Tuesday, May 23, 2006

Rigging Executive Pay

The Wall Street Journal, NPR, etc. are expressing outrage that companies have been backdating executive options to surreptitiously give executives huge payoffs.  The gig looks like this.  Companies give executives stock options ostensibly to align the executives' interests with the interests of stockholders: if the stock goes up, companies and executives both profit from the increased stock value.  Some companies, however, apparently have been backdating the options so that the executives received their options on precisely the same day that the stock prices hit all-year lows.  KLA-Tencor, for example, gave its Chair 10 stock-option grants over 8 years, all precisely timed at market lows.  WSJ estimates that the probability of that happening by chance is one in 20 million.

Perhaps the bigger story, however, is that this heads-I-win-tails-you-lose game is endemic to executive stock grants.  A recent empirical survey of executive employment contracts found that a miniscule percentage of the contracts granting stock options restrict in any way an executive's ability to hedge or pledge those options on the derivatives market.  The derivatives market permits executives to trade the options for fixed payment streams unrelated to stock performance, thus eliminating entirely the incentive theory for granting the options in the first place.  In other words, stock options become simply another fat, albeit somewhat veiled, bonus.

For more on executive employment contracts, see Stewart Schwab & Randall Thomas, An Empirical Analysis of CEO Employment Contracts: What Do Top Executives Bargain For?, 63 Wash. & Lee L. Rev. 231 (2006).

rb

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