BAD CALL?
How companies are rethinking the way they use shares to pay staff.
By Justin Wood

Remember the financial crisis that swept through Asia in 1998? Oon Kum Loon, a 24-year veteran of Singapore-based DBS Bank at the time, certainly does. As one business after another buckled under the pressure of the regional meltdown, her company was forced to write off millions of dollars in bad debts. To make matters worse, the Singapore government had recently announced plans to throw open its doors to competition from foreign banks. The situation didn't look good.

Fortunately, says Oon, who was running DBS's trading room back then, the bank had foreseen these challenges.

At the start of 1998, it hired John Olds from JP Morgan to be its new CEO. His mandate? To transform DBS from a largely Singapore-focused bank with outdated practices into a pan-Asian powerhouse capable of competing on the world stage.

What followed was dramatic. DBS was restructured to improve areas such as capital allocation and strategic planning. The group made a string of regional acquisitions, including Bangkok-based Thai Danu Bank, and it invested heavily in IT. For Oon, the changes meant a promotion, and she was put in charge of overhauling the bank's risk management processes.

Equally important, in 1999 DBS Bank pulled the covers off a new share-based compensation scheme. The bank had long encouraged its staff to buy stock in the company - as far back as 1980, for every dollar an employee spent buying shares in DBS, the bank matched 50 percent of their contribution. And since 1990 the company had run a stock option scheme for senior managers. In 1999, however, the bank added a third strand to its equity-based pay program: a performance share plan that stands out in Asia for its sophistication. "We wanted our employees to think and act more like owners of the company," explains Oon, who was promoted again in July this year to become CFO of DBS.

Under the terms of the performance share plan, the bank's staff are each allotted an amount of shares every year for free, with the amount based on personal performance. However, they only receive those shares if DBS meets its rolling three-year ROE target. If the target is met, the staff receive all their allotted shares. If the target is exceeded, they get more, but if they fail then they receive fewer shares. Oon declines to reveal the exact targets behind the plan, but the bank's long-term ROE goal is 15 percent - some way above last year's result of 8.9 percent.

Taking Stock

Ahead of its time in Asia - and in many other parts of the world too - DBS's performance share plan shows how companies are rethinking the way they use equity to pay their staff. Many investors believe such changes haven't come a moment too soon.

For decades, shareholders have struggled to work out how to get the managers of a company to act in the best interests of its owners. The most recent solution to this so-called "principal-agent dilemma" has been to pay managers with some form of equity, so making them owners too. And by far the most popular form of equity-based pay has been the stock option. Not only do options focus the attention of managers on growing their share price, say supporters, but options neatly link pay with performance and provide a long-term incentive.

Perfect, it would seem. That's certainly the conclusion that thousands of companies around the world came to during the past ten to 15 years when the use of stock options spread like wildfire. A survey by Towers Perrin, a US-based consultancy, shows that in 2001, 100 percent of large listed companies in the US, Canada and the UK used options. In Asia, the figures were lower - for example, 75 percent in Singapore, and 50 percent each in Taiwan and Hong Kong - but growing rapidly.

More recently, however, options have started to lose some of their appeal. "Stock options were always viewed as the silver bullet in terms of executive pay," notes Ian Speirs, director of rewards in the Singapore office of HR consultancy Watson Wyatt. "But over the last year or so, that silver bullet has become somewhat tarnished."

Much of the criticism has focused on the role that options played in blowing hot air into the stock market bubble of the late 1990s, especially in the US. Equally, the subsequent bear market has brought other faults to the fore. Alan Greenspan, chairman of the US Federal Reserve, and Warren Buffett, arguably the world's most widely respected investor, are just two of the more prominent voices among a growing clamor calling for reform. Equity-based pay as we know it today, and particularly the stock option, say detractors, has had its day.

Stock in the Dock

The criticisms leveled at stock options fall into three camps. First, it's argued that stock options are a poor way to link pay with performance. For example, in a bull market, the share prices of all companies tend to rise, so that stock options reward mediocre or even poor managers, while in a bear market, all shares tend to fall, so that excellent managers end up with nothing.

What's more, it's also debatable just how much control managers have over their share price, given the influence of external factors such as interest rates. Consider the results of a study carried out by Richard Dobbs and Timothy Koller, two consultants at McKinsey. They examined the total returns to shareholders at around 400 firms in the US since 1962 and found that, on average, more than 40 percent of the returns during any one- or three-year period can be explained away by trends in the broader market. "It follows that, if performance is measured on the basis of share price movements, then managers are being rewarded or punished for events outside their control," says Dobbs.

Dobbs highlights another way that options are a bad method of lining up pay with performance: the issue of expectation. As Dobbs points out, share prices often move in anticipation of the future, which makes stock options a bad way of paying for past performance. Say a company has an excellent management team in place and that the market has already factored high expectations of future performance into the company's share price based on the strength of that team. The company may well go on to outperform its peers, but the company's share price will hardly move. "Extraordinary managers may deliver only ordinary share price increases," explains Dobbs, "which makes options a bad way of rewarding them."

State of Pay

The second major criticism of stock options is that they encourage the wrong sort of behavior. That's partly because options give managers an asymmetric payout - they're a one-way bet. If the share price rises then managers face an infinite upside; but if the share price falls, managers don't lose anything. Given this asymmetry, observes Amar Gill, head of research at Hong Kong-based Credit Lyonnais Securities Asia, options encourage excessive risk-taking. "Managers are incentivized to roll the dice and take big gambles," he says.

Academic studies back up his assertion. Brian Hall, Luis Viceira and Randolph Cohen, three researchers at Harvard Business School in the US, released a report in May 2000 that examined the CEOs of 478 large US firms over a 15-year period. Given that the value of an option increases with volatility, they wanted to see whether CEOs with big stock option holdings made their firms more volatile (ie, risky). The answer, they discovered, was a resounding yes. They also looked at the two main ways in which CEOs can make their firms' share price more volatile: either by taking on riskier projects or by increasing the company's gearing ratio. Their research concluded that, rather than find new projects, CEOs "take the quickest route to increased volatility of stock price: they tend to increase firm leverage".

All of which leads onto another way that stock options encourage the wrong sort of behavior: they promote short-termism. Just ask Tony Watson, CEO of Hermes, a UK-based fund manager with US$74 billion under management. As he sees it: "Stock options encourage managers to focus on short-term stock price alone rather than on the things that grow long-term shareholder value."
Again, academic research bears out these suspicions. For example, a report released in December 2000 by US-based Daniel Bens of the University of Chicago, Venky Nagar of the University of Michigan Business School, and Franco Wong of the Haas School of Business at Berkeley University, shows a clear correlation between stock options and short-termism. "We find that firms experiencing significant stock option exercises shift resources away from real investments towards the repurchase of their own stock," the report reveals. It concludes: "Our findings indicate that stock option exercises impose a real cost on the firm in terms of foregone investment opportunities."

At Hermes, Watson further believes that, during the 1990s, stock options created an obsession with boosting share prices in the short-term that, in turn, played a big role in inflating the recent stock market bubble. "Do we think stock options are good to pay people? No we don't," he snorts.
At the US Federal Reserve, chairman Alan Greenspan agrees. In a speech delivered on Capitol Hill on July 16, he said: "The spread of shareholding and options among business managers perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising."

The third broad criticism of stock options centers not so much on the nature of the instrument itself as the way in which option programs are implemented. Issues such as the repricing of under-water options, and the way that options are accounted for in financial statements - which in many countries fails to reflect their true economic cost - have all angered investors. So too have instances of CEOs awarding themselves overly large option grants that translate into salaries worth hundreds of millions of dollars.

A Rewarding Experience

So should companies abandon equity-based pay entirely? And if not, what can be done to solve these issues?

It's true that some companies have already rejected shares as a way to pay staff. At Hong Kong-based Hutchison Whampoa, the US$11.4 billion ports-to-telecoms conglomerate, the board took a long hard look at implementing a stock option scheme but decided against it. Some observers reckon that's because the group's controlling shareholder, tycoon Li Ka-shing, is reluctant to loosen his grip on the company, but Hutchison denies this. "Dilution has not been a consideration," says Susan Chow, Hutchison's executive director and deputy group managing director. "We've simply found cash-based bonuses to be a more effective means of employee compensation," she says.
Nonetheless, Hutchison is likely to remain in the minority. Most experts reckon stock-based remuneration still has much going for it and is here to stay. What needs to change, they argue, is the way these plans are designed.

One major trend, predicts Speirs at Watson Wyatt, will be a move away from stock options towards shares, "but subject to pretty rigorous performance hurdles", he adds. The performance share scheme in place at DBS Bank is a good example, where ROE acts as the hurdle. Another type of share-based scheme is the use of restricted stock, whereby managers are awarded part of their annual bonus in shares rather than cash but they don't receive those shares until some time in the future, say three years on.

By using share schemes such as these, companies avoid the problems of asymmetry inherent in options. If the share price falls, then management bonuses decrease, and executives feel the pain just as shareholders do. Paying in shares, rather than options, can also avoid the demotivational effect of deeply under-water options - when a company's share price is well below the strike price of its stock options then executives face no prospect of any bonus at all.

A different type of performance share plan is used at UK-based Diageo, the US$17.3 billion-a-year drinks group. Called a total shareholder return (TSR) scheme, it measures Diageo's performance against a peer group of 18 other fast-moving consumer goods companies. Every year, Diageo's top 50 managers are eligible to receive a set amount of shares depending on how well the company has performed against its peer group over the previous three years. With TSR calculated by looking at share price gains coupled with reinvested dividends, the plan pays out 150 percent of the allotted shares if Diageo finishes either first or second in its peer group. Should Diageo finish only ninth, it pays out just 50 percent of the shares, while positions ten to 18 pay out nothing.

For Keith Chapman, group compensation and benefits director at Diageo, the attraction of the scheme is that it filters out share price gains due to the wider market - the company must outperform before the plan pays out. "If anything is wrong with the way that many companies compensate their executives, it is the lack of performance criteria that underpin their programs," he says. And Chapman sees another benefit to his TSR plan. "By measuring ourselves against world-beating firms like Coca-Cola and Procter & Gamble, we're sending out a message that we want to be an iconic company," he says.

One further way that straight shares rather than options will play a bigger role in future is the requirement for managers to hold a permanent stake in their companies. At Diageo, for example, the firm's top 900 managers are required to buy shares or else they can't take part in the company's various benefits schemes. For the most senior directors, the size of the holding must equal 225 percent of their base salary at all times..

Down But Not Out

As for stock options, don't count them out just yet. While they may have faults, some companies have found ways they hope will address those issues. Up until recently, most companies around the world have used "plain vanilla" stock options, where the strike price is equal to the market price on the grant date and the vesting period is around three years. The share price only has to rise a little bit for managers to make a lot of money. But now that looks set to change.

In future, expect the addition of tough performance criteria so that, for example, managers don't receive windfall gains in a bull market when they have only produced average returns. In other words, executive pay will be more tightly linked to performance. To get a flavor of how this can be done, it's worth looking to Germany, where stock options are required by law to have a performance element built into them.

One simple technique, says Michael Kramarsch, a partner at Towers Perrin in Germany, is to use either premium price options or performance-vesting options. In both cases, the strike price of the option is set above the market price when the options are granted, for example at a 15 percent premium. With premium price options, executives receive only the upside above the 15 percent. With performance-vesting options, managers get the full value over the market price of the shares at the time the options were granted, including the 15 percent.

More sophisticated still are index options, where the vesting price is set against a broader stock market index, such as the Dax 30 in Germany, so as to single out a company's relative - rather than absolute - share price performance. In order for such options to vest, a company's share price must beat its benchmark index by a certain margin over a set period of years. Kramarsch says that quite a few German firms are using index options, such as soap and detergent giant Henkel, which pitches its performance against the Dow Jones Stock Index (see box). "Stock options are neither good nor bad in principle," says Kramarsch. "It all comes down to how you use them," he says.

As things stand today, few companies in Asia have taken steps to add performance criteria to their options. But that's not to say they won't. Hong Kong-based Noble Group, a US$1.8 billion-a-year trading and logistics group, has a standard stock option plan in place, which financial controller Louis Tang says works well. Nonetheless, he also sees merit in index options. "It's true that, in some cases, option schemes have paid out to undeserving managers," he notes. Not that anyone could accuse executives at Noble of getting lucky. Over the past two years the firm's share price has risen by around 100 percent at a time when Asian markets have all tumbled.

Tang's only concerns would be taking care to choose an index that suited the company, and then not making the scheme too convoluted. "It could add a lot of complexity to what is a simple process," he points out.

Given the variety of equity-based pay plans available, executives could be forgiven for scratching their heads when it comes to picking one for their own company. Still, it's worth making the effort, says Gordon Clark, managing director of Kepler Associates, a UK-based consultancy. "Staff costs typically make up 70 percent of a company's overall expenses, so you need to see a return on that investment," he maintains. "Using stock-based compensation is a great way of doing that," he says.

At DBS, Oon is banking on it.

Justin Wood is executive editor, southeast Asia, for CFO Asia