The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISdozen firms announced their intention to expense options voluntarily; more than 150 firmshad elected to expense options by early 2003 (Aboody, Barth and Kasznik (2004)).Moreover, shareholder groups (most often representing union pension funds) begandemanding shareholder votes on whether options should be expensed; more than 150shareholder proposals on option expensing were submitted during the 2003 and 2004 proxyseason (Ferri and Sandino (2009)). By late 2004, about 750 companies had voluntarilyadopted or announced their intention to expense options.In December 2004, FASB announced FAS123R which revised FAS123 by requiring allUSA firms to recognize an accounting expense when granting stock options, effective forfiscal years beginning after June 15, 2005. The expense would be based on the fair marketvalue at time of grant, calculated using Black and Scholes (1973) or a similar methodology,amortized over the period when the option is non-exercisable. Using “fair market-valueaccounting” brought USA standards in line with the international standards issued inFebruary 2004 by the International Accounting Standards Board (IASB). The rule also“leveled the playing field” between stock options and restricted stock, which had beenexpensed at their grant-date fair market value (amortized over their vesting period) sinceAPB Opinion No. 25 in 1972. As a result, companies reduced the number of options grantedto top executives (and other employees), and greatly expanded the use of restricted shares.Financial economists generally dismiss the idea that executives would react toaccounting changes that have no effect on current or future cash flows. But, as we discuss inSection 2.5 below (see also Murphy (2002); Hall and Murphy (2003)), there is ampleevidence that options were granted in such great quantities, and to so many employees,precisely because executives and boards of directors viewed options as essentially “free” (orat least cheap) to grant. Advocates of broad-based option programs in Congress, fearing thatfair market-value accounting for options would end of option grants to low-level employees,introduced several (ultimately shelved) bills to protect such programs, including:• The “Workplace Employee Stock Option Act of 2002.” (H.R. 5242), which providedincentives for broad-based option programs by allowing employees to purchase optionsand stock through pre-tax payroll deductions, and providing accelerated tax deductionsfor employers.• The “Rank-and-File Stock Option Act of 2002” (S. 2877), which limited the taxdeduction companies could take if a stock-option program was not broad based.-39-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISThese bills, and several others, were shelved in committee. Ultimately, and predictably, theexpensing of options indeed curtailed the practice of broad-based option plans: firms thatalready had such plans granted fewer options, and virtually no firms without plans introducedone. As evident from Figure 2.9, the average number of options granted by firms to allemployees fell by half from 2001 to 2005 (from 2.6% of outstanding shares each year in2001 to 1.3% in 2005).While accounting issues can explain the reduction in option grants and increasedemphasis on restricted stock, the 2000 burst in the Internet bubble (followed by the terroristattack in September 2001) also certainly also played a role. In particular, the sharp marketwidedecline in stock prices in the early 2000s left many outstanding options underwater andlowered executive expectations for the future increases in their company’s stock prices.Indeed, in many cases, including Microsoft and Cablevision, current outstanding (but out-ofthe-money)options were cancelled and replaced with restricted stock, often at terms veryfavorable to executives. Executives will naturally prefer restricted stock to options when theyhave low expectations for future firm performance. While restricted stock will always retainsome value as long as the firm is valued at greater than its liabilities, executives often expectthat options granted in a declining market are likely to expire worthless.Indeed, in addition to tax and accounting considerations, stock options have alwaysbecome more popular when stock markets are trending upward (i.e., “bull markets”) and lesspopular when markets trend down (i.e., “bear markets”). Indeed, almost every recession overthe past 60 years has been associated with a reduced use of stock options, and during the“lackluster” 1970s many firms replaced their option plans with a plethora of new accountingbasedplans designed to provide more predictable payouts, including: book-value plans(where executives receive dividends plus the appreciation in book values); long-termperformance plans (with payouts based on long-term earnings growth targets); andguaranteed bonuses (with payouts guaranteed independent of performance). 53 Therefore,stock options would have predictably fallen in the market collapse in the early 2000s, butwould also have predictably increased as markets improved. However, firms relied less andnot more on options during the market run-up from March 2003 through October 2007,which is consistent with the accounting hypothesis.53 Ricklefs, “Sweetening the Pot: Stock Options Allure Fades, So Firms Seek Different Incentives,” WallStreet Journal (May 27, 1975), p. 1; Hyatt, “No Strings: Firms Lure Executives By Promising Bonuses NotLinked To Profits,” Wall Street Journal (December 24, 1975), p. 1; Ricklefs, “Firms Offer Packages of Long-Term Incentives as Stock Options Go Sour for Some Executives,” Wall Street Journal (May 9, 1977), p. 40.-40-
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