Biotech Values

[DewDiligence]

Executive Stock Options Are Bad for Business

[This piece is from The Economist, who warned of the dangers of stock options as far back as the late 1990s.]

http://www.economist.com/daily/columns/businessview/displaystory.cfm?story_id=9932208

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Oct 9th 2007

Only yesterday stock options seemed to be a sort of corporate wonder-drug, doing to business what steroids do to weight-lifters: dose up your executives, and watch your profits grow. Now, like steroids, everyone is more concerned about the nasty side-effects, which can include jail time for executives who backdate them to give them more oomph.

Next month Greg Reyes, the former boss of Brocade Communications, will be sentenced following his conviction in August on fraud charges relating to options backdating. He faces up to 20 years behind bars, unless the newly launched Friends of Greg Reyes campaign convinces the authorities that he has been the victim of a miscarriage of justice [LOL].

One thing that prosecutors have so far failed satisfactorily to explain is why so many top executives engaged in backdating, which was done so openly and widely in Silicon Valley that it is hard to believe anyone thought they were committing a crime. Even Steve Jobs, the iconic boss of Apple, did it—though, unlike dozens of other executives, he has not (so far) had his collar felt by the authorities.

One possible explanation is that everyone in Silicon Valley at the time was so convinced in the potency of options that the possibility of illegality was not even contemplated. After all, the accounting rules did not even count options as a cost of doing business—unless, as it turned out, they were backdated.

The mystery is why options were regarded as so wonderful in the first place. Being (apparently) costless helped. Options advocates invariably point to the motivational power that they have, giving employees a powerful financial incentive to do whatever is necessary to get their firm’s share price up.

They certainly didn’t take any notice of The Economist, which in August 1999 ran a cover story called “The trouble with share options”. This argued, among other things, that the “spread of share options may be distorting the economy, contributing to a temporary overvaluation of equities, encouraging short-sighted managerial decisions and storing up problems for companies in future.” Well, no one can claim they weren’t warned.

Belatedly, the evidence is now mounting that share options are not all they were cracked up to be. Consider, for example, “Swinging for the fences: The Effect of CEO Stock Options on Company Risk-taking and Performance,” a study in the October issue of The Academy of Management Journal.

The authors, two economists, Gerard Sanders and Donald Hambrick, observe that options create asymmetric incentives: they pay out when a firm’s share price rises above the option exercise price, but once they fall below the exercise price, all further falls make no difference to the ultimate payout, which is nothing. This, posit the authors, gives an incentive to take big bets, by investing in risky activities with long odds on a high pay-off. They also posit that these bets will produce more extreme losses than extreme wins.. [All this seems obvious, IMO, so the word “posit” comes across as a classic British understatement.]

To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000. This showed that the bigger the role played by share options in the boss’s pay package, the more likely firms were to invest heavily in risky activities. It also confirmed that high levels of share options were associated with more extreme ups and downs in a firm’s share price, and that the big downs significantly exceeded the extreme highs.

The authors conclude that “not only does this asymmetry affect the selection of strategic initiatives, as we have discussed, but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation.” Surely this is not the sort of motivational incentives that shareholders want.

To be fair, since the bursting of the dotcom bubble in 2000, and the more recent backdating scandal, companies have talked about reducing their dependence on options, not least in favour of less asymmetric share-related schemes. But this sort of steroid seems to be addictive. As Messrs Sanders and Hambrick note, share options still represent the largest single form of CEO compensation.
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