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CRISIS IN CORPORATE AMERICA

Stock Options Lavished on Executives Come Under Fire

Wall Street: Huge grants may provide an incentive for managers to falsify earnings to keep share prices up, experts say.

July 12, 2002|KATHY M. KRISTOF and JAMES FLANIGAN | TIMES STAFF WRITERS

Stock options, once considered a valuable tool to link the interests of corporate executives to those of shareholders, now are being examined as a potential culprit in the scandals plaguing corporate America.

From President Bush on down, critics are looking for ways to rein in the practice of providing top corporate managers with huge grants of stock options--which give the right to buy company shares at a set price in the future--after accounting upheavals at a series of major companies, including WorldCom Inc. and Enron Corp.

Although stock options clearly were not the only culprit in these scandals, many industry experts believe they provide a compelling incentive for managers to falsify earnings to keep Wall Street happy, the stock price up and manager paychecks rising at a rapid clip.

"Stock options have encouraged managers to take risks beyond what is potentially prudent," said Robert Felton, director of McKinsey & Co.'s Seattle office. "Because they have so much at stake with these huge grants, options are also likely to have encouraged some managers to cheat and cook the books."

About 75% of executive pay is made up of stock options rather than cash pay, said Peter G. Peterson, head of the Commission on Public Trust and Private Enterprise for the Conference Board. That creates a huge incentive to keep earnings up, even during a downturn.

At Enron, former Chairman Kenneth L. Lay exercised $180.3 million in options from 1998 to the end of 2000, and former Chief Executive Jeffrey K. Skilling got $111.7 million. During that period, Enron inflated earnings by hiding losses in off-the-books partnerships.

But stock options have plenty of supporters, who say cash-strapped companies need to rely on them to attract seasoned workers who otherwise would demand higher cash pay.

"I was a director of a small company that didn't have any cash flow," said Frank Vogl, vice chairman of Transparency International, a nonprofit group dedicated to stamping out corporate and political corruption worldwide. "The only way you can really pay your executives is through this promise of pay over time through stock options."

The wave of corporate meltdowns has sparked an outcry for new rules or legislation to stop potential abuses and punish wrongdoers. Although few of these proposals have made it into formal legislation, more than a dozen ideas are being kicked around Washington, Vogl said.

On Thursday, Sen. John McCain (R-Ariz.) tried unsuccessfully to force a Senate vote on his proposal to require companies to account for stock options as an expense, while Sen. Barbara Boxer (D-Calif.) was holding a news conference with senior managers of pension funds, decrying the effect of corporate malfeasance on the retirement plans of the average American. Earlier this week, President Bush suggested a series of reforms, including prison sentences for cheating corporate managers and requiring greater disclosure of executive pay costs.

The current environment is a stark departure from the laissez faire attitude toward executive pay--and the general support for giving managers significant grants of stock options--during the 1990s, when the stock market was roaring ahead.

Companies were encouraged to lavish options on managers to ensure that executives were paid in accordance with their companies' success. As stock prices rose, so would the value of management pay packages--a formula meant to drive long-term performance in the best interest of shareholders.

And lavish they did. From 1995 to 1999, the value of stock options granted to U.S. executives more than quadrupled to $110.5 billion from $26.5 billion, according to a study by the Federal Reserve Bank of New York. Although comparable data on the raw value of options granted in 2000 and 2001 are not available, all indications are that the largess continued.

A study issued earlier this year by the Investor Responsibility Research Center notes that companies granted more stock options in 2000 than they had in any of the three prior years on average. IRRC, which looks at stock options from the standpoint of how much they dilute the interest of public shareholders, notes that the average company has a 14.1% "overhang" from stock options. That's how much the value of each shareholder stake in the company would be reduced in the future if all outstanding options were exercised.

At some companies, the dilutive effect could be far greater. At Irvine-based Broadcom Corp., for example, the future effect of exercising options could run as high as 83.5%, according to the IRRC. Broadcom has said the company's strategy is to provide little in the way of cash pay, but substantial stock incentives to all workers. Still, such potential dilution provides little incentive to public shareholders, experts contend.

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