Indexing Stock Options or Granting Stock: which is a better method of compensating executives?

Rewarding a CEO (or for that matter, any senior corporate official) by using an indexed stock option only goes part of the way in properly compensating management and they fail to adjust for the risk that managers take but do not disclose.[1] In nearly every case over the past several decades of corporate misgovernance, shareholders and sometimes Boards, only learn after a corporate disaster that huge, undisclosed risks were taken along the way. Options, indexed or not, offer leverage to managers but provide no downside penalties for bets that turn out badly for the shareholders. One-way optionality is a serious problem for corporate governance.

It is not wrong for corporations to take risks, nor is it wrong that benefits from risk taking are shared with management. What does matter, however, is that equity holders be well informed about the kind of risks to which their investment is exposed well before they purchase their shares. For that, shareholders depend not only upon what managers tell them in quarterly and annual reports, but also upon competent and well informed Boards who monitor the managers. Our current system of corporate governance doesn’t accomplish that as we have clearly outlined in our book, Disorganized Crimes that captures many of these issues since the 1990’s Boom through the financial disasters of 2007/2008.

It is highly unusual for Boards to reward significant performance without judging corporate performance against the company’s corporate peers. Sadly, however, Boards often don’t know or understand the risks that their managers take and are less likely to know about risks taken by competitors. Indexing stock options doesn’t do anything to disclose those risks. Options are still a one-way bet with no downside for managerial misbehavior, incompetence or excessive risk taking.  What’s the alternative

Granting stock, rather than a stock option, is a better alternative. It would at least put managers in the same risk position as their less than well-informed shareholders. It would also make managers far more aware that they are gambling their own money as well as that of their shareholders when they place the company into a high-risk situation.   ‘Heads I win, tails you lose,’ is a bad compensation metric, even if it is indexed against the performance of the industry.

It’s about time to deal with the real problem, not the taxation aspects of different compensation forms. If it ever turns out that income tax rates on currently earned income versus capital gains income get equalized, the real issues of managerial compensation would appear far more distinctly.   Compensation based upon transparent risk reporting and corporate accountability is what shareholders really need.

Let’s focus on the real problem to be solved, not the tax system that makes option compensation seem so attractive. Options distort the reality of undisclosed managerial risk taking. It’s time we pay attention to the

[1]This is a reply to the OpEd of Robert C. Pozen that appeared in the WSJ on November 14, 2016. See “A Nobel Idea to Pay CEOs What They’re Actually Worth: Indexing stock options would reward only skilled executives who beat their industry average.”