unting stock options as expense would reduce overuse

The drumbeat for reining in executive pay keeps getting louder.

The latest proposals excellent ones recently came from The Conference Board, the highly-regarded New York business research organization. The nonprofit board is best known for its monthly Consumer Confidence Index and its index of leading economic indicators, but it examines many other business issues as well.

High on the list of proposed solutions is a favorite of mine: getting companies to count executive stock options as a business expense.

The Conference Board can’t dictate policy to anyone. But its 12-member Commission on Public Trust and Private Enterprise commands attention. It is full of pro-investor names, including Vanguard Group founder John Bogle and former Securities and Exchange Commission Chairman Arthur Levitt Jr.

If you suspect that the uproar over executive compensation has gone overboard, consider these facts the commission culled from various sources in producing its report:

l Between 1992 and 2000, median compensation for chief executive officers at large public companies rose from $1.8 million to $6.1 million.

l It also cited another study that found typical CEO compensation rose 340 percent during the past 10 years while ordinary employees gained only 36 percent.

l In 1992 stock options accounted for 27 percent of the median CEO compensation; by 2000 the figure had soared to 60 percent.

Issuing new shares of stock to cover options grants reduces the value of shares that are already in circulation, since company profits are spread among more shares. At the median company, this “dilution” reduced share values by 8.3 percent in 1990. In 2000, the figure was 16.3 percent.

Clearly, stock options are a big part of the problem. The “excessive use of stock options” is encouraged by accounting rules that allow companies to issue the most popular form of options without counting them as business expenses, which would reduce profits reported to shareholders, the commission said.

The typical “fixed-price” option gives the recipient the right to buy a set number of shares of the company’s stock at a set price any time over the following 10 years. The purchase price is usually the market price of the shares on the day the grant is awarded.

If the shares trade at a closing price of $10 each on the grant date, the executive receiving the options can buy shares for $10. If the price goes to, say, $20 during the next decade, the executive can use the option to buy shares for $10 and sell them immediately for $20, pocketing $10 per share. It’s all accomplished without the risk borne by ordinary folk who hold shares in their accounts and can lose money if prices drop.

Companies are encouraged to use this type of option because it’s hard for shareholders to see what it’s costing them.

If the options were counted as an expense, profits for the average company in the Standard & Poor’s 500 would drop by 10 percent, the board said, citing a study by Merrill Lynch. Among high-tech firms, where options use is most extensive, expensing them would reduce reported profits by a whopping 70 percent.

Another problem is that fixed-price options allowed executives who had not performed very well to get rich as their companies’ shares were simply carried by the current in the ’90s.

The solution? Put fixed-price options on a par with performance-based options, which already are counted as an expense, the commission said. A performance-based option has value only if a specific corporate goal is reached after the option is granted. Perhaps sales or profits have to rise to a given level. Or perhaps the option gives the right to buy shares at a price that is much higher than the price on the date the option is granted.

Performance-based options do what options are supposed to do encourage the recipients to do really good work. Many companies would turn to this form of option were it not for the preferable accounting treatment given fixed-price options, the board said.