Stock Options And The New Rules Of Corporate Accountability (Mcgraw Hill - 2004) (pdf)
“This is an excellent book for anyone interested in the important
discussion of stock option expensing and, more significantly, the
optimal use of stock options in compensation plans. It is written
from the point of view of an experienced and knowledgeable com-
pensation consultant who has advised board compensation com-
mittees and talked with many people outside the field considering
the economic and incentive effects of the overuse of stock options in
the 90s.”—John M. Biggs, former Chairman & CEO of TIAA-
CREF ...
“Don Delves is one of the industry's most knowledgeable compen-
sation consultants. His book makes an important contribution to
the stock option dialogue.”—Larry Hirsch, Chairman & CEO of
Centex Corporation
“This is an excellent book for anyone interested in the important
discussion of stock option expensing and, more significantly, the
optimal use of stock options in compensation plans. It is written
from the point of view of an experienced and knowledgeable com-
pensation consultant who has advised board compensation com-
mittees and talked with many people outside the field considering
the economic and incentive effects of the overuse of stock options in
the 90s.”—John M. Biggs, former Chairman & CEO of TIAA-
CREF
“This book is very thoughtful and insightful. There are no right
answers– only degrees of balance. The author has achieved that
well.”—John Rau, President and CEO of Miami Corporation; for-
mer CEO of Chicago Title & Trust Company
“If you are on the Compensation or Finance Committee of a Board,
this is a must read. With the portfolio of executive compensation
Don Delves assisted us with, BorgWarner has risen to the top with-
out megagrants of stock options.”—John F. Fiedler, former Chair-
man and CEO of BorgWarner
“Don Delves has given us a clear, lively exposition of multiple
issues and variables to be considered in formulating incentives to
improve corporate and executive performance. Along with his
unequivocal advocacy of expensing stock options, he calls for a
more balanced approach to compensation, one that blends a variety
of elements to engender more attention on the long-term health of
the enterprise. His interviews with thought leaders such as Paul
Volcker and Myron Scholes and the incisive questions he poses help
frame a robust debate on the proper use of options.”—Ronald L.
Turner, Chairman, President, and CEO of Ceridian Corporation
This page intentionally left blank.
STOCK OPTIONS
AND THE NEW
RULES OF
CORPORATE
ACCOUNTABILITY
Measuring, Managing, and
Rewarding Executive
Performance
DONALD P. DELVES
McGraw-Hill
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tort or otherwise.
DOI: 10.1036/0071436324
Dedicated to
my mentors, Bob and Judith Wright,
and the Wright Institute for Lifelong Learning
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For more information about this title, click here.
CONTENTS
FOREWORD: A Conversation with Paul Volcker xi
ACKNOWLEDGMENTS xvii
INTRODUCTION xix
PART ONE
THE STOCK OPTION PROBLEM 1
Chapter One
Dimensions of the Problem 3
The Problem with Options 6
The Current Situation 8
Executive Wealth and the Positive Power of Greed 9
Stock Options and Corporate Culture 10
Shareholder Activism 11
The Specter of Government Regulations 13
A Sea Change for Options and Executive Compensation 15
Board Responsibility 15
What Do You Think? 18
Chapter Two
The Sources of the Problem 19
Brief History of Compensation 19
Cultural Phenomena 21
Modern History of Compensation 27
Lessons of the LBO 29
When Executives Become Owners 33
The Role of Boards in Compensation 35
Stock Options for Start-Ups and the Technology Revolution 38
A Skewed Incentive System 40
vii
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viii CONTENTS
Chapter Three
The Accounting Story 43
Behind the Scenes of the Accounting Debate 45
FASB’s Renewed Campaign 48
Measuring the Value of Options 51
Determining Fair Value 54
A New Chapter in the Story 58
PART TWO
ELEMENTS OF THE SOLUTION 63
Chapter Four
An Accounting Solution Everyone Can Live With 65
Accounting Rule Implications 67
Special Treatment for Start-Ups? 69
What Do You Think? 75
Bridging the Gulf 76
Chapter Five
Valuing Options 81
Black-Scholes and Beyond 83
The Four Guiding Principles 88
The Purposes of Stock 91
What Do You Think? 92
The Transition to Expensing Options 93
Chapter Six
Providing the Right Questions—and the Right Tools—
for Boards 101
Board Members’ Concerns 102
The Tyranny of Competitive Data 104
Taking a Deeper Look 110
What Do You Think? 114
CONTENTS ix
Chapter Seven
Making Options Performance Based 117
Weighing Performance-Based Options 118
The Purpose of Options 119
Adding Performance Measures 120
Dealing with Underwater Options 122
Other Option Tricks 125
What Do You Think? 127
Bringing Balance to Executive Compensation 127
Chapter Eight
Designing a Balanced Portfolio of Incentives 131
The Risk Decision 131
The Psychology of Risk 132
From Bureaucrats to Innovative Thinkers 133
Taking a Healthy Risk 134
The Balanced Portfolio Approach 136
The Benefit of Stock Ownership 142
A Revolutionary Stock Concept 143
What Do You Think? 144
Building a Balanced Incentive Program 145
Chapter Nine
Building Healthy Employee-Employer Contracts for Public
and Private Companies 149
An Unhealthy Contract 151
Lessons of the New Economy 154
Making Healthier Contracts 155
The Role of Compensation 156
The Role of Long-Term Incentives 161
The Private Company 162
What Do You Think? 164
Valuing People and the Purpose of the Corporation 164
x CONTENTS
PART THREE
THE PATH TO ACCOUNTABILITY 169
Chapter Ten
Restoring Corporate Integrity 171
Restoring Corporate Integrity: 9 Steps to a Healthier Organization 173
What Do You Think? 180
The Role of the CEO 180
Chapter Eleven
Vision for the Future 185
The Power of the Corporate Executive 186
A Vision for the Future 187
Endnotes 193
Index 195
F O R E W O R D : A C O N V E R S AT I O N
B E T W E E N D O N D E LV E S A N D P A U L
VOLCKER, FORMER FEDERAL
RESERVE CHAIRMAN
When I set out to write this book, my topic was stock options.
Specifically, my intent was to explore the much debated issue of
expensing stock options. While that remains an essential theme of
this book, it is impossible to address stock options without looking
at the broader picture. Put another way, stock options are the trees;
executive compensation and effective corporate governance are the
forest.
After completing this project, I am left with several compelling
questions. What can we do differently? How can executive com-
pensation become more balanced and healthier? What changes in
corporate governance are necessary to ensure that independent-
minded boards are better equipped to design and implement exec-
utive compensation packages that are based on performance? How
can ownership in a corporation be used as a reward after perfor-
mance is demonstrated instead of as a perk that comes with the job?
This then leads to the ultimate question: what is the purpose of
the corporation and how is its success measured? Is the end goal of
the corporation to serve its shareholders? If so, then the stock price
would be the ultimate benchmark of its success. Or is the purpose of
the corporation something more, with shareholders, executives,
board members, and employees as integral parts of a greater mission?
These are the questions I had in mind when I spoke with Paul
Volcker, former Federal Reserve Chairman (1979 to 1987) and cur-
rent chairman of the International Accounting Standards Com-
mittee (IASC) Foundation, which oversees the International
Accounting Standards Board (IASB). Mr. Volcker is also among the
12 members of The Conference Board’s Commission on Public Trust
and Private Enterprise, which has undertaken an in-depth study of
compensation, auditing, and governance issues. He is an outspoken
advocate for better corporate governance and more sensible execu-
tive compensation.
In our discussion I was pleased to find that Mr. Volcker and I
shared many views, particularly the need for a better system of
executive compensation and more rational use of stock options. An
excerpt from our conversation follows:
xi
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xii FOREWORD
Paul Volcker: What I find fascinating is that, even though the market
is down, executive compensation has not come down significantly.
Stock options, in particular, have continued to be as high, or higher,
as in the past.
Don Delves: In recent years, you have been very vocal about your
opposition to excessive use of stock options.
Volcker: What I am opposed to are fixed-price stock options for large,
broadly held companies. When you talk about stock options, it’s eas-
ier to think about it the other way around. A private company that’s
a start-up can do what it wants. It can choose to give away stock in
the form of options, largely because it doesn’t really have any cash. I
would say the same thing applies pretty much for a technological,
publicly held company with a large concentrated ownership.
However, when you get to most big, publicly held companies,
the stockholder is not in charge. He’s at the mercy of what the board
says and the board does. The stockholder is pretty far removed in
terms of direct decisions. And, except in the most egregious cases,
you can get very big stock option grants in a very big company. And
it still doesn’t have that much dilution for the typical stockholder—
not enough that he’s going to be charging the barricades over it!
Delves: There are clearly times when stock options make sense and
when they do not. For example, with a new company, options are a
way to offer stock without really giving ownership, and they are a
way to pay people without use of scarce cash. But there is absolutely
no way that stock options are the best incentive for every single cor-
poration in America and for every single executive in vast quantities.
Volcker: We never would have had these excesses in executive com-
pensation in my view, except for the growing popularity of stock
options. People did not think they were giving away all that much.
But when you have the greatest boom in the stock market in all of
history, what they thought was very large and generous became
grotesque.
Delves: It’s gotten to absurd proportions. Another interesting factor is
when I assess the value of an option using the Black-Scholes (option
valuation) formula. It used to be an option was worth 0.35 times the
exercise price. Today it’s 0.5 times the exercise price. The reason is
because the volatility of the market has gone up. The primary thing
that has made an option worth more is the fact that volatility is
higher. At the same time that occurred, option grants have gone up
400 to 600 percent. It was a remarkable explosion.
FOREWORD xiii
F I G U R E I-1
The Good, the Bad, and the Ugly of Stock Options
Good: Options for start-ups and other cash-strapped companies; options
that vest based on performance; options with exercise prices
that vary with the market.
OK: Fixed-price options as part of a mix of performance-based
incentives and/or required stock ownership.
Bad: Fixed-price options for large, established public companies.
Ugly: Mega grants of fixed-price options to executives of large,
established public companies.
Very Ugly: Mega grants of options to executives of poorly performing
companies whose stock price has dropped precipitously.
Volcker: Some people have made the calculation that 80 to 90 percent
of the payoff from stock options must be capricious. The problem,
however, was that in the midst of a stock market boom, everybody
was getting paid off—even if you weren’t doing that well. And then
it reached truly grotesque proportions when people were getting
paid off when the company was going bankrupt! Looking at it in
hindsight, and it is partly because of the bull market, you can see just
how capricious stock options really were as a reward mechanism.
There isn’t much relationship between the reward and the effort, the
ability, or the contribution.
Delves: You have done a lot of work on board governance, particu-
larly as it relates to executive compensation. How do you get boards
to govern better?
Volcker: My favorite corporate governance reform is to have inde-
pendent directors who make independent judgments and who have
responsibility for oversight. That’s a starting point. That’s the kind of
board you ought to have. But it’s not going to be effective unless you
get some kind of leader of the board who is able to coalesce that dis-
cussion. This says to me that the preferred way in an organization is
a nonexecutive chairman. Find independent directors, not to be
antagonistic, but to have the opportunity to discuss things among
themselves, to put things on the agenda, and to demand things be
put on the agenda. When something goes wrong and there is a real
question about the CEO, then you have some ability to discuss it and
take action.
xiv FOREWORD
Delves: The other part of executive compensation is the subject of
ownership. Why do we feel compelled to give people ownership?
Why don’t we expect them to earn it? Shouldn’t we be structuring
compensation systems that say, okay, we’re going to give you an
interest in the company, but you have to earn it over time? You have
to consistently demonstrate and create value in order for this to come
to fruition. So if it’s an option, it vests based on some kind of long-
term, demonstrable performance. It’s an option that allows an exec-
utive to buy stock at today’s price—or even below today’s price—but
over the next 5, 7, or 10 years. But someone has to consistently create
value that is greater than what they are receiving their salary for.
Volcker: In my own thinking I believe this whole idea of equity com-
pensation is overdone. Take this whole idea of paying directors in
stock. Should directors who were overseeing the behavior of the
company be motivated themselves for the short-term performance of
the stock?
Delves: That goes back to the larger point that we focus way too much
on stock and stock prices. Some studies show that 75 percent of the
movement of the stock has very little to do with what the executives
actually do.
Volcker: This is not just a function of stock options, but stock options
do exaggerate it. I’ve told the story many times, but I remember sit-
ting here with a Wall Street business leader. He said, “What can you
expect when for 20 years the best business schools have been teach-
ing that all that matters is stock price.” I thought about that and came
to the conclusion that he was right.
Delves: We were taught to believe that total return to shareholders is
the be-all, end-all, and ultimate measure of a company’s health and
success.
Volcker: But you’ve got these big public companies, and they
aren’t issuing any stock. The stock price is irrelevant to their basic
financing. Right through this past decade—the greatest bull market
in history—what did these companies do? They bought stock. They
didn’t sell stock. Some individual companies did. But companies
as a whole were buying back stock and not issuing stock.
I remember addressing an audience, it was probably during the
late 1970s when I was Federal Reserve Chairman, and there was a
CEO in the audience. He said, “When it comes right down to it, I
don’t know why we care that much about stock price. I don’t sell
FOREWORD xv
stock. I don’t go to the market for new capital ever. There are a lot
more important things to the company than the day-to-day move-
ment of the stock price.”
Delves: If we are not looking at the stock market strictly as a source of
equity capital, then that turns everything upside down. We assume
the purpose of the company is to serve the shareholders. Yes, they are
important as a source of capital. But that capital is used in pursuit of
the company’s actual purpose: to produce goods and services and
sell them in the market.
Volcker: That’s right. The purpose of the company is really to provide
goods and services at the best possible price, at the highest level of
productivity, and in a way that serves society and communities. That
is the purpose of the company. The stock is just the way that we get
there.
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ACKNOWLEDGMENTS
To my wife, Denise, for her consistent belief in me, and whose con-
stant, loving, and sustaining support creates the environment in
which I live and work. To my daughter, Lucy, who cheers me on,
and is consistently proud of her dad for running a business, writing
a book, and doing positive things in the world.
To my father, Gene Delves, on whose shoulders I stand. For his
35 years as an Arthur Andersen partner, which provided me with
an example of life as a consultant and what it means to work for a
meritocracy, and for his many, invaluable business contacts. To my
mother, Sue Delves, whose energetic demeanor and tireless com-
mitment to public service and public speaking have been a great
example and inspiration.
To Bob Wright, my mentor and coach, for his inspiring, com-
pelling vision of what’s possible, and for leading me to believe
I can make a positive difference in the world. To Judith Wright,
my spiritual leader and guide, whose dedication to service and her
belief that we are all loved deeply and unconditionally have been
an inspiration and helped me to expand my vision beyond what I
ever thought possible.
To my fellow leaders at the Wright Institute, who coach me,
encourage me, give me helpful criticism, and expect the most from
me, including Rich and Gertrude Lyons, Mike Zwell, Tom Terry,
Angie Calkins, Kathy Schroeder, Barb Burgess, Collin Canright,
John Trakselis, Brian Laperriere, Art Silver, Jeff Stitely, Corey
Coscioni, Stan Smith, Rob Johnson, James Gustin, Jeff Golden,
Kevin McCann, Paul Minnihan, and Marty Goldman.
To John Balkcom, with whom I worked at Sibson and Com-
pany, and who encouraged me to pursue stock option reform as a
“life’s work.” To Rich Semmler, who taught me to be a damn good
compensation consultant. To Warren Batts, former CEO of Premark,
who has coached and encouraged me to speak the truth and under-
stand the perspective of a highly conscientious and concerned
board member.
A special thanks to Charles “Chuck” Bowsher, former Con-
troller General of the United States and a member of The Conference
Board Commission on Public Trust and Private Enterprise, who
appreciated the importance of my message and opened several
valuable doors for me.
xvii
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xviii ACKNOWLEDGMENTS
To the thought leaders who took the time to speak with me
and to share their thoughts on compensation in general and
stock options in particular. They include John Biggs, immediate
past chairman and CEO of the Teachers Insurance and Annuity
Association-College Retirement Equities Fund (TIAA-CREF); Graef
“Bud” Crystal, former compensation consultant, author, and colum-
nist on executive compensation for Bloomberg.com; John Fiedler,
former Chairman and CEO of BorgWarner; Larry Hirsch, Chairman
and CEO of Centex Corp.; Gary Hirshberg, Chairman and CEO of
Stonyfield Farm; Jim Leisenring, board member of the International
Accounting Standards Board (IASB); Jon Najarian, options trader
and principal of Mercury Trading and PTI Securities; Ronald Turner,
Chairman, President and CEO of Ceridian Corp.; Nobel Laureate
and economist Myron Scholes, coauthor of the Black-Scholes
methodology for valuing options, and Paul Volcker, former Federal
Reserve Chairman, member of the Conference Board Commission,
and chairman of the International Accounting Standards Commis-
sion Foundation.
To Scott Balutowicz, my associate at the Delves Group, for his
valuable research and consistent cheerleading; and to Tricia Jacobs,
who assisted with the graphics.
To Ela Booty, who introduced me to my publisher.
To my editor, Kelli Christiansen, for championing this project,
for her enthusiasm, and for her valuable editorial guidance.
And to my writer, Tricia Crisafulli, whose brilliance, speed,
passion, partnership, and true caring for the message helped shape
this book.
(For more information about The Delves Group, please see our Web site at
www.delvesgroup.com. To contact the author, send an email to optionsbook@
delvesgroup.com.)
