After years of lurking in the wings, the collapse of the Enron Corporation and the subsequent corporate governance crisis, along with the current economic recession, have pushed these internal corporate wage differentials to the center of American life. This article argues that wide gaps between the top and bottom of the pay scale can, in certain circumstances, directly and adversely affect firm value. This section then analyzes the stock option components of current CEO pay contracts and identifies them as a significant cause of the rapid expansion in internal pay disparities at most American corporations.
Stock option compensation is the main cause of these differences.8 The widening gap between the pay of US CEOs and that of average workers in their firms arises from the apparent increase in the long-term compensation elements of CEO pay packages. .9 Similarly. when we compare the salary of American CEOs with the salary of foreign CEOs, the biggest difference between them is that. The value of the compensation ultimately paid can be thought of as the price for it. Promotions within an internal labor market have been analogized to tournaments: the best performers in the workplace are promoted to the next level of jobs.” an elimination tournament.38 The.
Once you reach the top of the pyramid, there is nowhere else to go. So, as noted, explicit performance pay should become most important to those at the top of the organization. See infra part B for a discussion of some of the issues associated with using stock prices as a measure of CEO performance.
Stock options give managers incentives to undertake riskier, high-return projects because the expected value of stock options increases with the volatility of the underlying stock's price.69 Manage it.
Another oft-cited virtue of stock options is that they can align managers' and shareholders' incentives to maximize firm value.65 In widely held public corporations, this alignment function is an important corporate governance tool for reducing of management agency costs. Stock options were originally promoted as a means of inducing risk-averse managers to act more like shareholders.6 Managers are risk averse because their jobs and salaries are at risk if the corporation becomes insolvent.6 The value of their wages are fixed and relatively unchanging if the firm's wealth fluctuates significantly. For this reason, and because they are often restricted from exercising or selling options, company executives will place a lower value on stock options than other investors.
Managers who hold large amounts of stock options have incentives to take large chances to drive up their companies' stock price in order to increase the value of their options. If the big gamble doesn't pay off, the managers' stock option value may just drop to zero, even if the stock price falls well below the options' strike price. Stock options were promoted at many companies because they were seen as a relatively inexpensive way to compensate managers for accounting purposes.
Under existing accounting rules, stock options can be issued without any charge to a company's profits,76 while cash compensation must be deducted from profits. In 2002, many companies announced that they would deduct stock option costs from their profits, and companies that don't do so face increasing questions from analysts and others about their footnotes on these costs. If the options have a predetermined exercise price and expiration date, no costs are recognized by the company when the option is granted if it has no intrinsic value (the spread between the market price and the exercise price) at the time of grant.
Most companies grant options at an exercise price equal to the fair market value at the time of grant, so there is no accounting expense. Subsequent tax consequences are calculated at the time the option is exercised. If the stock options are non-qualified, then when they are exercised, the executive realizes a taxable gain equal to the difference between the exercise price and the market price at the time of exercise.
34;Incentive Stock Option ISOs"), the manager does not pay taxes at the time of exercise, but upon the eventual sale of the security (if the security is sold). The use of stock options as a form of compensation only makes sense if the difference between their cost to the company and their value to the executive, say A C, less than any additional value created by options that is not created by cash compensation, say A V. All of these factors have led to renewed calls to reconsider the use of stock option compensation, particularly awards mega-grants.
Large Internal Pay Differentials May Reduce Firm Value In recent years, scholars have studied the connection between
Options also create opportunities for corporate managers to unfairly exploit their information advantages over shareholders.77 Corporate insiders have access to better information about their companies than external shareholders. Insiders know when the firm is about to announce important information, or the industry is about to undergo significant changes. Insiders' ability to exercise options provides them with a way to capitalize on their informational advantage.
Finally, there has been a flurry of academic research showing that options are an expensive way to compensate executives compared to cash. Several studies have shown that the cost to companies of issuing options, as measured by the Black-Scholes formula, far exceeds the value that managers place on them.79 This difference stems from the contingent nature of option value, which prompts managers to attach a lower security value to them. A V may consist, for example, of any value arising from the best alignment of the interests of shareholders and managers, which, as mentioned above, is uncertain.
Internal Pay Differentials Affect Firm Value
Should Boards Consider the Costs of Internal Pay Differentials?
Directors need to be better informed about the value of pay-for-performance systems. The duty of care requires that boards have a reasonable basis for concluding that large incentive awards are beneficial to the company.” The duty of care requires that boards be reasonably informed as to whether their actions are in the best interests of the company.
For an extensive discussion of the implications of this decision for the standards of judicial review of executive compensation decisions, see Randall S. When challenged, boards of directors generally point to the opinions of their compensation consultants that their executive compensation packages are adequate.”9 These consultants are typically knowledgeable about the company's relative pay practices in its industry sector. They will have access to very detailed studies of the executive pay systems used by comparable companies that compete with the company they are advising.
Although this information can be very useful in determining the opportunity cost of management, it does not address the key question before the board: what level of executive compensation will maximize the value of the firm?'6° Without this information, directors cannot claim make informed decisions about the impact of executive pay levels on their firms and shareholders. They must demand that directors justify executive pay packages as value maximization for the firm. These stakeholders have the power to insist on an accounting of the costs of greater degrees of wage dispersion.
This could include estimates of the increased level of employee turnover, decreased morale and loss in worker productivity. UAL Corp., United Airlines' parent company, has already agreed to a similar request and will tie top executives' bonuses in part to employee satisfaction. Giving managers options to buy ten percent of the company's shares is not cost-free to investors, despite the accounting treatment of stock options.' If these opportunities increase firm value by incentivizing managers to work harder, stakeholders should ask boards to provide evidence to support this claim.
The duty of care should require directors to be informed of the effect of internal pay differentials on the value of the firm. Boards must consider the negative consequences for the company as a whole if one group is perceived to be unfairly rewarded. Directors also need to determine whether high director salaries have a negative impact on the productivity of other workers, turnover and ultimately whether these factors have a negative impact on the value of the company.
Conclusion
Shareholders should also ask the board to justify the cost of incentive compensation packages awarded to management. The board needs to know at what level of compensation these effects begin and whether they increase at higher levels. However, the studies discussed above point in the direction of placing a ceiling on executive compensation due to these effects.
Likewise, more research needs to be done on the effects of internal pay differentials on firm value. Such research would be very useful to executives if it could provide some guidelines for appropriate pay differentials at different types of companies. Without further work on these issues, corporate boards will continue to make uninformed and very expensive judgments about how to pay their directors.
