Real Estate Causes Real Problems for Investors: Regulating Executive Liquidation of Stock Options as a Source of Real-Estate Financing

• Author: Lindsey A. Reighard
• Position: J.D. Candidate, The University of Iowa College of Law, 2009; B.B.A., The University of Iowa, 2006.
• Pages: 04

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IIntroduction

Over the last fifteen years, compensation of Fortune 500 Chief Executive Officers ("CEOs") has moved from 140 times that of the average employee to over 500 times that of the average employee. ¹ In 2007, the average total compensation of a CEO of a Standard & Poor's 500 company totaled $11.07 million.² Much of the increase in executive compensation is due largely to significantly enhanced equity-based compensation, particularly in the form of stock options.³

With salaries of this magnitude, executives can afford to acquire impressive residences. For example, Larry Ellison, co-founder and CEO of Oracle Corporation, built a "palace" that cost more than $100 million; Bill Gates, co-founder and former CEO of Microsoft, has a home that is worth over $140 million; and Paul Allen, Gates' co-founder of Microsoft, spent $120 million on his home.⁴ Some CEOs seem to have more modest properties, but a CEO can create the appearance of modesty by disclosing a smaller property while living secretly in a mansion elsewhere.⁵

How do executives come up with the financing to purchase such extravagant real estate? A recent study by finance professors Crocker Liu and David Yermack (the "Liu and Yermack study") examined the real-estate purchases of almost every top executive in the Standard & Poor's 500 index. ⁶ The study found that, on average, CEOs finance twenty-seven percent of their real estate costs through equity-based financing by exercising stock options and selling shares. ⁷ CEOs are wealthy enough to finance real estate through other means, such as bank loans, the proceeds from the sale of a previous home, or even out-of-pocket.⁸ However, since the majority of CEO pay comes from equity-based compensation, such as stock options, it is not hard to understand why it is tempting for CEOs to finance Page1796 real estate-or other expensive personal assets⁹-by exercising their stock options.

Financing real estate with equity-based compensation, while beneficial to top executives, is problematic for investors. The Liu and Yermack study concluded that companies with CEOs who obtain extremely large properties demonstrate substandard ex post stock performance, particularly when the CEOs sell shares or exercise options to help cover the cost of the new home. ¹⁰ The study found that when CEOs use equity-based financing, the company stock underperforms the market benchmarks for the next several years.¹¹ Conversely, when CEOs use other financing methods that do not involve selling equity, the stock performs well after the purchase. ¹²

The Liu and Yermack study shows that a CEO's method of financing a home acquisition predicts the future stock returns of the company. 13 Financing a home by exercising stock options and shares sends a message of entrenchment to shareholders and predicts poor future stock performance. ¹⁴ Financing a home without selling shares conveys commitment to the company and tells shareholders to expect positive stock returns.¹⁵ These results suggest that equity-based financing makes the "[p]igs get fat and hogs get slaughtered."¹⁶ In effect, an executive places the executive's interests above those of the shareholders by using equity-based compensation to finance extravagant real estate.¹⁷

Equity-based compensation is a popular form of compensation for executives.¹⁸ While executives should be able to spend their compensation as they would like, there are downsides that occur when executives exercise Page1797 their stock options to finance luxury homes-and potentially other extravagant personal assets. Regulations are required to minimize these downsides. ¹⁹ This Note addresses the problems with executives' use of equity-based compensation to finance personal real estate and suggests some possible solutions. Part II defines equity-based compensation, discusses how companies grant equity-based compensation packages to executives, and explains the current regulation of equity-based compensation. Part III asserts that allowing executives to exercise their stock options and liquidate their shares as a source of personal financing is problematic. Part IV examines the current regulation and identifies its shortcomings. Part V suggests practical solutions to the equity-based financing problem that are in the interests of both executives and shareholders.

IIEquity-Based Compensation

Equity-based compensation is an important and widespread part of executive pay structure.²⁰ In 2003, equity-based compensation constituted fifty-five percent of total compensation, up from thirty-seven percent ten years earlier in 1993.²¹ Today, some executive-compensation packages are almost entirely equity-based.²²

ABasic Structure

Equity-based compensation for corporate executives comes in two forms: true equity compensation (grants of stock, restricted stock, stock options, or performance-based stock) and equity-related compensation (stock appreciation rights, phantom stock, or performance-unit plans).²³ Of these forms, stock-option compensation is the principal method that Page1798 companies use to compensate top executives.²⁴ The increased use of stock-option compensation in the 1990s caused executive salaries to grow significantly. ²⁵ By granting an executive the right to purchase stock at a future date at the current market price, stock options can result in huge profits for executives when they sell the stock on the open market for a much higher price than the exercise price.²⁶ However, a stock option is only profitable if the corporation's share price is above the exercise price-if the market price for the stock drops below the exercise price, the stock option is worthless to the executive.²⁷ Furthermore, an executive usually does not have the right to exercise a stock option until a particular period of time has passed or until the executive meets certain performance goals. ²⁸

Companies realize substantial advantages by conferring equity-based compensation such as stock options instead of other forms of compensation like salary. Equity-based compensation has three distinct advantages: (1) it does not require the corporation to dispense any cash, making it a particularly attractive option for companies with fewer financial resources; (2) it helps companies retain executives because an executive forfeits the potential value of the options by leaving the corporation; and (3) it reaps beneficial tax deductions for the company when executives exercise their stock options. ²⁹ Equity-based compensation also creates an incentive for Page1799 executives to "work hard to increase the market price of the employer's stock," since their compensation is tied to that stock.³⁰

Along with its advantages, equity-based compensation has some significant drawbacks. A major disadvantage of equity-based compensation is that it shifts corporate control to executives and may cause executive overcompensation.³¹ Equity-based compensation tempts executives to manipulate stock prices in order to maximize their compensation.³² When the value of options decreases, they lose their advantage of being an incentive for executives to maximize market value in a weak economy, thus causing executives to leave the corporation. ³³ Equity-based compensation, particularly in the form of stock options, lowers the corporation's earnings-per-share and reduces shareholder voting power. ³⁴ Stock options increase the potential number of outstanding shares and, as a result, dilute the proportionate ownership of shareholders.³⁵ Problematic stock-option pricing practices, such as backdating and springloading, can cause a number of negative consequences for both the shareholders and the corporation. ³⁶Page1800 Thus, wlhie equity-based compensation has some benefits, it is not without its risks.

BDirector Approval

Before a corporation grants an equity-based compensation plan to one of its executives, the board of directors of the corporation must approve the plan. The board's management powers make it responsible for determining the compensation packages of its top executives.³⁷ In carrying out its task of determining executive compensation, the board can delegate this responsibility to one or more committees.³⁸ Public companies commonly create such committees to develop and recommend appropriate executive-compensation packages to the board. ³⁹ Directors may rely on the committees' advice when making a decision on executive-compensation packages. ⁴⁰ The business-judgment rule-a presumption that the directors have complied with their fiduciary duties when making business decisions- protects the decision of a board or compensation committee regarding an executive-compensation package. ⁴¹

A major drawback to the board determining a CEO's compensation is that the lack of an arm's-length relationship between the board of directors Page1801 and the CEO produces an opportunity for self-dealing.⁴² Most...