While the use of stock options are seen as a key element of the "New Economy," they have also been portrayed as one way to ensure the survival of capitalism since they were established in 1950. Intended to induce work and encourage creativity, they have become an important component of pay packages for budding dot.com millionaires. A more ambitious, if less generous scheme, was the advent of employee stock option plans (ESOPS) that were supposed to turn workers into capitalists. However, the reality behind this important tax loophole is more complex than the theory.
According to a study of company proxy statements filed with the US Securities and Exchange Commission (SEC) between May 31, 1999 and May 31 of this year by Graef Crystal for Bloomberg, the average total pay was US$12.5 million for the CEOs of the 500 largest US companies with the largest market values. Included in total pay are base salary; annual bonus; the estimated present value at grant of stock options awarded during the year calculated with the Black-Scholes pricing model; the value at grant of free shares of stock awarded; payouts made under other long-term incentive plans; and "other annual compensation" and "all other compensation" as defined by the SEC.
Out of those 500 corporations, eight of their chief executives received pay packages of US$100 million or more. Their combined income exceeds US$1.5 billion which was mostly derived from stock option grants but also included salary, bonus, free shares and other compensation granted during the latest fiscal year. Charles Wang of Computer Associates International Inc ranks first on the list with earnings of US$511 million.
Many economists dismiss criticisms of executive pay packages of extreme dimensions and proportions by insisting that it is the free market at work. Their retort is that if some executives were overpaid, shareholders would revolt or other investors would shun the offending companies' shares or both. In the end, such punishment on the stock market capitalization would serve as a self-correcting remedy against abuses.
At the same time, there is a dominant argument that CEO pay is linked to performance, especially the enhancement of shareholder value.
However, the argument that market participants will punish malefactors may assume too much knowledge on the part of investors and too much power in the hands of dissenting shareholders.
Crystal's study also attempted to discover the important determinants of CEO remuneration and, in particular, to match pay with performance. It turns out that the most significant indicator of pay disparity is company size as measured by differences in revenue, invested capital and number of employees. But an examination of shareholder performance over three, two and one-year returns (measured by the sum of stock price appreciation and reinvested dividends) explained only 2 percent of the CEO's variation in their pay packets.
Interestingly, the principal source of the disparities in incomes was the issuance of stock options. The present value of all the options granted to CEOs of all 500 companies during 1999 totaled US$3.9 billion. As it turns out, a favorable tax treatment insures that the cost of such options is not charged off on the companies' earnings. Consequently, there is little discipline exercised in this practice so that the practice of issuing options does not have to reflect performance.
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