Now that an underperforming stock market and the excesses of Enron have focused new attention on the use and abuse of stock options as a way to incentivize senior managers, what changes, if any, should companies make in their design of compensation packages?

It depends on the philosophy and goals of the company. In addition, more attention should be given to instituting safeguards to thwart the types of stock price and accounting manipulations that have recently made headlines. As Wharton accounting professor David Larcker puts it: But the truth is, much of it remains an art form. In his view, a compensation program should be balanced by some base salary, some annual bonus and some stock options or restricted stock, because each of these provides different incentives.

Stock options came into prominence during the s and s when companies realized that by requiring CEOs and top managers to invest a large portion of their personal wealth in firm equity stock and stock options , these individuals would have the same objective as the shareholders — maximizing stock price.

And for the most part, this approach appears to have worked well. The vast majority of large U. And for employees, stock options offer the possibility of eventually making substantial amounts of money and of course, losing substantial amounts as well, although presumably the incentives to work harder and smarter are now heightened. Indeed, some observers see stock price as the only means of providing incentives to chief executives.

Management professor Martin Conyon agrees, in general, with the power of stock options, even at a time when the market has suffered through two relatively flat years and the options of many firms are worthless underwater.

Options, however, have recently come under scrutiny for a number of reasons.

That issue, however, may well be taken care of by outsiders. According to CFO magazine, The International Accounting Standards Board recently proposed that stock options be expensed. The IASB is responsible for establishing common accounting rules for companies in the European Union by , and eventually for the U. In addition, the magazine reported, starting in April, the SEC is requiring companies to include tables in their K reports disclosing information about all employee stock option plans, not just ones approved by shareholders.

In addition, as noted in a recent New York Times article, due to the large number of option grants made during the stock market bubble, the number of shares outstanding grew sharply, thereby diluting per share earnings growth. And then there is the pressure to manipulate stock prices in order to increase the value of the options. Through fraud, managers can temporarily manipulate the stock price.

Mark Ubelhart, practice leader for value based management at Hewitt Associates in Lincolnshire, Ill. So I think there is risk of abuse of stock options. The big question of course, is just how much stock prices are manipulated and how? Or right before they exercise their options they may try to drive the stock price up. But ultimately this kind of manipulation gets discovered. Once an executive starts exercising his options and selling the underlying stock, that comes under tremendous scrutiny.

Is it reasonable to think that executives, if they have big equity positions, could manipulate the stock up and get the cash out before it catches up with them? If there is any suspicion of manipulation, the penalties can be severe …. What seems to be clear is that while stock fraud can and does exist, it is usually a short-term phenomenon.

Since no one seems to be suggesting that stock options be thrown out as a form of compensation, the question becomes, how big a role should they play and how can abuses of stock options be minimized? Ubelhart suggests indexing stock options — a concept he first proposed in and which was also the subject of a Harvard Business Review article last year— so that an executive would gain only if the stock outperforms the market or a peer group. Some companies, however, will say that if the shareholders benefit, so should their executives, even if the reason is overall aggregate market movements or economic trends over which shareholders and executives have no control.

Because indexed options produce an accounting charge to earnings that does not occur with more traditional stock options, they have yet to become a popular form of compensation. The other consideration, Ubelhart adds, is timing.

Employees' Retirement Plan Is a Victim as Enron Tumbles - The New York Times

Later on shareholders lost everything. In designing a compensation program, he says, you can always take steps like stretching out the exercise period of options or granting restricted shares that have long-term vesting. The extreme of this is what often occurs in private companies where compensation packages for executives who are not owners or family members have a very long-term focus that allows them to reap gains only when they retire.

In a public company there are multiple owners and they have multiple horizons. Again, there is no single answer. That makes it much tighter. So rather than delivering plain vanilla contracts, compensation committees and compensation consultants should be more innovative in the contract design. All these things have to be worked out simultaneously.

We will see how this plays out in the case of Hewlett Packard and Compaq.

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As for shareholders and options holders in companies that have recently hit the skids, Core places the blame, in part, on an unquestioning public. For some reason, investors never stopped to consider that commodity trading is a very competitive, low-growth business. They help find a balance between hard core financial numbers and things that are expressed in some other kind of unit.

We have a lot of statistics that measure this. As Ubelhart says, the trick is establishing the importance of the metric to long-term shareholder value. So these other yardsticks are fraught with measurement problems of their own, perhaps even more so than the metric underlying equity-based compensation.

The board could write a formula for the CEO that would make his or her bonus dependent on certain specific courses of action and target goals.

In general this approach places tremendous pressure on the expertise of the board to make performance assessments. One other theme in the whole question of compensation is shareholder value creation, an idea that has been evolving in the last two decades and which two years ago inspired a book called The End of Shareholder Value: Corporations at the Crossroads , by Allan Kennedy.

In other words, it is taking a very short-term myopic perspective. Or does shareholder value mean positioning companies to create long term economic value for years and years? In some cases stock options can serve that purpose. In other cases you might need to look at cash flow, return on investment and cash value added — all the better economic measures.

This kind of approach has been popular and will become even more so because of the recent criticisms of stock options. Financial reforms in China lag far behind the country's outsized impact on the global economy.

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It has widespread implications for everything from genomics to medical devices, and creates new models for enterprises. Log In or sign up to comment. All materials copyright of the Wharton School of the University of Pennsylvania. Wharton, University of Pennsylvania The K W Network: Finance Re-examining Stock Options as a Way to Compensate Executives Mar 13, Podcasts North America.

Manipulating Stock Price Options, however, have recently come under scrutiny for a number of reasons. How Far, How Fast Financial reforms in China lag far behind the country's outsized impact on the global economy.

What Whole Foods Brings to the Table Amazon's purchase of Whole Foods expands its presence in the grocery space, but could also provide a boost to the company across multiple sectors. Sponsored Content Precision Medicine: New Paradigms, Risks and Opportunities Precision medicine is changing the way therapies are being developed. Join The Discussion No Comments So Far Log In or sign up to comment. Knowledge Wharton Partners View All Partners Partner Collaborations Become a Content Partner.

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