Executive Compensation: A Tilted Playing Field

Alan Reynolds
Shortly after the Enron banruptcy there !ere several efforts to attribute the
company"s financial crisis to supposedly fundamental fla!s in the !ays in !hich
executives in general are paid# T!o distinct issues soon became intert!ined# $ne !as a
broad complaint about the level of compensation being excessive% using Enron as though
it !as a representative example of a much broader problem# The other !as a narro!er
complaint about one particular form of such compensation & stoc options & and about
the !ay that form of compensation !as accounted for and taxed# The agitation about
'expensing( options seemed to ac)uire symbolic value% as though that technical and
controversial accounting procedure had some connection to accusations of actual fraud in
the !ay Enron accounted for debts or in the !ay *orldCom depreciated operating costs#
+edia and political attention to the level and form of executive compensation in
,--./,--0 began as an almost exact replay of events ten years earlier# This chapter
therefore begins !ith a brief history of the controversy about executive compensation in
the early .11-s% sho!ing ho! some intended 'reforms( of that era contributed to
excesses and imbalances by the end of that decade# The follo!ing section includes a
criti)ue of recent efforts to place a large share of blame for the Enron crisis on executive
compensation% particularly stoc options 2a topic dealt !ith more intensively in later
sections section3# These first t!o sections set the stage for a more detailed loo into the
complexities of executive compensation in the context of rents 2paying more than
necessary3 and agency costs 2trying to bring the personal interests of managers into
alignment !ith interests of shareholders and creditors3# Subse)uent sections survey
statistics and studies concerning both the level and particular forms of executive
compensation# This is follo!ed by a descriptive analysis of the many !ays in !hich
stoc options are or could be accounted for and taxed & a topic that has once again
generated an un!arranted intensity of political and regulatory interest recently% as it did
in the early nineties#
Among numerous conclusions t!o stand out most clearly# The first conclusion is
that federal efforts to influence executive compensation in .11,/.110 proved
counterproductive# Those efforts included SEC disclosure rules% increased tax rates on
salaries and dividends% and a million dollar limit on deductibility of salaries# The second
conclusion is that federal efforts to influence executive compensation policy in the future
are also liely to prove counterproductive# Remedies that appeal to activist and populist
sentiment 2such as disclosure and shareholder approval of executive pay3 may put too
much authority in the hands of those !ho have neither the information nor the incentives
to negotiate on behalf of all o!ners of the firm 2including creditors and nonvoting
shareholders3# This chapter also suggests that if FAS4 compels public companies to treat
as an actual expense the estimated fair value of stoc options at the date they are granted
the main effects !ill be to 2.3 reduce the transparency and pay/for/performance
effectiveness of executive compensation !hile 2,3 maing 5AAP earnings even less
informative for investors 2due to treating unreliable estimates as actual expenses3#
Executive compensation is certainly a legitimate concern of ma6or shareholders
and directors% but introducing third parties into the negotiation 2such as the FAS4% the
7RS or trial la!yers3 is )uite liely to introduce rigidities that lead to suboptimal
arrangements from the point of vie! of both executives and shareholders# $ne/si8e/fits/
all accounting rules can become impediment to the flexibility needed to deal !ith the
inherently individuali8ed and sub6ective process of negotiating customi8ed contracts to
attract and retaining highly speciali8ed managerial talent#
Cautionary Lessons from the 1990s
At a Harvard Business Review roundtable of compensation experts% 9e! :or
attorney ;oe 4achelder reminded everyone that% 'in .1<, !e !ere critici8ing CE$ pay#
*e !ere still doing it in .1=,# 7n .11,% a raft of regulations and legislation !ere directed
at reining in CE$ compensation# Today !e are still discussing it# +uch of the current
criticism comes from the fact that # # # nearly =- percent of the gain in CE$ pay in the
.11-s is attributable to stoc options# And stoc marets did pretty !ell in the .11-s#
*eren"t !e saying in the .1=-s that !e should tie CE$s to the maret in order to identify
them !ith shareholder value> *e got !hat !e ased for#(
To!ard the end of prolonged economic expansions% such as .1=0/1- or .11,/
,---% stoc prices reach a cyclical pea and so does compensation lined to stoc prices#
7nformation about executive compensation is gathered and reported !ith a lag% !ith the
result that pea compensation is reported a year or t!o after the economy has slipped into
recession# Comparing boom pay !ith bust conditions then becomes irresistible fodder
for media and political outrage about excessive compensation during the previous
cyclical boom# 7n ;une ,--.% for example% a typical Fortune featured 'The 5reat Pay
?eist%( complaining about the 'high!ay robbery( of the year before#
As ;oe 4achelder
suggested% ho!ever% the 'raft of regulations and legislation( in .11,/10 should remind us
that this latest cycle of indignation could lie!ise inspire changes in tax and regulatory
policies that end up aggravating the situation they promised to fix#
4ac in .11-% The Harvard Business Review published a provocative and
influential study by +ichael ;ensen and @evin ;# +urphy% !ho had studied compensation
of CE$s at .A-- companies from .1<A to .1==# They found that 'a B.--- change in
corporate value corresponds to a Ct!o/yearD change in CE$ compensation of 6ust B,#E1#(
They also found that 'CE$s of large public companies are only slightly more liely to
step do!n after very poor performance#( *ith pay and 6ob security appearing to be so
insensitive to performance% ;ensen and +urphy complained that 'corporate America pays
its most important leaders lie bureaucrats#( Fater studies often disputed that
conclusion% but that is largely because the post/.11- shift from short/term bonuses
to!ard relatively long/term stoc options has greatly improved the sensitivity of pay to
stoc performance# 4y .11=% for example% ?all and Fiebman estimated that a .- percent
increase in a firm"s maret value added B.#,E million dollars to value of a median CE$"s
accumulated stocs and options 2!hile it also added billions to the value of shareholders"

Comparing CE$ compensation in the late eighties !ith the far more generous pay
of partners at la! firms and investment bans% ;ensen and +urphy argued that CE$ pay
should be higher for superior stoc performance# 4ut they also thought probability of
being fired should also be higher for inferior performance# 7n that case% less/talented
managers '!ould be replaced by more able and more highly motivated executives !ho
!ould% on average% perform better and earn higher levels of pay#( To re!ard 'increased
success fostered by greater ris taing% effort and ability%( they argued% '!ould eventually
mean paying the average CE$ more#(
Among smaller companies% the ;ensen/+urphy
study found the most potent pay/for/perfomance incentives by far !ere paid to the CE$
of 4ershire ?atha!ay% *arren 4uffett% a gentleman !ho has been no!n to complain
that much smaller incentives for other CE$s are excessive#
As other economists began looing into executive compensation% it seemed that
;ensen and +urphy probably exaggerated the alleged inefficiency of the maret for
corporate leadership# Summari8ing numerous studies on executive compensation
produced for the 9ational 4ureau of Economic Research through .11A% 9ancy Rose
remared: '*e find no evidence for the popular vie! that boards typically fail to
penali8e CE$s for poor financial performance or re!ard them disproportionately !ell for
good performance#(
Regardless of the possible exaggeration of the ;ensen/+urphy
study in .11- and its probable obsolescence today 2due to !idespread substitution of
stoc options for salary and bonuses3% the basic idea that CE$ pay and tenure !ere often
unrelated to performance made CE$ compensation appear arbitrary# And the impression
that CE$ compensation !as arbitrary !as easily be abused by those !ho% )uite unlie
;ensen and +urphy% imagined CE$"s to be typically overpaid# As a result% t!o
seemingly )uite different ideas & that CE$ pay should be more closely tied to stoc
prices or that CE$ pay should be reduced by la! // came together as a hot political issue
in .11. and .11,# The result !as federal intervention that !as intended to limit CE$
pay but actually ended up having the opposite effect#
7n +ay .11.% t!o months before the start of recession% Carl Fevin 2G/+73% then
Chairman of a Senate $versight subcommittee% held hearings on executive compensation
in response to inflammatory articles then appearing in the press about CE$ earnings
during the stoc maret"s preceding pea# $n ;une A% .11. Senator Fevin and
Representative ;ohn 4ryant 2G / TH3 introduced the 'Corporate Pay Responsibility Act(
to re)uire more disclosure of CE$ pay and to re)uire the value of stoc options to be
estimated at the time they !ere granted and charged against earnings#
Congress did not
act on the bill% despite subcommittee hearings $n $ctober .<# 4ut the political pressure
did appear to affect regulatory policy at the Financial Accounting Standards 4oard
2FAS43 and Securities and Exchange Commission 2SEC3# FAS4 agreed to loo into the
matter of 'expensing( estimated option values 2as the FAS4 did again in ,--0 in
response to very similar political and media pressure3# 7n +ay .11A% ho!ever% the Senate
eventually passed a resolution re6ecting Senator Fevin"s proposal of mandatory
'expensing( of the estimated value of employee stoc options by vote of == to 1#

$n $ctober .I% .11,% the SEC amended 7tem A-, of Regulation S/@ to re)uire
much greater public disclosure of executive compensation and to facilitate shareholder
voting on such compensation# This action% noted Prevost and *agster% '!as in reaction
to intense political pressure from shareholder activists% presidential candidates% the media
and the J#S# Congress#( ;ensen and +urphy had anticipated this development in .11-%
!arning that 'public disclosure of K!hat the boss maes" give ammunition to outside
constituencies !ith their o!n special/interest agendas# # # #?o! often do shareholder
activists or union leaders denounce a corporate board for underpaying a CE$>(

+aing CE$ compensation a political target for activist groups !ith )uite
different goals than maximi8ing shareholder !ealth can be risy for shareholders# Prevost
and *agster surveyed several studies suggesting that managers of labor union or
government pension funds have often adopted the stance of being crusaders against big
business to further their o!n personal interests% including running for political office#
They examined several events leading up to the SEC rule change and estimated the
impact on stoc prices of firms targeted for institutional monitoring by the California
Pubic Employees Retirement System 2CalPERS3# They found that firms targeted by
CalPERS suffered 'significant !ealth losses( from the activist threat to CE$ incentives
caused by ne! SEC rules designed to mae CE$ pay an easier target#

*hat ne!ly empo!ered activists often did !ith the ne! SEC rules% ho!ever% !as
to use their special interest leverage to restrain CE$ salaries and bonuses% not pay/for/
performance 2i#e#% stoc options3# As if such external meddling in employment contracts
!as not dangerous enough% Congress decided to lend a hand#
$n August I% .110 President Clinton signed into la! the Revenue Reconciliation
Act of .110# The .110 tax la! fulfilled t!o campaign promises in the .11, Clinton/
5ore campaign boo% Putting People First# $ne !as to 'limit corporate deductions at B.
million for CE$s Csalary and bonusD#( The other !as to impose a 'surtax on millionaires(
2meaning% once in office% 6oint incomes above B,E-%---3#(

The million dollar rule% Section .I,2m3 of the tax code% denies public companies
any deduction for the cost of executive compensation in excess of B. million a year#
This rule !as never really about 'fairness( since it does not apply to other occupations%
such as actors% athletes or attorneys# And it !as not really about revenue either: The
Clinton/5ore boo claimed it !ould raise only BA-- million a year% !hich !ould have
been possible only if the ceiling had been ineffective# The main point% or at least the
main effect of this tax la!% !as to discourage companies from paying using non/salary
forms of pay to attract and eep top managers# That is because the million dollar rule
does not apply to performance/related pay% such as grants of stoc options and restricted
stoc# The million dollar rule does apply% ho!ever% to any stoc options that are 'in the
money( 2above the maret price3 !hen granted% thus effectively banning that type of
?all and Fiebman found that the million dollar rule 'led firms to ad6ust the
composition of their pay and to!ard performance related pay( but did not decrease 'the
total level of compensation#(
They focused on the short/term impact% and thus found a
relatively minor tax/related shift from salary to options# :et the million dollar cap
becomes more binding !ith each passing year% as *illiam +cGonough pointed out%
because that million dollar figure has never even been ad6usted to eep pace !ith
inflation% much less !ith the real increase in other professional incomes#
The .110 tax la! added a ne! marginal tax rate to 0I percent% up from 0.
percent% on taxable income bet!een B.A-%--- and B,E-%---# And an extra .- percent
surtax 2'the millionaires" surtax(3 raised the top rate to 01#I percent on incomes above
B,E-%---# That ,= percent hie left the top individual rate far above the ne! 0E percent
corporate rate 2also increased by . percentage point3# The steep ne! tax on marginal
salary income contributed to a shift to!ard deferred compensation% including stoc
options# And the steep tax on marginal dividend income contributed to excessive
corporate debt and inefficient corporate ac)uisitions#
7ncreasing the individual income tax to 01#I percent from 0. percent meant the
double tax on dividends after .110 !as increased from about EE to I- percent at the
federal level alone# That increased tax on dividends made stocholders even less
interested in dividends# Ayers% Cloyd and Robinson found 'conditioned on dividend
yield% a negative stoc price reaction during the t!o !ees that Congress passed and
President Clinton signed the increase in individual income tax rates in August .110#(

7ndividual investors subse)uently became more inclined to favor companies that used
earnings to increase assets per share% through ac)uisitions or share repurchases% thus
generating capital gains# The individual tax on capital gains !as far less punitive than the
tax on dividends% particularly since .11< !hen the tax on long/term gains !as reduced to
,- percent from ,= percent#
The higher tax rate on corporate profits% particularly !hen paid out as dividends%
also increased the incentive for corporate managers to use increased debt as a tax shield#
Enron and *orldCom created the appearance of rapid revenue gro!th largely by using
retained earnings and debt to ac)uire companies# That may have been clever tax
planning% but it proved to be dangerous business planning#
Another relatively minor effect% explained in Taxes and Business Strategy by
+yron Scholes and others% !as that 'because the corporate rate !as no! lo!er than the
ordinary income tax rate% the corporate form offered a deferral advantage#(
facing much higher tax rates on salaries and bonuses after .110 could negotiate to let
their companies use the ne! deferral advantage by s!itching a larger share of CE$
compensation to!ard the future through larger stoc options% deferred income plans and
retirement pers#
7t is one thing to recommend to corporate boards that they should mae executive
compensation more dependent on stoc prices% as scholars such as ;ensen and +urphy
!ere doing in the early nineties 2and many other scholars still do3# 4ut it is )uite another
thing for the government to use tax policy or accounting mandates to tilt the playing field
either in favor of stoc options or against them#

The SEC in .11, and the Clinton Administration in .110 acted on a belief that
regulations and tax policy should entice companies to tilt executive compensation to!ard
risy stoc options and a!ay from the security of salaries and pers# Recent complaints
that most of the increases in executive pay from .110 to ,--- came from options rather
than salaries are ironic: That !as precisely !hat the SEC and Clinton Administration
!ere trying to accomplish# 4ut they surely never anticipated & and neither did most
corporations // !hat a roaring bull maret !ould do to the value of stoc options in the
late nineties !hen even the benchmar SLP E-- index !as rising by nearly 0- percent
per year#
That bull maret !as over by April ,---% and t!o years later Business Week !as
reporting that 'average CE$ pay declined .IM Cin ,--.D% to B.. billion#(
A year after
that% in April ,--0% Fortune reported that average CE$ compensation among the .--
largest companies fell by ,0 percent in ,--.#
A different survey in The New York
Ties found 'total compensation of chief executives declined ,- percent#(
surveys differ in !ays that can be )uite misleading# Some surveys bravely attempt to
estimate the value of ne! options granted during the previous year 2such as the highly
unliely B<I million estimate for A$F options granted to Steve Case in ,--.3# $thers
count the value of old options that !ere finally exercised% and then !rite an irate story
comparing such CE$ compensation to a drop in the company"s profits# 4ut sales of
stoc during a year are not compensation earned during that year% so this is an absurd !ay
to compare pay !ith performance# 7n many cases the stoc sold by executives !as
purchased rather than earned% yet some ne!s reports have even referred to proceeds from
stoc sales as if that !as extra compensation# Selling financial assets is no different than
selling a home // it does not mae executives more !ealthy and it is not 'income#(
7n ,--,% as in .11,% popular articles complaining about stoc/related pay began to
appear long after the values of stocs and stoc options had collapsed# 7n $ctober ,--,%
for example% Paul @rugman !rote in The New York Ties !aga"ine that CE$ salaries
from Fortune"s top .-- had risen from B.#0 million in .1<- to B0<#E million in .111#
The latter figure% he claimed% !as 'more than .--- times the pay of ordinary !orers(
2supposedly B0E%=IA3#
@rugman"s .---/to/. figure even outbid the AFF/C7$% !hich
used similar statistical magic to claim CE$ pay in ,--- !as A.. times average 'hourly
!orer( !ages#
Fortune"s .111 figures on CE$ pay greatly exaggerated the estimated
value of options granted in that boom year% but the more obvious point is those .111
figures !ere inexcusably anti)ue by $ctober ,--,# 7t should have been obvious to +r#
@rugman"s readers% if not to the author% that CE$ pay had been hugely reduced by the
maret"s long and horrific decline#
For ,--,% Fortune"s estimate of average top .--- CE$ salaries and benefits !as
B.E#< million & nearly I- percent smaller than the B0<#E million figure @rugman used#
?is figures on 'salaries( of 'ordinary !orers( certainly did not refer to average salaries
!ithin the same top .-- firmsN it !as a national average diluted by hourly !ages of many
fast food and farm !orers# Jnlie figures on CE$ compensation% the 'pay of ordinary
!orers( excluded increasingly important health and pension benefits and% in many
cases% stoc options# @rugman"s measure of average salaries 2and !ages3 !ould have
been BAA%I.0 in ,--- if basic benefits !ere properly included% but BI1%EE1 in finance and
B<E% I<1 in communications#
7ndustries !ith high CE$ pay also offer higher salaries to
'ordinary !orers( and top .-- firms offer even higher salaries#
The @rugman statistical exaggerations of $ctober ,--, !ere very similar to
e)ually misleading articles !ritten in .11, about allegedly excessive CE$ pay in .1=1#
Such politici8ed misinformation !as not helpful then either#
*hat began in .11- as a plausible academic complaint 2from ;ensen and +urphy3
that CE$ pay !as insufficiently lined to the firm"s performance soon turned into a
change in regulations and taxes that !as designed to designed to encourage companies to
pay less in salaries and more in stoc options or stoc# 9obody imagined that options
and restricted stoc granted in .110/1E !ould end up being hugely valuable after only
three or four years of vesting# Thans to the bull maret% the populist tax and regulatory
reforms of .11,/10 had the ironic effect of maing CE$"s far more !ealthy than they
!ould have been if salaries and bonuses had been permitted to remain a larger share of
total pay pacages#

An Imaginary Link to Enron
7n the !ae of the Enron banruptcy% a flood of press stories about supposedly
excessive executive pay echoed the media agitation of a decade earlier# Enron"s failure
!as often attributed to corporate greed% said to be a result of !hat Paul @rugman labeled
'permissive capitalism#( Senators Carl Fevin and ;ohn +cCain 2R/AO3 )uicly sei8ed
on this media opportunity to revive their moribund .11< proposal to arbitrarily limit
employer deductions for the cost of exercised employee stoc options#
$n February .0% ,--,% Senator +cCain attempted to connect his recycled tax plan
to Enron by arguing that 'according to a recent analysis Cfrom Citi8ens for Tax ;usticeD%
Enron issued nearly BI-- million in stoc options% collecting tax deductions !hich
allo!ed the corporation to severely reduce their payment in taxes#( The Senator
apparently failed to reali8e that the estimated value of options !hen issued issued tells us
nothing about the amount of tax deductions for options that may or may not be exercised
several years later# ?e also failed to understand that comparing corporate taxes paid
!ith income during the same year% as his cited 'analysis( had done% is meaningless
because the corporate tax is largely based on accruals rather than immediate cash flo!#
Tax liabilities are sometimes deferred and operating losses are carried for!ard or bac in
7n any event% Senators +cCain and Fevin never explained ho! paying larger
taxes !ould have made it any easier for Enron to pay its bills and thus avoid banruptcy#
The concocted lin bet!een Enron and the +cCain/Fevin assault on executive stoc
options !as political opportunism# :et many reporters hungrily leaped for the bait#
The proposed Fevin/+cCain tax penalty on options !as explained in the
follo!ing Press Release from Senator Fevin"s office% also dated February .0% ,--,:
CThe billD '!ould restrict the compensation deduction that company could claim
for the exercise of a stoc option by limiting the stoc option deduction to the
amount that company has claimed as an expense in its financial statement# This
section !ould also mae it clear that the deduction cannot be taen prior to the
year in !hich the employee declares the stoc option income# # # #
Companies !ould have to expense the estimated value of options in the year they
!ere granted% under the +cCain/Fevin plan% but could deduct the cost of employee stoc
options only after such options had been vested% exercised and reported as taxable income
by employees# :et the cost deducted by the employer !ould not e)ual the income
received by employees% as is the case today !ith this and every other form of
compensation% but it !ould be limited to the amount that had previously been estimated
to have been the fair value of those options !hen granted years before# 7f the actual cost
exceeded the early estimates of fair value 2!hich% as explained later% are not even
intended to forecast actual cost3% the difference !ould be taxable to employees but not
deductible to employees# This !ould have been an indefensible bias in tax policy# :et
many press reports about this scheme in early ,--, completely ignored the tax aspects of
the +cCain/Fevin plan and instead focused on alleged improprieties of executive stoc
options at Enron and stretched that political complaint to stoc options in general# '*hat
ne! reforms !ould do%( claimed a Wall Street #ournal reporter% 'is shine a spotlight on
companies that overuse options% in particular high/tech concerns in Silicon Palley#(

Proposing to arbitrarily limit tax deductions for one form of compensation !as never
about shining a spotlight#
Trying to connect Enron to political complaints about stoc options re)uired
considerable 6ournalistic creativity# The first approach !as to suggest that failure to
'expense( employee stoc options in one particular !ay 2i#e#% !hen granted rather than
!hen vested% in/the/money or exercised3 had caused Enron"s earnings to be seriously
overstated% !ith the result that investors !ere thought to have been deluded into paying
too much for Enron stoc#
$n +arch ,I% ,--,% a seminal front/page Wall Street #ournal feature by 5regg
?itt and ;acob +# Schlesinger !as titled 'Stoc $ptions Come Jnder Fire 7n the *ae
of Enron"s Collapse#( Citing Senator Carl Fevin% a +ichigan Gemocrat% the article
claimed executive options 'pump up the earnings figures( and thus deceived investors
into paying too much for Enron stoc# '7n ,---% Enron issued stoc options !orth B.EE
million% according to a common method of valuing options Cthe 4lac/Scholes modelD#
?ad accounting rules forced the company to deduct the cost of those options from its
,--- profit # # # Enron"s operating profits for the year !ould have been =M lo!er#( This
theme !as subse)uently echoed uncritically throughout the business press and broadened
to lump most companies together !ith Enron% eventually producing a thunderous
drumbeat on behalf of deducting estimates of the value of options in the year !hen they
are granted 2lie that B.EE million3# *hat someho! escaped the Wall Street #ournal$s
reporters and their editors% ho!ever% !as the fact that stoc options Enron issued in ,---
!ere not !orth B.EE million but !ere% in fact% completely !orthless# ?ad accounting
rule forced the company to deduct that B.EE million estimate from its ,--- profit% then
the resulting earnings figure !ould have been erroneous by B.EE million#
Several ne!s reports echoed the claim of Senators +cCain and Fevin that tax
deductions for the cost of stoc options !ere the main reason Enron"s J#S# taxes
appeared small relative to 2grossly overstated3 domestic and foreign earnings# That
claim !as even inconsistent !ith the fla!ed ?itt/Schlesinger calculation that the
estimated value of ne!ly granted options amounted to no more than = percent of
earnings# :et 6ournalists nonetheless sei8ed on the alleged unfairness of employers
deducting the cost of options as though this !as another indictment of options in general#
$n +arch ,=% ,--, & t!o days after the misleading Wall Street #ournal piece //
Washington Post staff !riter Charles R# 4abcoc !rote% 'Guring the boom year of ,---%
some highly successful companies issued so many stoc options to their executives and
employees that they paid little or no corporate tax because the options !ere deductible#(
That statement !as completely !rong# There is no corporate tax deduction during the
year in !hich options are granted% so options granted during the boom year of ,---
resulted in no tax deductions# 7ndeed% most options granted during ,--- !ere so far
under !ater by +arch ,--, that they !ere unliely to ever produce taxable income for
employees% !ithout !hich there can be no deductible expense for employers#
$n +arch ,<% ,--,% one day before the other erroneous reports% Washington Post
staff !riter Alec @lein !rote that% 'Gespite a tough financial year% A$F Time *arner
7nc"s chairman and chief executive !as re!arded in ,--. !ith stoc options !orth an
estimated B<I million#( @lein at least said 'estimated%( !hich is more than many similar
reports on CE$ pay have done# ?alf of that estiated B<I million depends on A$F
stoc rising higher than BA1 a share & about four times the level of early ,--0 //
other!ise the options !ill be !orthless# The other B0= million of +r# Case"s supposed
!indfall depends on A$F stoc someho! exceeding BI./<0# That is the trouble !ith
estimates & they often loo ridiculous !ithin a year# :et proponents of 'expensing( have
been seriously insisting that estimates of exactly this sort 'should( 2in some Calvinist
sense3 be treated as actual expenses and subtracted from earnings# *e !ill have more to
say about this later# +ean!hile% eep in mind that subtracting +r# Case"s estimated B<I
million booty from A$F"s ,--. earnings !ould indeed have made that company"s BA#1
billion loss loo even !orse# 4ut that certainly does not mean that treating estimates as
reality !ould have provided investors !ith more accurate information#
9on)ualified options become deductible only after they are vested after three or
four years% in/the money and exercised# At that point% any gain on options becomes
taxable to the employee and deductible to the employer# This raises income taxed by the
individual tax 6ust as much as it lo!ers income taxed by the corporate tax# And since the
top t!o individual tax rates !ere higher than the corporate rate after .110% the net effect
!as a !indfall for the Treasury# :et the Washington Post mistae about tax deductions
being taen in the year ,--- for options granted in that same year% and the other
Washington Post story about Steve Case"s options being !orth B<I million% and the Wall
Street #ournal blunder about the estimated value of Enron"s !orthless options granted
during ,---% became part of a grounds!ell of accumulating follore that% in turn%
supported a confused and greatly exaggerated fascination !ith 'reforming( 2in one
particular and rigid !ay3 the manner and timing of stoc option booeeping# And those
three ne!s reports are merely a t!o/day sampling from the flood of media
misinformation about executive stocs options#
7n February ,--0 the ;oint Committee on Taxation 2;CT3 issued a massive report
in response to political charges that Enron"s problems may have been someho!
connected to its executive compensation programs# They had virtually nothing to say
about stoc options% except that many !ere exercised !hen the stoc !as high and many
others lost value !hen the stoc fell# *hen it came to effects of taxation on CE$
compensation% ho!ever% the ;CT"s strongest and most relevant recommendation !as that
'the limitation on the deduction for compensation in excess of B. million should be
7t could nonetheless be argued that there really !ere uni)ue peculiarities about
Enron"s compensation plans that might have contributed to executives" incentives to
manage earnings in increasingly devious !ays# 4ut the fact that these features !ere
unusual and not confined to stoc options is the reason they cannot be plausibly
converted into a generali8ed complaint about options# Such successful companies as
+icrosoft and Cisco mae much greater use of stoc options than Enron ever did#
7f there is a specific lesson to be learned from Enron about compensation policy%
it concerns the pace and duration of vesting rather than the particular %or of incentive
pay# Some critics of typical stoc option plans claim that restricted stoc is a superior
incentive% for example% yet Enron used e)ual measures of both# $ther critics say
performance pay should be indexed & that is% made more valuable if company stoc gains
exceeded those of some stoc index// but Enron did that too#
Enron"s compensation plan involved the usual mix of salary% annual bonuses and
long/term incentive grants !hich in recent years consisted of one/half restricted stoc and
one/half stoc options# *hat !as unusual about Enron"s restricted stoc !as that it had
an 'accelerated vesting( feature# That meant an executive !ould be allo!ed to sell
restricted stoc sooner than the usual four year 'cliff vesting( re)uirement if Enron"s
stoc outperformed the SLP E-- average# *hat !as unusual about Enron"s stoc options
is that they vested in only three years but expired in five# $ther companies" stoc
options plans vest only gradually after three or four years and most employee options do
not expire for ten years# Feaving only t!o years bet!een the time options could be
exercised and the time they expired% as Enron did% meant there !as a narro! !indo! of
opportunity to either gain much or lose it all# 7n some cases% stoc options a!ards had
accelerated vesting if Enron achieved .EM compounded gro!th in earnings/per/share#
Although it appears arguable that accelerated vesting !as an imprudent policy% it
!ould be e)ually imprudent to excuse executive activities that resulted in criminal
charges% and the absence of effective ethical supervision by directors% as merely a
sensible response to financial incentives# Feaving 6e!elry on the dresser !hen your
house is being cleaned is an incentive to theft too% but housecleaners !ho value their
integrity and reputation never steal#
5illan and +artin of the Center for Corporate 5overnance note that 'B.--
invested in Enron stoc in .11E gre! to BA<A#I. in ,---% compared to B,,<#=1 for the
SLP E--#( Enron executives% lie Enron stocholders% had comparable increases in
!ealth in those years% but that is the point of performance/related pay# Enron executives
did not reali8e all those paper gains% ho!ever% so they faced substantial do!nside ris
right up to the end# 'Fay and more than .A- senior executives at Enron apparently held
some BA0- million of stoc before the firm declared banruptcy% of !hich Fay accounted
for BE- million%( according to 5illan and +artinN 'they stood to loose a substantial
amount in the event of the company"s demise#( They also stood to ruin lucrative careers%
!hich is probably the best explanation !hy accounting trics accelerated after the house
of cards began to tumble# 7n the end% 5illian and +artin conclude that 'many !ould
argue that Enron"s personnel and compensation programs !ere not only innovative% but
in concert !ith recommended best practices#(

*hether or not Enron"s compensation plans !ere !hat experts regard as 'best
practices%( they surely had little to do !ith the '!orst practices( of many other
professionals !ho are supposed to act as !atchdogs and gateeepers & directors% auditors%
credit/rating agencies% and stoc analysts#
The populist crusade against executive pay during the early .11-s ended up
saddling the J#S# !ith 7RS and SEC regulations that had the unintended conse)uence of
over/promoting stoc options% thus generating huge !indfalls for CE$s !hen the stoc
maret boomed#
There is a serious ris that the latest populist crusade against the stoc options
promoted by the last populist crusade could lie!ise end up generating unanticipated and
decidedly unpleasant conse)uences# Executive compensation is a complex and critical
topic% and one in !hich the best arrangements are inherently sub6ective% differing for
every firm and every executive# There is a large body of evidence suggesting that
voluntary compensation agreements are remarably efficient in terms of the interests of
corporate managers and o!ners# Third parties% such as government regulators and self/
styled activists% are generally un!elcome at this bargaining table#
7n a recent survey of the evidence on executive compensation for the Federal
Reserve 4an of 9e! :or% Core% 5uay and Farer of the *harton School note that 'in
contrast to the allegations of many media pundits # # # !ho assert that incentive levels are
random% arbitrary or out of e)uilibrium% empirical evidence suggests that% on average%
firms base their e)uity incentives on systematic and theoretically sensible factors#(
Efforts to impose any one/si8e/fits/all regulations% including FAS4 rules about
accounting for stoc options% ris adding many costs and fe! benefits# *hen it comes to
meddling !ith contracts bet!een consenting adults% the best rule to follo! is normally
not 7RS% SEC or FAS4 but +:$4 2mind your o!n business3#
Theory and Evidence of Executive Compensation
Theoretical problems of executive compensation involve agency costs and rents#
Agency costs arise because corporate managers are not the firm"s o!ners but merely
agents ostensibly acting on behalf of principals !ho supply the firm"s e)uity and debt
capital 2stocholders and creditors3# Jnfortunately% agents have their o!n interests !hich
can be the opposite of the interests of principals#
7n this context% 'rent( essentially means executives being paid more than !as
really re)uired to attract% retain and motivate them# Fegal theorists 4ebchuc% Fried and
Facts and Conectures a!out Executive "tock #ptions
Stoc options give some employees the right to buy a certain number of company
shares in the future% almost al!ays at today"s price# According to a 4ureau of Fabor
Statistics survey% about <= percent of ES$s are 'non)ualified%( !hich means any gains
!ill be taxed at ordinary income tax rates# 'Qualified or incentive stoc options 27S$s3
!ere provided to more than 0. percent of all employees%( notes the 4FS% but !ith
'minimal overlap#(
7ncentive stoc options must be held long after they are exercised%
so they are ostensibly taxed at the lo!er ,- percent rate for long/term capital gains 2but
can actually be taxed by the ,= percent alternative minimum tax !hether there is any gain
or not3#
The current controversy is entirely focused on non)ualified options# Such options
are granted at the maret price at the time of the grant% called the 'exercise( or 'strie(
price# They usually re)uire 0/E years of vesting before they can be 'exercised( 2!hich
means buying the stoc at the previous strie price3# Pesting can be all at once 2cliff
vesting3% but often re)uires more gradual exercises% such as one/fourth per )uarter# The
options usually expire !ithin ten years of the grant and are most often exercised soon
after they are 'in the money( & that is% as soon as the stoc price is significantly higher
than the strie price# 7f the maret price stays belo! the strie price% options are said to
be under !ater# Employee stoc options become !orthless and are 'forfeited( if they
are not in the money bet!een the time of vesting and expiration% or if the employees )uits
or is 'retired( 2fired3#
Estimating #ptions $eans Estimating Earnings
7n ,--0% the seven/member Financial Accounting Standards 4oard 2FAS43 voted
unamiously to reconsider re)uiring JS corportions to treat employee stoc options as an
estimated expense !hen the options are granted# Fondon"s 7nternational Accounting
Standards 4oard !as contemplating similar regulations#
+any business reporters have described this topic as merely a moral battle !ith
greedy executives and lobbyists on one side and heroic defenders of honesty and virtue
on the other# The issues are more complicated than that% but they can be boiled do!n to
t!o simple points: First of all% a possible future expense is not the same as an actual
current expense# Second% the estimated fair value of options to employees !hen they are
granted is not the same as the actual expense to employers if and !hen those options are
later exercised#
$n the surface the issue of ho! and !hen to account for employee stoc options
may loo lie a trivial booeeping detail# :et the idea has generated a heated debate%
even among academics# *riting on this page last year% economists 4urton +aliel of
Princeton and *illiam 4aumol of 9e! :or Jniversity !arned that this politici8ed
accounting crusade riss 'destruction of e)uity compensation instruments that have been
engines or innovation and entrepreneurship#(
An entirely different perspective !as offered in a +arch ,--0 Harvard Business
Review article 'For the Fast Time: Stoc $ptions Are an Expense( by Professors Ovi
4odie% Robert S# @aplan and Robert C# +erton#
The title and much of the text seemed
to challenge an argument no serious critic of expensing ever made & namely% to suggest
that options are either !orthless to employees or a free lunch for employers# The real
debate has to do !ith 6ust !hat that expense is% !hen it occurs% and ho! and !hen it
should be reported on company boos#
Companies !ith a highly mobile labor force and a highly uncertain future lie to
offer stoc options precisely because there is an excellent chance those options !ill cost
the firm nothing# Executives put up !ith that do!nside ris for the same reason people
buy lottery ticets & options offer a slim chance of becoming very rich#

4efore the 4odie% @aplan and +erton article appeared% the Gecember ,--,
Harvard Business Review published 'Expensing $ptions Solves 9othing( by *illiam A#
Sahlman of the ?arvard 4usiness School# Sahlman emphasi8ed that the issue of
expensing options has been a huge distraction from serious issues of deceptive
accounting# ?e noted that 'options have the earmars of an investment in the future
rather than an operating expense#( $n balance% Sahlman concluded% options should not
be expensed% 'particularly if it entails disclosing less information in their footnotes#(

Jnder current FAS4 rules% companies that expense options are not re)uired to provide
the information that others do about ho! many options !ere granted% outstanding%
forfeited or exercised and at !hat prices# Expensing estimated costs thus 'increases
reporting complexity and decreases transparency%( according to Robert 4licer% professor
of accounting at Case *estern Reserve Jniversity#
4efore investors allo! FAS4% an unelected and largely unaccountable agency% to
compel all JS companies to replace transparency !ith estimates% !e need to thin
seriously about the nature of the cost of employee options to shareholders including !hen
that cost occurs# Jntil !e agree on !hat the cost is% !e cannot agree on ho! and !hen
to report it#
Advocates of expensing options gloss over the fact that they are advocating
treating an estiate as an actual expense# To re)uire companies to estimate costs is to
re)uire them to estimate earnings# That 6ust adds a ne! element of !himsy to measured
earnings# 7t does not mae reported earnings more honestN it 6ust maes them more
4odie% @aplan and +erton echo a familiar argument that companies have to
estimate depreciation too# 4ut that is a !ea analogy# *hen depreciating the cost of a
machine% the exact cost of the machine is no!n and only the pace at !hich it must be
!ritten/off is uncertain# *hen granting employee stoc options% nobody no!s if those
options !ill eventually be !orth millions or nothing# The finance professors reply that
'financial statements should strive to be approximately right%( but these particular
estimates cannot be even approximately right unless cost is defined in a uni)uely
academic !ay#
The debate has focused on technical problems of valuation% meaning the relevance
and accuracy of the .1<0 4lac/Scholes model for estimating the value of short/term
tradable options# 4ut even if 4lac/Scholes could fla!lessly estimate the sub6ective
value of options to employees on the day the options !ere granted that has literally
nothing to do !ith the actual cost to employers several years later% !hen some unno!n
fraction of those options may or may not become vested and exercised# *hat advocates
of expensing are saying% in a some!hat ambivalent !ay% is that the cost of exercised
options does not really matter# *hat matters% they say% is the 'opportunity cost( on the
day options are granted#
Any 4lac/Scholes estimate depends on the stoc price% volatility and interest
rates !hen the estimate is made% and all of those things change constantly# Some
scholars therefore recommend revising the estimates )uarterly% !hich is called 'mar/to/
maret#( 4ut that means the estimated cost of granted options !ould rise and fall !ith
the stoc maret# Jsing a mar/to/maret method !ould have made reported earnings
loo smaller as stocs and profits rose in .11=/11% and larger in ,--./,--, as stocs and
profits fell% but it is difficult to see ho! introducing such random feedbac bet!een stoc
prices and reported earnings !ould have made the earnings reports more informative for
shareholers# At the end of this undulating process% the sum of all those continuous
corrections !ould merely !ind up !ith the actual cost at the time of exercise% !hich
already automatically reported as reduced earnings per share 2or% if options are financed
by share repurchases% as a reduction in cash on hand3# The fact that all estimates prior to
exercise had to be revised to conform !ith the actual cost at the time of exercise clearly
demonstrates that all previous estimates !ere incorrect and that basing reported earnings
on such estimates therefore made the earnings figures incorrect#
Proponents of expensing estimates at the time options are granted say granting
options to an executive is no different from granting stoc# 4ut options% unlie company
shares% have big strings attached: They cannot be sold until after a fe! years of vesting
and they become !orthless if the stoc falls or the excutive )uits or is fired# 7ndeed% this
is !hy options are so considered so important by employers% particularly in firms !ith a
highly uncertain future#
5ranting an employee the right to buy shares at the current price after a fe! years
of vesting creates a contingent liability to provide those shares to employees if 2.3 the
stoc price goes up and 2,3 the employee remains !ith the firm long enough to be vested#
7f and only if those t!o contingencies are met% the company must either issue more
shares% or it must dip into cash to repurchase shares in the stoc maret# Gilution
obviously reduces earnings per share // the only measure of earnings that matters !hen it
comes to stoc prices per share# And share repurchases bviously reduce company cash
and 2because that cash !ould other!ise have been invested3 future earnings# The
common claim that the cost of employee options to shareholders is not reported in
earnings per share is flatly untrue#
7f !e could agree that the cost of options consists of dilution 2or share
repurchases3 at the time of exercise% then there !ould be no reason to expect that cost to
be even approximated by a 4lac/Scholes estimate of value at the time options are
granted# Estimating the value of options !hen they are granted is not at all the same as
forecasting the cost if and !hen they are exercised# The 4lac/Scholes model is based on
information available at a particular moment in time# 7t !as never intended to forecast
the future value of stocs or options# The value of options today is not the same as the
future cost of deferred and contingent compensation% and estimates of the former are not
forecasts of the latter#
Potential dilution from options that are !orth anything is prominently displayed
in every earnings report as diluted earnings per share# 4odie% @aplan and +erton%
ho!ever% prefer a more academic definition of cost% one !hich is not at all comparable to
the !ay companies measure other costs# They say the 'opportunity cost( of granting
stoc options consists of the cash the company could other!ise have received by selling
those options to investors# This is% they claim% is 'exactly( lie giving stoc to employees
rather than selling it# 4ut is it> 9o option maret is remotely comparable to employee
option grants# 5iving options to employees is not at all comparable to giving them stoc
because the options 2unlie stoc3 !ill have value only if the employee remains
employed at least long enough to be vested and 2if the stoc has not risen before then3
possibly for ten years## 9o investor purchasing stoc or options has to !orry about being
fired before the option can be exercised% but employees holding stoc options certainly
do# 4esides% selling options to buy a company"s stoc several years from no! at today"s
price !ould be lie announcing that management expects the stoc to fall#

The main problem !ith estimating earnings by estimating the cost of employee
stoc option is not that simply that 4lac/Scholes estimates are inherently inaccurate
2!hich they are3% but that such estimates are essentially irrelevant to the actual cost of
exercised options#
The reason this matters is that R
'*hat"s *rong !ith Executive Compensation>: A Roundtable +oderated by Charles Elson%( The Harvard Business
Review 2;anuary ,--03 p# I1#
5eoffrey Colvin% 'The 5reat CE$ Pay ?eist%( Fortune 2;une ,E% ,--.3 p# IA#
4rian ;# ?all and ;effery 4# Fiebman% 'The Taxation of Executive Compensation( 9ational 4ureau of Economic Research
*oring Paper 9o# <E1I 2+arch ,---3 p# 0#
+ichael C# ;ensen and @evin ;# +urphy% 'CE$ 7ncentives & 7t"s 9ot ?o! +uch :ou Pay% 4ut ?o!%( The Harvard
Business Review 2+ay/;une .11-3 pp# .0=/.E0#
9ancy F# Rose% 'Executive Compensation%( 9ational 4ureau of Economic Research% 94ER Reporter% 2*inter .11A/1E3
p# ..#
;oseph E# 4achelder% 'Proposed Tax Changes: Stoc $ptions%( New York &aw #ournal% +arch ,1% .110#
'FAS4 Rule Re6ected%( The San Fran'is'o (hroni'le% +ay E% .11A% p# G,#
;ensen and +urphy% op) 'it)
Andre! @# Prevost and ;ohn G# *agster% '7mpact of the .11, Changes in the SEC Proxy Rules and Executive
Compensation Reporting Re)uirements%( mimeo% *ayne State Jniversity School of 4usiness Administration 2September
5overnor 4ill Clinton and Senator Al 5ore% Putting People First% 9e! :or% Times 4oos 2.11,3 p# 0.#
4rian ;# ?all and ;effrey 4# Fiebman% 'The Taxation of Executive Compensation%( 9ational 4ureau of Economic
Research% 94ER *oring Paper 9o# *<E1I 2+arch ,---3#
4en6amin C# Ayers% C# 4ryan Cloyd and ;ohn R# Robinson% 'Capitali8ation of Shareholder Taxes in Stoc Prices:
Evidence fro the Revenue Reconciliation Act of .110%( mimeo% Tull School of Accounting% Jniversity of 5eorgia 2$ctober
,-% ,---3#
+yron S# Scholes% +ar A# *olfson% +erle Ericson% Ed!ard F# +ayde! and Terry Shevlin% Taxes and Business
Strategy* Prentice ?all 2,
edition% ,--,3 p# <<#
Fouis Favelle% 'Executive Pay%( Business Week 2April .I% ,--,3% p# =-#
;erry Jseem% '?ave They 9o Shame>( Fortune% April ,=% ,--0# The article describes an increase in median
compensation 'more telling( than the mean average% but that is dubious spin# The only !ay the median could have risen
!hile the mean fell !as for the largest pay pacages to have been deeply cut#
Patric +c5eehan% 'Executive Pay: A Special Report( The New York Ties 2April I% ,--03#
Paul @rugman% 'For Richer: ?o! the permissive capitalism of the boom destroyed American e)uality%( The New York
Ties !aga"ine 2$ctober ,-% ,--,3 p# IA# $n the !idespread misuse of income distribution statistics% by @rugman and
others% see Alan Reynolds% 'Economic Foundations of the American Gream( in Famar Alexander and Chester E# Finn% ;r#%
eds#% The New Proise o% +eri'an &i%e% 7ndianapolis% ?udson 7nstitute 2.11E3 pp# .1A/,,-#
AFF/C7$% 'Trends in Executive Pay( http:SS!!!#alfcio#orgScorporateamericaSpay!atchSpaySindex#cfm> Accessed +ay
.E% ,--0#
J#S# Census 4ureau% Statisti'al +bstra't o% the ,nited States 2,--,3# Table 9o# I-< p# A--#
'For # # # Citi8en for Tax ;ustice purposes% the effective tax is defined as taxes paid currently divided by net income before
tax# The numerator includes not only implicit taxes but also tax deferrals#( Scholes% op) 'it)% p# A1En#
;anet *hitman% 'Stoc $ption A!ards Jndergo Scrutiny 7n *ae of $utcry for +ore Accountability%( The Wall Street
#ournal% April 0% ,--,#
;oint Committee on Taxation% 'Report of 7nvestigation of Enron Corporation and Related Entities Regarding Federal Tax
and Compensation 7ssues% and Policy Recommendations( 2February ,--03 Polume .% p# ,-#
Stuart F# 5illan and ;ohn G# +artin% 'Financial Engineering% Corporate 5overnance and the Collapse of Enron%(
Jniversity of Gela!are Center for Corporate 5overnance% *oring Paper *P ,--,/--. 29ovember I% ,--,3 pp# ,1/0,#
;ohn E# Core% *ayne R# 5uay and Gavid F# Farcer% 'Executive E)uity Compensation and 7ncentives: A Survey%(
Federal Reserve 4an of 9e! :or% FRBNY Poli'y Review 2April ,--03% p# 0,#
4eth Fevin Crimmel L ;effrey F# Schildraut% 'Stoc $ption Plans Surveyed by 9CS C9ational Compensation SurveyD%(
J#S# 4ureau of Fabor Statistics* (opensation and Working (onditions 2Spring ,--.3 p# E#
Ovi 4odie% Robert S# @aplan and Robert C# +erton% 'For the Fast Time: Stoc $ptions Are an Expense%( The Harvard
Business Review 2+arch ,--03 pp# I0/<.#
*illiam A# Sahlman% 'Expensing $ptions Solves 9othing%( The Harvard Business Review 2Gecember ,--,3% pp# 1./1I#

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