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September 25, 2007

BURSTING THE PAY BUBBLE
FORUM COLUMN

By Mark Labaton

When it comes to stock options, some corporate executives maintain that Oscar Wilde was right when he said "nothing succeeds like excess."

But excess in awarding stock options can lead to criminal and civil liability for altering corporate records, concealing material information, engaging in conflicted behavior, trading on insider information or lying to shareholders — sometimes to hide the backdating of option grants or to understate the financial consequences of doing so.

The awarding of millions of dollars in stock-option grants is a relatively new development. The doling out of such grants to executives increased sharply in the 1980s with the escalation of mergers and changes in the tax laws. Later, the dot-com boom of the 1990s led to a further proliferation of stock options to compensate corporate executives. Prior to this development, executive compensation consisted of salaries and monetary bonuses.

Today, stock options account for more than half of CEO pay and roughly 30 percent of the pay for operational managers in companies whose stock is traded on public exchanges.

Excessive executive compensation stemming largely from these options has become a growing concern among investors and among academics and judges at the forefront of corporate governance circles.

William B. Chandler III and Leo Strine Jr., the chancellor and vice chancellor of the Delaware Chancery Court, respectively, highlighted this concern in an article they wrote a few years ago for the University of Pennsylvania Law Review. There, they suggest the need for "reinvigorated application of the concept of waste" to respond to the "Argentine-like inflation in executive compensation."

Compounding the problem of excessive compensation are the troublesome practices of "backdating" and "spring loading" option grants.

Spring-loaded grants are awarded by and to company insiders just prior to positive company news likely to instantly boost the grants' value. The grantor and grantee know about the undisclosed positive development, but the public does not.

Backdating and spring-loading both involve dishonest behavior that often results in breaches in the fiduciary duties of loyalty and candor, which is why the prevalence of such practices is a stain on corporate America.

The beneficiaries of significant option grants contend that they are a cheap way to reward corporate managers. This is a convenient but defective rationale. Beginning in 1993, the Financial Accounting Standards Board, which sets auditing standards, began advocating that companies deduct the value of stock option grant awards from company earnings because of their high cost. But extensive lobbying from Silicon Valley executives who profited enormously from such grants ensured that public companies were not required to begin making the deductions until December 2005.

Since then, the cost of options grants to corporate insiders has been required to be treated as a corporate expense in financial statements. This is how it should be; these grants are a significant expense that comes off of the bottom line.

Stock option grants also dilute the value of outstanding stock shares. Advocates of large grant awards contend otherwise, but their argument is flawed. Indeed, many of the same corporate officers who receive and grant large option awards also support expensive stock company buy-back programs because they recognize that buy-backs result in the reduction of outstanding shares and boost the per share value of the remaining outstanding shares.

Worse than stock dilution, huge option grant awards motivate some officers and directors to make false statements and trade on inside information to enhance the value of their options and/or to cash them out at artificially inflated stock prices.

Despite these problems, corporate America still loves to award stock options as a significant component of executive compensation, partly because of the enormous value of the options and partly because they help disguise the growing disparity between executive compensation and that of rank-and-file employees.

The average public company CEO's pay was approximately 40 times greater than the average employee's pay in 1980; now it is more than 400 times as much. Stock options not only account for much of this disparity, but also enable corporate managers to mask the true value of compensation packages — worth, on average, more than $10.5 million a year for public company chief executive officers.

A CEO like Steve Jobs, who receives grants worth hundreds of millions a year, can boast that his annual salary officially is $1 a year, while other corporate executives can similarly downplay and understate their true compensation.

Another problem is that, as with executive compensation generally, such grants are not typically negotiated in arm's-length transactions. All too often, they are the product of quid pro quos among corporate managers, each scratching one another's back.

At the same time, because of the business judgment rule and the inherent difficulties of bringing lawsuits based on corporate "waste," such decisions are rarely subject to challenge by shareholders.

Some corporate boards hire compensation consultants to recommend the amount of options to grant corporate mangers. But these consultants typically remain beholden to the same company for multiple contracts, and they know that if they are perceived as too independent, few, if any, companies will retain them.

Starting this year, corporations like Verizon and Blockbuster decided to give their shareholders a limited vote in their managers' compensation decisions by passing "say-on-pay" referendums. These token votes, however, are not binding.

More helpfully, the Sarbanes-Oxley Act of 2002 made it difficult to backdate option grants by requiring that corporations report such grants within two business days of their receipt (the law previously allowed up to 40 days).

This has had a positive effect, as evidenced by the fact that almost all of the more than 200 option backdating cases under investigation by the Securities and Exchange Commission involve conduct pre-dating this legislation.

So, what else can be done? Corporations can make shareholder votes on compensation binding, draw out the vesting dates for stock-option grants to corporate managers or return to awarding cash bonuses tied to performance. They can also award restricted stock instead of stock options.

If such restricted stock is not redeemable until several years after the executive leaves the company, or for at least five years after the award, the recipient would be vested in that company's long-term future prosperity.

The aim is to align executive compensation to performance, democratize compensation decisions and reduce the incentives for corporate insiders to manipulate company financial results to show artificial short-term gains.

Separately or in combination, implementation of these proposals is likely to decrease incentives for corporate stewards to put their personal interests above those of shareholders.

My corporate law professor once said that in a capitalist society where corporate executives have enormous discretion under the "business judgment rule," officers and directors can get away with being pigs. But, he added, they will get into big trouble if they act like unrestrained hogs.

Using excessive stock option grants as a form of compensation creates too great an incentive for corporate mangers to put their interests above those of the shareholders, the true owners of any company.

Mark Labaton is a partner in the Los Angeles office of Kreindler & Kreindler, where he represents plaintiffs in securities, corporation governance and consumer class actions and relators in False Claims Act whistle-blower cases.

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