Proposed changes in New York Stock Exchange listing rules have highlighted a growing debate over stock options. For some years now, US institutions have encouraged the granting of stock options to directors, executives and other employees as a way to align their interests with shareholders. Companies like them too because, especially in bull markets, they can substitute options for cash to sweeten the compensation pot. This is especially important in start-up and high-tech companies where the future holds greater promise than current cash flow permits.
But substantial increases in stock option grants have recently begun to trigger alarms that the dilutive effects of exercising these options may not be in the best interest of the original shareholder proponents. Key questions arise: How much economic and voting power can be transferred to insiders at the expense of external shareholders? And what role can regulatory authorities play to require that certain plans be put to shareholder vote?
Conference Board data indicate that use of stock payment of various kinds for US directors in 1998 was reported by 88 percent of all companies. This continues an increasing trend from 75 percent in 1996 and 84 percent in 1997. Stock options are still the most popular form of stock compensation, reported by 55 percent of companies.
While stock options have no ascertainable value at grant, Conference Board analysts estimate the present value of future benefits, taking into consideration risk of forfeiture, market volatility and restrictions on exercise, at 30 percent of the grant size. Median basic director compensation in 1998 increases substantially when stock compensation, largely in the form of stock options, is added. In manufacturing companies it rises from $35,000 to $51,000; in financial companies it rises from $31,800 to $42,475; and in the service sector from $32,000 to $42,115.
Top executive compensation
By far the more controversial use of options is for CEOs and other top executives. Size of stock option grants (number of shares multiplied by price per share on date of grant) and value of grant (size multiplied by the same 30 percent estimate noted above) show significant increases over base salary in several industries. The use of options in the telecoms and computer services sectors leads all other industries:
- Telecommunications – median size of grant as a percent of CEO salary is 1,270 percent (low is 684 percent and high is 3,119 percent); median value of grant as a percent of CEO salary is 349 percent (low is 137 percent and high is 936 percent)
- Computer services – median size of grant as a percent of CEO salary is 666 percent (low is 341 percent and high is 1,653 percent); median value of grant as a percent of CEO salary is 278 percent (low is 135 percent and high is 805 percent)
- Commercial banking – median size of grant as a percent of CEO salary is 409 percent (low is 163 percent and high is 944 percent); median value of grant as a percent of CEO salary is 101 percent (low is 44 percent and high is 283 percent)
- Manufacturing – median size of grant as a percent of CEO salary is 369 percent (low is 184 percent and high is 859 percent); median value of grant as a percent of CEO salary is 112 percent (low is 57 percent and high is 260 percent).
Dilutive effects
Research from the Washington-based Investor Responsibility Research Center (IRRC) for the S&P Super 1,500 companies finds the average potential dilution from stock option plans to be 10 percent for the S&P 500, 10.5 percent for S&P 400 mid-cap companies, and 13.8 percent for S&P small cap companies.
IRRC finds small cap companies, which are often cash-poor and rely on stock-based incentives as a significant portion of overall compensation packages, tend to have higher levels of potential dilution. While 82.8 percent of S&P 500 companies have total potential dilution below 15 percent, far fewer (63.2 percent) small cap companies fall below the 15 percent threshold.
Are shareholders better off when they trade extra dilution for providing compensation tied to stock? Some countries do not allow companies to give stock options (Sweden, Chile) and others have only let them be granted recently (UK, Germany). Arguments against the granting of options center on the concern that directors and executives will do things to run up the price of the stock to the detriment of the long-term viability of the corporation. Intuitively, however, most agree that options align interests, especially if exercising them to acquire stock is in some way restricted so there are incentives to work on behalf of the company and hold the stock for the long term at the same time.
A Conference Board review of studies linking corporate governance and corporate performance found results varied substantially and correlations difficult to prove. One recent study by Sanjai Bhagat, Dennis Carey and Charles Elson makes a compelling case that, when directors own stock, they are more likely to oust a CEO, presumably in times of poor performance. The study is based on analyzing 449 US companies during 1991-1997 where the CEO ‘turned over.’ Directors’ stock ownership is higher in companies where the CEO resigned or no reason was given for the CEO to leave, compared to companies where the CEO retired.
Who decides?
Who should control the decision how much to grant? Many large US corporations voluntarily put their top executive stock option plans to shareholder vote. But should there be a regulatory requirement to do so? If so, what should be the dilution trigger point beyond which management should obtain permission for the effective stock transfer?
Finally, who should determine these requirements? The SEC bowed out of the process some time ago and the NYSE is looking into the matter now. In the end, granting stock options is a subtle but important change of corporate control issue. Whether or not the SEC or the NYSE should be prescribing any specific terms, they certainly can and should require appropriate disclosure.
Dr Carolyn Kay Brancato is head of the Conference Board’s Global Corporate Governance Center
