Executive compensation

Here is an excerpt from the 2003 book
Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
by Frank Partnoy.
The emphasis is added.

Chapter 6
Morals of the Marketplace

The regulatory treatment of stock options became a hot issue
in the new Clinton administration [in 1993].
The issue arose out of President Clinton’s campaign promise
to do something about allegedly excessive corporate-executive pay.
In reality, CEO compensation was not excessive, based on historical measures,
and was trivial compared to other corporate expenses,
at roughly one-sixteenth of one percent
of an average share-holder’s annual returns in 1992 [see].
But voters had been moved by various television programs on CEO pay,
as well as Graef Crystal’s expose, In Search of Excess.
Following up on his promise,
Clinton pushed Congress
to limit the tax deduction for the salaries of top corporate executives
to $1 million.
Never mind that only forty-nine CEOs had base salaries of more than $1M.
The law had popular appeal and easily passed.

However, the tax deduction contained a loophole
large enough to fly a private jet through.
The $1M cap didn’t apply to “performance-based compensation,”
which Internal Revenue Service regulations said
required “objective performance goals.”
The stated purpose of the regulations
was to remove discretion from the corporate directors
who determined the pay of top executives.
Instead of trusting directors to make judgments based on qualitative factors,
the rules required directors to follow quantitative ones,
based on metrics easily measured by the market.
The prime example of performance-based compensation
was a stock-option plan.
The value of a stock option was based, at least in part,
on a simple objective factor: the price of the company’s stock.
In response to the new regulations,
companies began shifting executive compensation from salary to stock options,
in part to preserve the rather small tax deduction
but, more important, to assure shareholders and commentators
that they were following the letter of the new law.

This relatively minor legal change would have unanticipated, insidious effects.
As companies shifted to
stock options and other forms of market-based compensation,
executives began to focus almost exclusively on those quantitative factors.
The more a CEO could increase the company’s stock price
(or its earnings per share, or some other objective measure),
the more money he would make,
regardless of how the board thought he had performed.
As the board’s power was reduced,
a mercenary culture developed among corporate executives.
Corporate executives began managing their company’s earnings,
buying potentially higher-growth companies,
and in too many cases even committing accounting fraud,
all of which resulted in higher compensation.
Much of the crisis of confidence in the financial markets in 2002
could be traced back to the cultural change that began in 1993,
with new tax rules encouraging
performance-based executive compensation.

This tax change was reinforced by
the FASB accounting rule for stock options,
which did not require companies to include options as an expense.
This rule—established in October 1972—
said the cost of an option to a company was
the difference between the market price
and the exercise price at the time the option was granted.
In other words, if a stock is trading for $10,
a company can give an executive the right to buy stock for $10
with no accounting charge.
To an investor looking at a company’s financial statements,
such options would appear to be “free.”

Just a few months after this rule was established,
economists Fischer Black, Myron Scholes, and Robert Merton
had published research showing how options could be valued.
The accounting rule was demonstrably wrong,
and stock options had an ascertainable value.
Yet even as traders began using financial models
to track changes in the value of stock options on a minute-by-minute basis,
the 1972 rule remained unchanged.

FASB officials knew that the $1M cap on non-performance-based pay
would lead companies to switch to stock options,
and they were concerned that investors wouldn’t understand
how much those stock options were costing the company.
The officials began considering a proposal to require that
companies include, as a compensation expense,
an estimate of the value
of the stock options they awarded to executives.

The proposal seemed reasonable enough:
the options clearly had a cost,
and options models such as Black-Scholes
had been churning out options valuations for two decades.

But companies—
especially high-technology companies in Silicon Valley—
didn’t want to include the options as an expense,
because it would limit their ability to match executives’ pay
to the performance of their stock.
It also would hurt the value of their stocks.
In theory, the accounting charge shouldn’t have mattered—
efficient-market theorists said that
as long as the options compensation
was disclosed in footnotes or appendices to financial statements,
the stock price would reflect that compensation.
(Existing disclosure rules for stock options and other compensation
required companies to describe all compensation in a footnote,
including a summary compensation table and performance graphs,
but did not require companies to include the cost of stock options
in their financial statements.
Theoretically, these rules should have had the same effect as
requiring that companies include stock options as an expense
in both financial statements and footnotes.)

Yet the difference mattered.
Corporate CEOs—especially those from Silicon Valley—
lobbied aggressively against FASB’s proposal.
They obviously did not think markets were efficient,
or that stock prices reflected the costs of stock-option compensation.
They were afraid the proposal would hurt their stock prices,
and they told regulators about their concerns.
They claimed that, without favorable treatment of options,
they wouldn’t be able to attract top executives,
because they didn’t have enough cash to pay them.
Lobbyists sent out hundreds of comment letters
and distributed thousands of “Stop FASB Action Kits.”

Again, individual shareholders were powerless to lobby against such forces.
The day before FASB was to issue its new rule for options,
Senators Joseph Lieberman, Barbara Boxer, Dianne Feinstein, and Connie Mack
introduced a bill to force FASB to drop the proposal.
Senator Carl Levin was a lonely voice in Congress supporting FASB,
although he had plenty of company among accounting and finance experts.
[SEC Chairman] Arthur Levitt
who earlier had expressed concern about stock-options accounting
during his confirmation hearing—
abruptly caved in,
and announced his opposition to the FASB proposal.
In May 1994,
the U.S. Senate passed a resolution condemning the proposal,
by a vote of 88 to 9.
Facing this opposition, FASB backed down.
Arthur Levitt would later describe his timid flip-flop on the accounting proposal
as his “greatest mistake.”

Senator Lieberman’s position was that,
“As a matter of abstract accounting theory,
FASB’s approach to stock accounting may be defensible.
But from a public policy, job creation, and competitiveness perspective,
it simply is unnecessary and unusually disruptive.”
Lieberman certainly was correct in arguing that some options—
particularly complex, long-term options—
were difficult to value,
as the losses at Bankers Trust and Salomon Brothers established.
But if companies couldn’t figure out what long-term stock options were worth,
should they really have been giving those options to their CEOs,
instead of simply paying them in stock,
which had an obvious value?

The next chapter (“Messages Received”) describes
the effect of large stock-option grants on the behavior of corporate executives.
It isn’t pretty.
For now, it is sufficient to note that
the increase in the use of stock options coincided with
a massive increase in accounting fraud by corporate executives,
who benefited from short-term increases in their stock prices.

More than half of the profits from some major high-technology firms
were from the accounting treatment for options.
The accounting treatment of stock options also was a dangerous precedent
in allowing companies to use stock to affect their own income.
When Jeffrey Skilling, formerly Enron’s CEO,
was challenged at a congressional hearing
to name one example of when a company was entitled to
use its own stock to affect its income statement,
he cited the accounting rules for stock options.