The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISimportantly, Section 162(m) does not apply to compensation considered “performancebased”for the CEO and the four highest paid people in the firm.Stock options granted with an exercise price at or above the grant-date market price aregenerally considered performance-based compensation as defined under Section 162(m), andare therefore gains from exercising such options are fully deductible as a compensationexpense. However, restricted stock, and options issued with an exercise price below thegrant-date market price do not qualify as performance based.<strong>The</strong> “safe harbor” for option grants under Section 162(m), coupled with the FASB’slargely contemporaneous decision that options could be granted without an accountingexpense to the company, opened the floodgate on option grants in the USA. As shown inFigure 2.3, CEO incentive compensation in the early 1990s was split about evenly betweenoptions and accounting-based bonuses. By 1996, options had become the largest singlecomponent of CEO compensation in S&P 500 firms, and the use of options was even greaterin smaller firms (and especially high-tech start-ups). By 2000, stock options accounted formore than half of total compensation for a typical S&P 500 CEO.As grants for top executives increased, companies faced growing pressure to pushgrants to managers and employees at lower levels in the organization 50 . Employees clamoredfor broad-based grants, but only if the company would promise that other components oftheir compensation would not be lowered. Boards readily succumbed, especially since (priorto changes in exchange listing requirements in mid-2003) shareholder approval was requiredfor plans where option awards were concentrated among top executives but was not requiredfor broad-based plans that covered large numbers of employees. In addition, several bills thatencouraged broad-based stock option plans were introduced in Congress, including the“Employee Stock Option Bill of 1997” (H.R. 2788) to ease the restrictions on qualifiedIncentive Stock Options granted to rank-and-file workers. As a result of these pressures, thenumber of options granted (expressed as a fraction of outstanding shares) grew substantially.50 See, for example, Flanigan, “It's Time for All Employees to Get Stock Options,” Los Angeles Times (April21, 1996), who argued that all employees should receive options if top executives receive options.-35-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISFigure 2.8 Grant-Date Values of Employee Stock Options in the USA S&P 500, 1992-2006Note: Figure shows the grant-date value of options granted to all employees in an average S&P 500 firm, based on datafrom S&P’s ExecuComp data. Grants below the Top 5 are estimated based on “Percent of Total Grant” disclosures;companies not granting options to any of their top five executives are excluded. Grant-values are based on companyfair-market valuations, when available, and otherwise use ExecuComp’s modified Black-Scholes approach. <strong>The</strong>number in parentheses indicates the value of the grant, on average, that is awarded to the indicated employee (oremployee group). Monetary amounts are converted to 2008-constant US dollars, and then converted to Euros usingthe 2008 year-end exchange rate.Figure 2.8 shows the average inflation-adjusted grant-date values of options awardedby the average firm in the S&P 500 from 1992-2005. 51 Over this decade, the value of optionsgranted increased from an average of €19 million per company in 1992 to nearly €200million per company in 2000, falling to €60 million per company in 2005. Ignored in thenews coverage and controversy over stock options awarded to CEOs and the next fourhighest-paid executives is the fact that employees and executives ranked below the top fivehave received between 85% and 90% of the total option awards. Figure 2.9 shows averageannual option grants as a fraction of total common shares outstanding. In 1992, the averageS&P 500 company granted its employees options on about 1.1% of its outstanding shares. In2001, in spite of the bull market that increased share prices (that, in turn, increased the valueof each granted option), the average S&P 500 company granted options to its executives and51 Options granted to lower-level executives and employees are estimated by dividing the options granted to theproxy-named executives by the percentage of all options that are granted to the proxy-named executives. Underthe new 2006 disclosure rules, the SEC no longer requires companies to report the percentage of all optionawards that went to the proxy-named executives, and therefore our estimates of grants across the company endin 2005.-36-
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