Shareholders should demand a decrease in executive pay

If you think of the economy as a business run for the benefit of the public, it’s easy to see why the extraordinary compensation paid to many executives matters: A healthy business minimizes costs, and we should pay just what it takes to get executives with the right skills, and no more.

Simple common sense tells us we can get good people without paying eight-figure packages. If every CEO’s pay was cut, say, 20 percent, would they all quit? Of course not. How else could they make this kind of money?

So why, then, is pay so high? Obviously, there is a kind of arms-race effect of companies constantly bidding up pay.

In theory, shareholders should step in to demand pay cuts for CEOs. One reason they don’t is that stock options, often the biggest component of an executive’s pay, are not calculated as an expense the way ordinary salary and bonus are. That makes the cost to shareholders hard to see.

In a typical options grant, the executive is given the right to buy a given number of shares for a set “strike” price, usually the market price on the grant date. So, if the share price rises above the strike price anytime during the life of the option generally 10 years the executive can exercise the option to buy the shares at the lower strike price. He can immediately sell the shares for a profit.

Corporate America would like shareholders to believe that options aren’t an expense. But well-respected people such as Alan Greenspan and Warren Buffett disagree. They have argued this spring that the failure to subtract the cost of options has allowed companies to make profits look bigger than they really are.

In the wake of the Enron scandal, some members of Congress have proposed measures to force companies to better account for options. Many shareholder groups, including those for institutional shareholders such as pension plans, want these changes enacted. Unfortunately, they face opposition from President Bush, many Republicans, some Democrats and much of the business community. Among the anti-reform arguments:

Options aren’t really an expense, since they don’t require cash payments, the way ordinary salaries do. But, of course, options have value, else executives wouldn’t want them. Giving away something of value incurs a cost.

Counting options as an expense will discourage their use, since companies won’t want to see their reported earnings decline. Would that be so bad? Perhaps options have become too widespread.

Options align executives’ interests with shareholders’, since both make money when the stock price goes up. Unfortunately, the alignment isn’t always that close. Shareholders have money tied up in the stock and face losses when the share price falls. Options holders do not have money tied up.

In fact, it’s in the executive’s interest to see a low share price on the date his option’s strike price is set. And executives holding options with looming expiration dates have reason to play accounting games or use other gimmicks to temporarily drive up share prices.

Shares that go up through sleight of hand are sure to come crashing down again, hurting all the investors who jumped on board in the meantime.