Compensation Stock Options

Burgundy: How Stock Options Became Prevalent in CEO Compensation

Stephen delivered the following speech on April 29, 2014, at the Burgundy Toronto Client Day

Recently, Larry Fink, the CEO of BlackRock, Inc. (NYSE:BLK), wrote a letter to each of the CEOs in the S&P 500 Index lamenting the short-term focus of American management.

He wrote, “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditures and even increased debt to boost dividends and increase share buybacks. We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company’s ability to generate sustainable long-term returns.”

We couldn’t agree more. Larry has effectively articulated the short-term focus that is currently prevalent in the management of American companies and the negative effect that it is having on capital allocation and long-term shareholder value. Unfortunately, we are skeptical about Larry Fink’s ability to change American CEO behavior. We believe that change will only come when the root cause for this behaviour is addressed. We believe that the root cause lies in the uniquely American compensation system that employs the use of stock options.

We require managements to allocate capital efficiently to balance the business needs of tomorrow versus the demands of today. We require managements to be good stewards of the business. Unfortunately, the use of stock options creates a perverse incentive structure for management that causes it to make poor capital allocation decisions and take actions that are detrimental to long-term shareholders like Burgundy. Today I am going to:

  1. Discuss why stock options were originally introduced to executive compensation in America and how they became so prevalent
  2. Outline why we believe that they greatly misalign management and shareholder interests
  3. Identify some of the worrisome manifestations and implications of their use for American businesses and their shareholders

The Rise of Stock Options: How They Became Prevalent in the Compensation of American CEOs

Before 1990, the use of stock options to compensate executives was largely unheard of and rarely used for American businesses. This began to change to a meaningful degree in 1993. In that year, responding to public outcry at American CEO compensation, Congress capped the tax deductibility of base pay at US$1 million. For any additional pay to be deductible, it had to be at risk, or variable. Shortly after that decision, Congress, under heavy pressure from American executives particularly in the technology sector, reversed the ruling of its own Accounting Standards Board and deemed that companies did not have to expense stock options. All of a sudden, companies could pay their people in stock options and not have to record any expense for that compensation on their income statement. You can understand why nearly every company would take advantage of this.

Companies could report higher earnings than they otherwise would for the same pay and therefore were at a competitive advantage when it came to recruiting and management retention.

Compensation Stock Options

The reason stock options became so entrenched within the U.S. was that they were highly lucrative for American executives. At the time that Congress capped excessive pay in 1993, the average American CEO was making about US$2 million. By 2000, predominately due to stock options, the same CEO made over US$14 million.

Managements loved stock options because they were paid more. Corporate directors, who should have been acting on behalf of shareholders in monitoring management and determining their compensation, received stock options as well. Shareholders didn’t protest, though ultimately they bear the cost of these plans because of the opaque and deceptive way in which stock option compensation was reported.

Compensation Stock Options 2

See full Stephen Mitchell: How Stock Options Became Prevalent in CEO Compensation in PDF format here.


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