Puzzling stock options and compensation norms.

• Jurisdiction: United States
• Date: 01 June 2001
• Author: Levmore, Saul

Why do so many executives and other employees receive fixed stock options as part of their compensation packages? Even though there is an impressive literature on compensatory options, it raises more puzzles than it solves. Tax law, option theory, and agency theory all suggest that we might have expected to find quite different practices than we observe. In particular, there is a puzzle in the popularity of conventional fixed options when indexed options would seem to be relatively attractive. The solution or story offered here develops arguments about signaling; employees will not want to be seen as preferring cash over options in their own employer's future. It relies on the idea that indexed options encourage more risk alteration, or inefficient differentiation, than other forms of compensation and it introduces the notion that there is something of a norm in favor of nonconflicting fortunes within a community. The norm part of the argument says something about the more general norm of privacy with respect to money matters and it illuminates the occasional practice of confidentiality regarding one's own compensation. This practice might be stable because of the negative signals emitted by defectors. The same analysis might help explain why stock option practices are somewhat sticky.

INTRODUCTION

This Article is in part about a puzzle associated with stock options and employee compensation. Many firms, and virtually all firms in certain industries, use stock options to form a significant part of the compensation they pay their more highly compensated employees. These options could take many forms, but there is remarkable conformity in the practice of giving a class of employees a large percentage of compensation (in expected value terms) in the form of options with strike prices set at or slightly above the underlying stock's market value at the time the options are granted. Moreover, this compensation practice has grown in popularity. It is associated with start-ups, especially with respect to granting options even to nonmanagerial employees, but it has grown to include a majority of traded firms and many employees who, individually, would seem to have only remote influence on firm profits or share prices.(1)

Criticism of this expansion of compensatory options has largely focused on the market value of these options and the frequent reissue or revision of options when these options become nearly worthless because of declines in share prices for the market as a whole or even for the employer-firm.(2) Revisions are defended as necessary to recreate the incentives and alignment of interests that were present before these options dropped underwater. But critics fear that agents are somehow overpaying themselves with options in a way that they could not with straight compensation. Part I takes prevailing practices and criticisms as its starting point, comparing conventional stock options to bonus plans and to indexed options. The discussion pays particular attention to risk and to tax law. Something of a puzzle emerges as to why conventional compensatory options are so popular. I refer to this as the "stock option puzzle."

Part II develops the idea that conventional practice may be explained with a combination of considerations. I describe one of these as "super-risk alteration" and another as something of a norm regarding the "nonconflicting fortunes" among similarly situated employees, or within other communities. These ideas play important roles in part because employees are, quite understandably, not compensated with instruments that extract payments from them when the firm does relatively poorly. A third consideration is signaling. At several points in the analysis, it appears that employees would have trouble bargaining away from prevailing practices because to do so might send an unpleasant signal that is wisely avoided.

Part III suggests that the norms portion of the argument is more plausible than it first seems because a similar norm regarding nonconflicting fortunes can be found in other settings. I do not insist that the norms label is critical to the larger explanation regarding compensation practices. It is possible that the work done by the norms argument could be rendered by a related claim about potential efficiency costs in the face of conflicts among employees. But the norms label does provide some purchase, and the focus, in any event, is on the larger task of explaining the popularity of conventional stock options. Moreover, compensation practices seem somewhat sticky and might, therefore, themselves be understood as constituting or reflecting various norms.

1. THE STOCK OPTION PUZZLE

   1. Incentive-Compatible Alternatives

      1. Compensatory Stock Options and Bonus Plans

         If there is a puzzle about options, it is in the details rather than the overall abstraction. The abstract idea is simply to provide employees, and especially high-level managers, with compensation packages that mitigate agency costs. Managers who receive straightforward, unadorned salaries might do what pleases shareholders who hold residual equity claims, if only because managers care about their reputations, pay increases, or other issues. But it is easy to see why shareholders might prefer that compensation track performance more directly, and one way to do this is to tie employee well-being to the firm's share price. The idea is to motivate managers with something less than a one-period lag. Of course, managers might make themselves attractive by bonding themselves through compensation packages that rise and fall with shareholder value. Incentive-compatible compensation offers, or ideas, might originate on either side of the employment bargain.

         There are, of course, many ways to align managerial well-being with shareholders' (or all investors') goals. This is hardly the place for a review of all such alternatives or for a catalogue of the advantages and pitfalls of each. But it is useful to visit some obvious alternatives.

         Employees of all stripes might be promised bonuses, perhaps at year's end, based loosely or tightly on the firm's profits or the employees' individual performances, defined and measured one way or another. Some bonuses, including those paid at many law firms, are neither specified nor guaranteed in advance, in which case a bonus is much like a raise--except that the employee can choose to depart immediately after the bonus is paid and the bonus does not become part of the employee's base salary for the purpose of future raises and benefits. In some settings these bonuses might be better thought of as liquidated damages aimed at preventing disruptive departures, but there is nothing terribly remarkable about slightly uncertain ex post rewards.(3)

         As compared with common stock options, an interesting thing about typical end-of-period bonuses--and even, perhaps, voluntary severance payments made to employees--is that they can be individualized even as they are linked to firm performance. A given employee is likely to perceive that her end-of-year bonus is very sensitive not only to the firm's overall profits, but also to a supervisor's or committee's perception of her individual performance during the preceding year. Even if the employee reasons that the true aim of the bonus is to discourage exit and to encourage hard work in the coming year, there is likely to be a strong correlation between the strength of these managerial sentiments and the individual's performance in the completed year.

         Stock options can be designed to be close substitutes for these conventional bonuses. Employees simply might not know in advance how many options they will receive at the end of a period, or, for that matter, what the exercise price will be. The exercise price and duration probably need to be set by the employer at the start of the period, so that employees will see that hard work and firm success during the period raises the expected value of their options. The number of options each employee receives--whether individualized or not--can in principle be determined at the end of the period based on the employee's performance. Employees might then be made indifferent between conventional bonuses and stock options. Both are expected to rise with the value of the firm, and both can be individually tailored with something of an ex post component, if so desired.

         These not quite conventional stock options--and others as well--may be inferior to bonuses from both employer and employee perspectives because of the risk that in the course of the period in question the price of the firm's stock will fall. The straightforward case is when there is a widespread drop in the stock market, so that the decrease in the expected value of an option could not have been prevented by better performance on the part of the employee or even by the particular firm as a whole. The same is true if only this firm's price falls, but for reasons unremediable by our targeted employee. The problem is interesting in part because it is asymmetric. If the market as a whole rises, the employee still knows that on the margin (assuming the employee can affect the firm's stock market price through hard work and so forth) this firm's value will rise more than average. But if the market drops, and the options are well "out of the money," then employer and employee will realize that there is no longer any incentive function served by the options or promise of options. Even the hardest working employee will not bring the share price into the range that was expected at the time the options were granted or written. The risk of such drops might be offset by the grant of more options in the first place, a topic discussed below in Part II.C, but the incentive effect is more stubborn.

         A related problem accompanying downward market movements concerns the logistics of pay periods. For a variety of well-known reasons, relating both to practicalities and...