. It wouldn’t hurt for them to occasionally act in the interests of those paying the bill.


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One thought on “Deacons wrong on performance rights

  1. DavidM

    Good work.
    Keep it up, Alan.


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