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Firms that make heavy use of stock options to pay CEOs are more likely than others to misstate finances, study finds

August 1, 2005

For more information, contact: Benjamin Haimowitz,

Two new reports raise questions about options as an incentive tool

According to a leading survey of CEO pay in major American companies, total direct compensation for chiefs rose a whopping 41% last year.

And for many or most of the CEOs who enjoyed that financial bonanza, the biggest part of their pay came from exercising stock options -- that is, instruments entitling the owner the right to purchase shares in the company at a specified price.

If no longer being bestowed on top executives at the feverish rate that prevailed in the late 1990s, stock options remain for many companies the principal component of CEO pay.

Yet, evidence that they have basic flaws as incentive tools continues to accumulate.

According to two new studies to be presented at the annual meeting of the Academy of Management (Honolulu, Aug. 7-10), stock options encourage not only bad management but out-and-out misrepresentation of financial data.

In a study from the University of Minnesota, Jared Harris and Philip Bromiley report that the greater the proportion of CEO pay from stock options, the greater the probability of accounting misrepresentation. Citing the view of former Federal Reserve Board chairman Paul Volcker that all stock option compensation should be scrapped, they conclude: "While our research does not attempt to evaluate such prescriptive policy suggestions, it strongly supports the intuition of these critics: large amounts of stock options substantially increase the likelihood of financial misrepresentation."

Meanwhile, in a second study to be presented at the meeting, entitled "Swinging for the Fences," William Gerard Sanders of Brigham Young University finds that "stock option incentives result in increased preferences for allocations to risky, long-term projects...The results found in this study suggest that such risk-taking does sometimes pay off, but more often than not it results in underperforming expectations rather than exceeding them."

Both studies find no such downside in annual CEO bonuses. Noting that "bonus pay has a very positive association with subsequent levels of [company] performance," Sanders surmises that "the use of annual bonus programs may have better aligned incentives [between executive and shareholders] than previously thought," and he urges greater use of bonus pay in preference to stock options.

Incentives to Cheat: An Empirical Study

Harris and Bromiley base their findings on an analysis of firms that the Government Accountability Office (GAO) identified as having restated financial results between January 1997 and June 2002 as a result of accounting irregularities. Like medical epidemiologists, they matched each firm with a similar company that did not have to restate results, providing them in the end with a sample of 435 pairs of companies. The misrepresenting firms' sales ranged from $357,000 to $39.1 billion, and the matching firms' sale ranged from $218,000 to $137.6 billion.

The authors found the percentage of CEO compensation represented by stock options to be strongly related to the likelihood of accounting misrepresentation. In restatement firms, options constituted 50% of total CEO pay, compared to 39% in the matching firms; in contrast, the matching firms provided on average 46% of compensation as salary, compared to 37% in the restatement group, and 15% as bonuses, compared to 12% in the restatement group.

The relationship of stock options to financial representation becomes particularly pronounced as the percentage of pay consisting of options rises above 76%. For firms at the top level (92% or more) the probability rises to 21% likelihood of restatement within five years. Normally, publicly traded companies have a probability of restatement within that period of slightly less than 10%.

In other words, heavy use of stock options more than doubles the likelihood of financial misrepresentation.

The period covered by the study predates the Sarbanes-Oxley bill, which imposes new measures to prevent corporate accounting irregularities. "Whether or not the legislation has reduced financial misrepresentation across the board is an open question," Harris comments. "But manipulative accounting is only one form of cheating. Sarbanes-Oxley is silent on the topic of executive compensation, and, even if it has reduced accounting irregularities, it doesn't address the underlying incentive to cheat that comes with high levels of executive stock options."

Swinging for the fences: CEO stock options, aggressive strategic investments and extreme performance

Sanders collected data for the period 1994-2000 on 1,000 randomly selected firms from the Standard & Poor's 500, Mid-Cap and Small-Cap indices. In the end he was able to obtain data for 922 firms and a total of 3,626 firm-years.

He found, unsurprisingly, that the greater the proportion of CEO compensation derived from stock options, the greater the subsequent long-term investments made by firms through research and development, capital expenditures, and acquisitions. Also not surprisingly, he found greater stock-option pay to be associated with extreme performance -- that is financial performance by a company significantly at variance with that of similar firms.

For Sanders, such high-risk investments and extreme performance amounts to "swinging for the fences." The key question was, how would the strikeouts and homeruns balance out in the end? Would they come out even, or would performance be lopsidedly positive or negative?

To get his answer, Sanders analyzed the relationship of stock-option pay over three years to firms' subsequent performance, both in terms of stockholder returns and company returns on assets. He found the relationship to be significantly negative on both counts.

Sanders concedes that the period he studied represented a high point in the use of stock options. "They intensity of stock-option activity gave us robust results, but are they relevant to 2005?" he asks. "Given the surge in stock-options grants and payoffs we saw last year, I believe they are."

The Academy of Management, founded in 1936, is the largest organization in the world devoted to management research and teaching. It has close to 16,000 members in 90 countries, including some 10,000 in the United States. The academy's 2005 annual meeting will draw more than 6,000 scholars and practitioners to Honolulu for more than 1,000 sessions on a host of issue relating to corporate organization and investment, the workplace, technology development, and other management-related subjects.

Media Coverage:
International Herald Tribune. August 5, 2005. Do Options Breed Fraud at the Top?. (Friday, August 05, 2005).
Reuters. August 5, 2005. Stock Option Plans Draw New Fire from Foes. (Friday, August 05, 2005).
The New York Times. August 5, 2005. Stock Options: Do They Make Bosses Cheat. (Friday, August 05, 2005).
The Observer. August 7, 2005. Management: All that's 'good' is pure poison. (Sunday, August 07, 2005).

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