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The Business
Sunday 16th February 2003

Executive pay - are executive share options now an endangered species?

Peter Newhouse

Already identified as the great culprit of the fat cat culture in the UK, share options are under pressure from all sides. Stock markets are down for three years in a row and, with no respite in sight, most executive share options look worthless.

The movement to charge share options to a company's profit and loss account is gathering pace with the promise of new accounting standards. This would bring share options under even greater shareholder scrutiny. Then there are the successive waves of corporate governance and institutional shareholder guidance. Finally, share options now offer little, if any, advantages to executives under the current UK tax regime.

Should we rejoice that this icon of corporate excess is on its knees? Probably not. The controversy surrounding share options stems from a different debate - one that will not go away. How big a slice should executives, government and shareholders extract for their involvement in wealth creation?

Of all the contestants, the government has had the easiest ride. It lays down the framework within which companies do business and then takes its share of profits, dividends, salaries and capital gains through the taxation system. In the spirit of free enterprise, it leaves shareholders and executives to fight out over what it leaves behind. Successive governments have, in effect, deregulated the frothy end of executive pay. How much easier it was when most executive share options capped at four times salary in order to receive advantageous tax treatment.

The attraction of share options has always been their simplicity. A share option provides the opportunity (but not the obligation) to buy shares on a future date for a price that is agreed today. The great claim for executive share options is that they provide a degree of alignment between the interests of executives and of shareholders. But significant gaps remain. Share options provide executives with a one way bet on the share price at no real cost to themselves. By contrast shareholders put real money on the table.

Nevertheless, for shareholders too, options provide some advantages. The shares placed under option are typically newly issued shares. Consequently, any gains to executives from share options are not actually paid out of company profits; the money is provided by the market in the company's shares.

The real price that shareholders pay for this is a dilution in their stake. Institutional investor guidelines set rigorous limits on dilution to control the potential erosion of earnings per share and to protect their dividend flow. This curtails excess. But the recent volatility in share markets has demonstrated the weakness of share options. A rational market would see the company's performance as the horse that pulls the share-price cart. But the horse and cart have been disconnected more times than not.

It is not surprising, therefore, that inexplicable levels of reward have been generated by placing a large proportion of the executive's financial interest in the share-price cart rather than on the company horse. Share options schemes have also become ever more complex in an attempt to plug these obvious gaps in the alignment of interests.

Now that most share options are not working, there is a movement to scrap existing options that have no realistic prospect of generating value for executives and start again; but investors are beginning to dig their heels. As the debate rages, it is timely to consider what alternative arrangements might better align the interests of shareholders and executives.

Let's start with performance-related bonuses. Dividends provide a transparent proportion of profits to shareholders. They are directly related to financial performance. If annual bonus pools were determined and disclosed in a similar way, there would be a clearer linkage between pay, performance and the relative share of profits between government, executives and shareholders.

This is not to say that one size should fit all. Executive pay ought to be open, fair, consistent and explainable but the spectator's ire is raised to the extent that this does not meet these simple tests. Full disclosure is clearly required. A greater level of comparability across organisations is also needed.

Most fundamentally, there must be a far clearer linkage between pay and performance. Disclosing the company's entire annual bonus pool as a proportion of profits would provide a clear indicator of how the company perceives its own performance and how it manages the division of profits.

Of course, the level of salary that the bonus pool augments will vary from one company to another. US proxy statements publish a comparison of executive pay levels against their industry competitors and it makes sense for UK companies to do the same. These two simple steps would shed bright light on the fairness of executive pay.

But how should the annual bonus pool be determined? Over recent years executive pay has become obsessed with league tables of competitive performance. Typically, these are focused on total shareholder return (dividends plus share price change).

In league tables of total shareholder return, however, the outcome has little to do with the underlying performance of the business. The consequence of this is that executives will have little idea of what they will get and only a slender influence over the outcome through their efforts. Clearly, such delinkage of pay from performance is unhelpful. If any league table has meaning in terms of executive pay, it should comprise an index of company performance - based on indicators such as income, costs, profits, economic value-added, earnings per share - that are central to achieving the company's stated aims.

Where performance goals and their linkage to executive pay are clear, there will be fewer unpleasant surprises about executive pay; either for shareholders or for the executives themselves. An openly calculated performance index would demonstrate the company's achievements and provide a sensible basis for determining the executives' entitlement to performance-related rewards.

Once entitlement to reward has been determined on the basis of the underlying financial performance of the company, it makes sense to deliver a large proportion of any award in shares or share options. This stake should be retained by the executives for a minimum period before it can be cashed in, to discourage short-term thinking.

Government needs to show greater leadership. Rather than trampling over the field of corporate governance with endless reams of guidance, it could use taxation to incentivise responsible pay arrangements. The enterprise management incentive scheme introduced by this government would be a good place to start. It provides capital gains tax taper relief on qualifying share options from the date they are awarded. This has the impact of lowering the tax on share option gains from 40% to 10% over four years.

Currently the scheme is limited to smaller companies and £100,000 (€152,000, $165,000) worth of shares. If these limits were raised to cover the executive directors of listed companies a whole industry built around fancy incentive schemes, offshore corporate structures and tax avoidance would be swept away at a stroke.

Taken together, these steps would produce greater clarity in executive pay. Companies which confront these issues early will stay ahead of the game.

Peter Newhouse is the Chairman of Peter Newhouse & Co. pay and performance management specialists.

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