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Another Reason to Cut Executives' Stock Options

Start by linking CEO pay to share prices, add in a stock market bubble, and you've got a recipe for accounting errors-to put it politely. That's one lesson to be learned from new research conducted by Anup Srivastava of the Kellogg School of Management, Jap Efendi, of the University of Texas at Arlington, and Edward Swanson, of Texas A&M.

The trio examined the earnings statements, options grants, share prices and compensation packages of 190 companies, half of which issued earnings restatements between January 1, 2001, and June 30, 2002--the aftermath of the dotcom bubble. Their findings:

  • CEOs who held onto options that they could have cashed in for big profits were more likely to lead companies that had to restate their earnings. (The researchers did not say how many companies' original statements were 'better' or 'worse' than the restated ones--just that the originals were wrong)
  • The companies that restated earnings had CEOs whose options were worth many times as much as those whose earnings were right the first time. The average CEO at a restating company had stock option holdings worth approximately $50 million, or 46 times their salary, compared to $9 million (or six times salary, on average) at similar firms that did not issue a restatement.
  • The more the CEOs options were worth, the more likely they were to fudge the earnings. If options were 53 times the value of CEO salary, the company was 43% more likely to issue a restatement.If options were 136 times the value of the CEO's salary, the company was 56% more likely to issue a restatement.
  • CEOs whose options are worth 100 times--or more--than their salary, "start taking extreme risks. They make acquisitions and play with their accounting numbers," says Srivastava, perhaps to preserve their perceived wealth. For these CEOs, a 10% drop in the price of the company's shares can cut their wealth in half. "In this scenario, they will do anything and everything to keep the stock values high," says Srivastava. They may also refrain from cashing in their shares, so as not to attract attention from the Securities and Exchange Commission or their investors.
Bubbles make billionaires--on paper
When a bubble causes the value of a CEOs options to climb to 100 times salary, says Srivastava, there is no way the stock price or the worth of the stock options can be justified by the company fundamentals. For context, it helps to remember just how generous stock option packages were during that time: The CEO of JDS Uniphase once had stock options worth nearly $1.28 billion. (JDS Uniphase is still around, by the way, and as of Feb. 9 was the top performing stock in the S&P 500 so far this year.) Coming in second was the CEO of Freemarkets, whose in-the-money stock options totaled more than $751 million. Freemarkets was bought by Ariba for $493 million in 2004.

Are CEO compensation packages in the billions of dollars ever justified? How about hundreds or tens of million?

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Photo courtesy of flickr user TKTK
Kimberly Weisul is a freelance writer and editor. Follow her on twitter at www.twitter.com/weisul.
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