Water Week

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Chief execs who get more than half their pay in stock options more likely to take risks, usually bad risks, say US academics

Posted by waterweek on 17 October 2007

A new paper, in the current issue of the Academy of Management Journal detailed work of two professors, W. Gerard Sanders of Brigham Young University and Donald Hambrick of Penn State, who studied 950 companies between 1994 and 2000 and found that those whose chief executives received more than half their compensation in stock options were far more likely to take risks in more and bigger acquisitions and somewhat more likely to spend heavily on research and equipment, wrote Floyd Norris in The Sydney Morning Herald (13/10/2007, p.43).

Poor performance: But the risks they took were often poor ones. “The more that a CEO is paid in stock options, the more extreme the firm’s subsequent performance, and the greater the likelihood that the extreme performance will be a big loss rather than a big gain,” they reported. Their calculations, by the way, were based on the value of options when they were granted, not on their eventual value when they were cashed in. The reasons for the poor performance of option-laden bosses seemed obvious. An option holder would get rich if the stock soared, but he or she was no worse off if it falls a lot rather than a little. So a project with a huge possible profit may seem attractive even if a big loss was also possible, or even probable.

More balanced view: It appeared that executives who had a lot of options with exercise prices far below the current market price – and thus that would lose value if the stock price fell – made better decisions. “It tends to impose a more balanced view of risk,” Sanders said. “It is your own money you are betting with, not just somebody else’s.” There were other ways to take a risk, of course. We learned a few years ago that some bosses were willing to commit accounting fraud. Sanders said other research of his indicated that “there is a positive relationship between fraud and high option pay”. If you believe this research, it made a lot of sense to reduce options for bosses, or to change them, so that executives were more like shareholders. They could be given in-the-money options, with exercise prices below the current market price, so that price drops would hurt. (That would be perfectly legal, as long as it was disclosed.) Or they could get restricted stock.

Shareholder protection: Sanders said another recommendation often made, tying options to an index so an executive would not profit if a stock just rose with the market, could be counterproductive. “That might make the excessive risk-takers really go wild,” he said. Instead, he suggested granting in-the-money options and requiring the executive to hold onto the stock – or at least the shares not required to pay taxes – for years after the option was exercised. That might not be popular with ambitious chief executives. For options to have the same total value when issued, companies shifting to in-the-money options would grant fewer of them than they do now, and so the boss’s profit from a brilliant move would be lower. But his loss from a disastrous one would also be real, and that could make life a bit less painful for other shareholders.

The Sydney Morning Herald, 13/10/2007, p. 43

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