Wouldn't it be great to set your own salary? That's exactly what many corporate executives are able to do -- thanks to stock options. And as a shareholder, you're the one paying for it.
Used correctly, stock options can be a great way to give a company's executives an economic incentive to boost the company's stock price. Options can align an executive's interests with shareholders better than a fixed salary. An option plan can set future targets for stock appreciation that rise over time, providing substantial rewards if executives get results that exceed those targets -- but forcing executives to work hard in order to get those rewards.
Unfortunately, that's not the way most company option plans work. Instead of tailoring stock options to give strong incentives for exceptional performance, most companies use their option plans as a way to funnel additional compensation to executives, rewarding even mediocre performance with cash.
Pushing it to the limit
Yet even that wasn't enough for some executives. As a result, they looked for ways to reap even more benefits from their options. That led to the options backdating scandal, which caught even some big name corporate leaders like Apple's (NASDAQ:AAPL) Steve Jobs and UnitedHealth (NYSE:UNH) CEO William McGuire. Other big companies -- including Home Depot (NYSE:HD), KB Home (NYSE:KBH), and Rambus (NASDAQ:RMBS) -- also fell prey to backdating allegations.
By changing the dates of option grants, executives were able to lower the price they'd eventually have to pay for shares, creating additional profit. But shareholders were faced with increased dilution, watering down the value of their own shares even further.
Solving the problem
In theory, corporate boards of directors have the responsibility to control executive pay. In practice, however, boards rarely exercise that control.
However, at least one board is bucking the trend. According to a recent report from NPR, Level 3 (NASDAQ:LVLT) has instituted a plan that helps eliminate some of the problems other companies have faced with options. Under a so-called "hands-off" option plan, executives get option grants apportioned over 12 months, with each grant date fixed in advance to avoid manipulation or backdating. In addition, rather than letting executives decide when to exercise their options, hands-off options automatically cash out after a fixed period.
Yet until more boards follow suit, executive compensation will remain a point of contention for shareholders. Every week, more companies make SEC filings detailing generous salary packages for executives.
In the end, it will take action from activist shareholders, in conjunction with pension plans and other institutional investors that hold the majority of the shares of most large companies, to change this trend and get corporate compensation under control. Until then, look closely at the stocks you own to make sure you're aware of any shady compensation practices.
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