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Executive stock options have basic flaws as incentive tools, studies find

April 1, 2002

For more information, contact: Benjamin Haimowitz,

In the swirling controversy that has enveloped the subject of executive stock options, the issue of the moment is over corporate accounting practices.

But this new controversy has overshadowed a more fundamental question: Are executive stock options an effective means of aligning the interests of managers with those of stockholders? Two recent studies presented under the auspices of the Academy of Management raise fresh doubts about whether they are.

Instead of steady leadership aligned with shareholder interests, the research reveals, executive stock options give rise to zigs of too much caution and zags of too much risk that can leave stockholders in the lurch.

When newly issued, one study finds, "options appear to lead executives to take risks… that shareholders might otherwise avoid. Executives may view the potential future pay-out associated with option pay as a form of compensation lottery."

But when stock prices rise well above the option strike price, they give rise to excessive caution, thereby contravening their principal reason for being.

As the boom of the nineties boom roared to a climax, virtually all major corporations offered executive stock options, which accounted for over 80% of average CEO pay. These studies argue for a much more limited and targeted use of these instruments.

Plenty of incentive -- but for risk or caution?

In a study presented at the Academy of Management annual meeting, August 2001, Robert M. Wiseman, Gerry McNamara, and Cynthia E. Devers of Michigan State University tested the widespread view that, because options entail no downside financial risk for the executives who hold them (since they have no investment to lose), these instruments encourage a bold brand of management. Suspecting this to be a simplistic view, the professors tested it by collecting data on 845 firms from 1997 and 1998.

From 1997 they gathered information on two option-related measures: 1) the value of each CEO's stock options at year's end, based on the stocks' current market price and the options' strike price, and 2) the amount of money each CEO got from exercising options over the year. Then they divided the second value by the first to obtain the proportion of options recently exercised by each CEO.

From 1998 the researchers recorded stock analysts' year-end forecasts for 2000 and calculated the amount of spread in their predictions for each company. The amount of spread in such predictions, reflecting analysts' uncertainty about firms' future income streams, is used by management scholars as a measure of risk in company management.

Wiseman and colleagues found greater CEO options holdings at the end of 1997 to translate into less spread in analysts' forecasts a year later; in other words, the greater the accumulated value of uncashed CEO stock options, the more cautious the company's management. In contrast, the higher the proportion of recently cashed CEO options, the more adventurous the management, as reflected in a greater spread of analysts' forecasts.

"Stock options may not provide the incentives for risk-taking that proponents of incentive alignment suggest," the study's authors conclude. "Indeed, we find evidence that stock options may actually aggravate CEO risk aversion and thus may depress shareholder value, as CEOs seek to minimize threats to the wealth contained in currently held options…This finding calls into question the prevalent use of stock options as an incentive-alignment tool and their role in internal corporate governance."

Are the risks they encourage the right kind?

A central finding of the Michigan State study is that exercising options leads to increased managerial risk-taking. Why? "Assuming that executives cash out those options with the greatest positive value first," the authors write, executives become willing "to accept greater risk in an attempt to maximize the value of the remaining options."

In other words, recently issued options can be a spur to taking risk, as can options with a strike price not appreciably above the current stock price. But what kind of risk? It is here that a new study published in the June 2001 comes in.

Gerard Sanders of the Marriott School of Brigham Young University studied the effect of recently bestowed options on the propensity of top management to undertake two kinds of risky corporate initiatives that more often than not prove ill-advised -- acquisitions and divestitures. He found that "firms were more likely to engage in acquisitions and divestitures when their CEOs were compensated with stock-option pay, but they were much less likely to engage in such activities when their CEOs owned stock."

Sanders reached this conclusion by studying 250 companies selected at random from the Standard and Poor's 500 over the five years 1991-95. For each year in that period he recorded the number of acquisitions and divestitures completed by each firm along with the worth of the CEO's stock at the end of the previous year and the worth of stock options granted to the CEO in the previous year. Stock options were valued using the method employed by the SEC, which computes the present value of stock options by assuming that the firm's stock price appreciates at 5% a year over a 10-year period. Sanders also obtained data on other factors that might affect managerial risk-taking, including CEO tenure and company financial performance.

As Sanders expected, the higher the value of a CEO's shares, the less likely the firm was to engage in acquisitions and divestitures; but the more stock options bestowed on the CEO in the previous year the more likely the firm was to undertake them. Longer CEO tenure tempered options' effect on risk-taking, but tenure did not influence one way or another the effect of stock ownership. As Sanders puts it, "CEOs who are relatively new on the job [are] much more willing than long-tenured CEOs to chase the potential 'lottery' returns that option pay can afford…However, even among long-tenured executives, option pay still has a positive effect on acquisitions and divestiture activity, just less strongly than among short-tenured CEOs."

While warning that "options appear to lead executives to take risks…that shareholders might otherwise avoid," Sanders does not rule out their use. "In some firm and industry contexts," he writes, "options may be more appropriate than stock ownership" -- for example, in declining industries or when substantial risk-taking is necessary or "to persuade long-tenured executives to engage in more risk than they would otherwise be willing to."

It is the routine use of options today that is worrisome, Sanders concludes, the fact that "boards of directors use stock option pay routinely as a substitute for stock ownership."

The Academy of Management, founded in 1936, is an international organization that works to foster the advancement of research, learning, teaching, and practice in management disciplines. It has about 12,000 members in 90 countries, including some 8,000 in the United States.

Media Coverage:
The Corporate Library. The problem with exec stock options goes deeper than accounting practices. (Thursday, April 11, 2002).

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