The challenge of turning managers into owners.

• Author: Hall, Brian J.
• Position: Research Summaries

During the past two decades, the influence of shareholders has grown dramatically as institutional investors and other shareholder representatives became increasingly vocal and activist in exercising their "ownership rights" over the decisions, policies, and governance of corporations. Shareholder anger over the recent corporate scandals appears to have further increased shareholder activism, continuing or even accelerating the trend of increasing shareholder power. (1) Aligning the interests of shareholders and managers has been a central goal of institutional investors and shareholder activists. To a significant extent, that goal has been realized, because the large increase in executive pay since the early" 1980s was caused primarily by dramatic increases in equity-based pay (especially stock options), which led to a nearly ten fold increase in the relationship between top executive wealth and shareholder returns. (2) In spite of this, there has been widespread concern (and outrage) among the press, shareholders, and the public that executive pay has become "excessive" while also motivating dysfunctional behavior. These concerns are targeted particularly at instances where large executive payoffs--typically from option exercises or sales of company stock--follow (or precede, in the case of the company scandals) poor corporate performance and declining company stock prices. The shareholder goal of "turning managers into owners" is more difficult to achieve than it may seem. What is the best equity-instrument? Over what period should equity grants vest? How much should be granted? What pay designs minimize risk-taking and gaming temptations? Much of my research concerns the many pay-design challenges and tradeoffs involved in turning managers into owners. In what follows, I discuss several of these issues.

Creating Leveraged Ownership Incentives

Although there has been a recent shift toward restricted stock (stock that vests over time), the vast majority of executive equity grants have been in the form of stock options rather than stock. But if the chief goal of equity-based pay has been to turn managers into owners (who own shares, not options), why has pay been dominated by options instead of stock? Although such an explanation does not always sit well with economists trained to think that important economic decisions are affected by real economic (not accounting) factors, there is considerable evidence that the accounting rules are one of the dominant factors determining choices among equity-pay instruments. (3) Current accounting regulations heavily favor stock options, because option grants create no accounting expense on company profit-and-loss statements while stock grants (and most other equity-pay instruments) do create accounting charges. As a result, equity-based pay plans are astoundingly similar across companies, with the vast majority of plans in the form of at-the-money options designed to qualify, for the favorable accounting treatment. Discount, indexed or performance-based Options (4), all of which have certain advantages, are rarely even given serious consideration by companies because they would lead to accounting charges. Beginning in 2005, the accounting rules are likely to be changed, requiring options to be expensed, and this should have large affects on equity-based pay design.

But even with a level playing field in terms of accounting, options have another advantage over stock. Options are a leveraged ownership instrument. (5) Because an option is less expensive to shareholders than a share of stock--in terms of the expected transfer from shareholders to the options holder--companies generally can grant two to three times more...