AmEx Does Options Right

Amid toxic spillover from the housing excess and egregious lending practices comes an admirable model of corporate governance. Even more impressive, it comes right when corporate governance needs a shot in the arm.

A recent article in Fortune outlines a simple, laudable approach American Express (NYSE: AXP  ) took in paying CEO Ken Chenault big bucks while keeping the interests of shareholders at the top of the list.

A model for options use
Seeing that Citigroup (NYSE: C  ) was in the market for a new CEO after the ouster of Chuck Prince, AmEx wanted to ensure that Chenault would stay exactly where he was. (There are no confirmed reports that an offer was made). American Express has no known subprime problems, making Chenault all the more appealing for Citi. Chenault, though, has produced an enviable record at the helm of AmEx, so keeping him around was a no-brainer. Long-time AmEx shareholder Warren Buffett of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) has regularly praised Chenault for his excellent long-term value creation.

So what did the company do that was so innovative? Like most corporate stock option issuances, this one was worth a bundle and would make the CEO a boatload of money. Unlike most option grants, however, this one really aligns executive incentives with those of shareholders'.

The general fallacy with typical options grants is that they have asymmetric payoffs. That means that if all goes well, executives profit. But if the company's share price declines, the executives are, unlike shareholders, no worse off than when they started (unless they get axed). As you can see, with this structure, the temptation to assume any risk to prop up the stock price in the short-term is very high.

Value in the details
Unlike typical option packages, this one is extraordinary because of the performance hurdles it imposes. In fact, the hurdles are so specific that they almost make you want to invest in the company -- almost. Remember, never invest without performing due diligence. Unlike options that are strictly tied to a specific stock price, these options are truly long-term and performance-based, as they require targets to be met over six years.

The specific hurdles are very noble indeed. First, American Express has to increase earnings by an average of 15% per year over the six years. Second, return on equity must average 36% a year and revenues must grow by 10% annually.

That's not all. The final hurdle -- and one that value investors will love -- is that total return on shares has to beat the S&P 500 index by an average of 2.5 points over the same stretch.

You don't need to be brilliant to realize that if ROE averages 36%, and earnings growth averages 15% a year for six years, the shares will appreciate. Of course, paying attention to the price you pay for shares will ultimately determine how much you make. If Chenault meets only a fraction of the hurdles, he will get only a portion of the grant.

This incentive structure ensures that the bonus is based on true performance of the company versus an overall rise in the market. As investors, we all know that a rising tide lifts all boats. It's one thing when your investments are up 20% while the market is up 20%, but a totally different and more impressive result when you are up, say, 10% and the market is up only 3%. AmEx's incentive plan rewards Chenault for producing the latter result and not the former.

A little means a lot
Corporate decisions such as this one by American Express should interest investors; they provide an additional standard to measure against other corporations.

For instance, when Procter & Gamble (NYSE: PG  ) took over Gillette, there was disagreement over Gillette CEO Jim Kilts getting such a large pay package. Yet when you consider the value created at Gillette under Kilts, the payout was understandable. Hopefully the same will hold true here.

The Fool has long stood against stock option abuse:


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