The director's stake in the enterprise.

• Author: McLaughlin, David J.
• Position: A study of director stock ownership and its implications for corporate performance

Here are the results of a pioneering study of director stock ownership and the implications for corporate performance.

Awards of common stock to managers and senior executives of public companies have long been regarded as a sound and desirable form of compensation and, concomitantly, as a performance incentive.

Recently, attention has turned to outside directors and the extent to which stock ownership enhances both their concern for the fortunes of the companies on whose boards they serve and their performance as directors.

There is a widespread perception that outside directors of public companies own but a token number of shares, if any. Shareholder activists and others who follow corporate governance issues have identified this perceived lack of stock ownership by directors as a significant failing of Corporate America. Their concerns may be misplaced, however. Our study of director ownership in 70 randomly selected multi-billion-dollar companies shows that non-management directors own an average of 2,300 shares with a median value of $109,000. Their holdings average 3.6 times their annual retainer.

That is not to say that all directors have a significant stake in the companies they govern. For example, at the end of 1992 the median stock holding of the outside directors of IBM (average board tenure, 9.1 years) was 1,074 shares worth $54,000, an amount less than the annual retainer of each of those directors. At beleaguered Armco, the average director owns less than $10,000 worth of stock. In six out of 10 companies in our survey, up to three outside board members have only a token stake -- 100 or so shares, reflecting an investment of but a few thousand dollars. While some of those with minimal stock holdings are newly appointed, the majority have served at least three years.

There is also growing evidence that companies whose outside directors have relatively high stock holdings outperform those whose non-management directors have minimal holdings. A recent study by Robert Stobaugh of the Harvard Business School contrasted the director holdings of the nine "most admired" public companies with those of nine other companies that were targets of at least three shareholder rights groups. The study found that the median amount of stock held by the directors of the former group was eight times that of the latter.

Our study of 70 companies with median annual sales of $9.4 billion shows that those with the highest director ownership delivered a return of 174% to their shareholders over the five years from 1988 to 1992, while those with the lowest delivered only a 73% return.

Behind these figures lie some important issues. Should board members be required to own stock, and if so how much? Should the board set ownership objectives for its members, particularly if it has established stock ownership guidelines for management? Will director stock ownership goals discourage the recruitment of independent directors from less remunerative fields (executives of non-profit institutions, for example)?

A Coherent View

Outside directors, particularly those serving on compensation committees, need to formulate a coherent view of the purpose of company stock plans and a philosophy with respect to stock ownership. About 10% of the 1993 compensation committee reports already take a strong stand for ownership. Primerica, for example, states unequivocally that "significant employee stock ownership has always been an important goal in the company's effort to link together the long-term interests of our executives and its stockholders." Gerber Products includes specific ownership goals for each of its top executives. So far, however, the focus of most of these statements has been on senior management.

Our survey addresses these issues in five parts:

1) A brief review of how the goal of stock ownership influenced the adoption of executive stock plans and how ownership became derailed when stock options evolved into a form of compensation.

2) The results of an in-depth study of director ownership levels in 70 pacesetter companies.

3) An overview of how director stock ownership correlates to company performance.

4) Consideration of the vehicles companies can use to foster director stock ownership.

5) In the context of these data, a discussion of director stock ownership standards and some conclusions and recommendations for an approach to this important and timely issue.

A Brief History of Stock Ownership

Sixty years ago, before the advent of the stock option, such well established companies as Du Pont paid a portion of executive compensation in company stock. The first stock options, used widely during the 1950s and early 1960s, were intended to help executives acquire and hold common stock in the companies they managed. Some companies factored into award guidelines the amount of stock different levels of senior management could acquire with their salaries and bonuses.

The emphasis on ownership waned as more complex "long-term incentive" schemes emerged in the 1970s, on the heels of several rounds of "tax simplification and reform." By the 1980s, stock plans in many companies had long since severed the connection with ownership and degenerated into...