CRG Executive Compensation

Executive Compensation

1.Explanation of what LTIPs and stock options are

LTIPs:

A reward system designed to improve employees' long-term performance by providing rewards that may not be

tied to the company's share price. In a typical LTIP, the employee (usually an executive) must fulfill various conditions and/or requirements that prove that he or she has contributed to increasing shareholder value. The incentives for doing this are usually conditional company shares, which are distributed in two parts. The first part represents an immediate distribution of half of the shares, while the remaining half of the shares will only be presented to the executive if he or she stays with the company for a predefined number of years.

Executive Stock Options (Booth, 2003):

A share option is basically a call option and linked to shareholders’ interests in the value of the firm. It is a long-

term form of remuneration which provides the holder with a right to purchase a specific number of shares within a definite time period at a prearranged price. Or

Executive stock options are simply call options issued to executives where exercise, like the granting of stock, is restricted to ensure that the executive commits to the firm.

For example, suppose a firm’s stock trades for $40; if a new CEO is granted a million stock options at $40 exercisable over the next three years. Suppose there are two possibilities for the stock price over the exercise period: it can increase to $60 or fall to $30. If the stock price increases, the executive can exercise the option by paying $40 for a stock worth $60. On a million shares this amounts to a $20-million profit. As the executive exercises the options, we see the amount reported as part of their compensation. When the stock price falls to $30 from $40, the CEO’s options are now wildly out of the money; that is, there is almost no chance of them ever being exercised.

2.Explanation of why they have been introduced:

?Theory: Agency problem creates a need for alignment of interests of shareholders and managers.

For the last two decades finance professors and governance experts have been arguing that executive stock options should be part of executive compensation. The reason is the separation of ownership from control that exists in many large corporations: with dispersed stock ownership and poor governance it is relatively easy for a corrupt or lazy CEO to use the company as their personal piggy bank. This does not necessarily mean outright theft—as was alleged with Adelphia—but does mean that decisions can be made for reasons other than what is best for the firm’s owners: that is, the stockholders. Giving senior executives stock options aligns their interest with those of the stockholders. If they work hard and the stock price goes up, they exercise their options and make money along with stockholders.

?Why don’t other forms of pay (e.g. salary) work in addressing agency problem – limited link to shareholder interests (i.e. share value and risk-taking).

3.Presentation of critique and evidence on both (either in conjunction with previous discussion or separately)

Executive Stock Options (Booth, 2003):

1)There are two flaws that have become very evident over the last a few years:

-The first flaw is that stock prices go up for reasons unrelated to the activity of senior executives.

We have just seen a massive bubble in the stock market (particularly the U.S. and technology-related stocks) with about a 60% increase in the S&P 500 from 1997 to 2000, then an equivalent decline. Clearly senior executives were not directly responsible for either the surge in stock prices or their subsequent collapse.

However, the surging stock market led many firms to issue significant grants of executive stock options. This may have been because boards of directors suddenly saw the light and wanted to align the interests of senior managers with their owners, or it may have been because executives saw a seemingly risk-free get-rich

strategy. Regardless, the fact that options are issued at seemingly no cost to the firm, but with the potential for great reward to executives in a raging bull market, led to an increase in executive stock option grants.

-The second problem is that the bubble burst and stock prices tumbled.

When the stock price is fallen below exercise price, the CEO’s options are now wildly out of the money; that is, there is almost no chance of them ever being exercised. Nortel, for example, once had almost 60 million executive stock options outstanding at prices above $30, while its stock price bounced around the penny stock level. The solution that many firms have come up with is simply to reprice the option; that is, lower the exercise price until there is some possibility of exercise and some incentive for the executive. The repricing of options, or the equivalent of further option grants, has governance experts up in arms. The whole point of options is to align the interests of managers with stockholders. It never is an exact alignment, since options don’t share the downside the way shares do. However, if even the loss of the option is taken away by repricing, the executive is in a “heads I win (big time), tails I can’t lose” scenario. This is not the scenario faced by investors.

2)In the literature, it has been argued that agency costs may be reduced as managerial ownership incentives rise

(e.g., Bethel and Liebeskind, 1993; Palmer and Wiseman, 1999). The reason is that, as ownership incentives

rise, the financial interests of insiders and shareholders will begin to converge. However, Wright et al (2002) state that such incentives may not consistently provide senior executives the motivation to lessen the agency costs associated with an acquisition strategy.

Portfolio theory suggests that investors or owner-managers may desire to diversify their personal wealth portfolios. Hence, managers with substantial equity investments in the firm may diversify the firm via risk-reducing acquisitions in order to diversify their own personal wealth portfolios. They may be especially concerned with risk-reducing acquisitions; however, their corporate strategies may not enhance firm value through takeovers, although managerial intention may be to boost corporate value. This is compatible with complementary arguments that suggest that insiders may acquire non-value-maximizing target companies although their intentions may be to enhance returns to shareholders.

The potential impact of stock options on executive attitudes toward firm risk taking is of concern as well.

Miller and Leiblein (1996) argue that stock ownership plans result in executives being exposed to upside as well as downside price movements, whereas stock options result in managers being exposed only to upside movements. Consequently, we expect that the relationship between executive stock option holdings and firm risk taking will be monotonically positive.

Increase in common stock ownership will not contribute to risk taking and the interests of shareholders where exe equity stakes are concentrated in the enterprise. Option values, however, will promote corporate risk taking and enhance the abnormal returns of acquiring firms.

3)Yermack (1997) finds that the timing of stock option awards coincides with favourable movements in

company stock prices. In particular, the author finds for 620 stock option awards to CEOs of Fortune 500 companies between 1992 and 1994 that stock prices experienced an average cumulative abnormal return of more than 2 percent in the 50 trading days following CEO option awards.

4)Cohen et al (2000) examines the risk-taking incentives created by executive stock options and the way in

which managers respond to those incentives, and then conclude that there is a statistically significant relationship between increases in option holdings by executives and subsequent increases in firm risk, but there the risk-taking incentives created by executive stock options leads to only modest increases in firm risk, which neither impose costs nor provide benefits to shareholders.

In particular, unlike stock, options have an asymmetric payoff and, unlike stock, options do not normally pay dividends. Since the value of options increase with firm volatility and decreased with dividends, options are purported to give executives incentives to increase risk-taking1 and to decrease dividends.

Young and O'Byrne (2001, 114–15) identify four basic objectives for a firm's compensation policy:

1.Alignment: To give management an incentive to choose strategies and investments that maximize shareholder

value.

2.Leverage: To give management sufficient incentive compensation to motivate them to work long hours, take

risks, and make unpleasant decisions, such as closing a plant or laying off staff, to maximize shareholder value.

3.Retention: To give managers sufficient total compensation to retain them, particularly during periods of poor

performance due to market and industry factors.

4.Shareholder cost: To limit the cost of management compensation to levels that will maximize the wealth of

current stockholders.