Learning How To Reward CEOs

Take a look at the compensation of top corporate CEOs from the mid-1990s through 2005. They typically follow a common pattern: Their base salary is less than $1 million but they earn tens-of-millions from cashing in stock options. This pattern is easily explained once you understand the U.S. tax code. Prior to 1992, most of an executive’s compensation was in base salary. But in that year, the U.S. Congress changed the tax code so companies could only deduct, as a business expense, salaries up to $1 million. This was done in response to the public outcry over the huge salaries that CEOs were making. CEOs and other top executives were not about to take huge cuts in pay. So board of directors merely changed the way that they paid their top people. Beginning in the mid-1990s, boards lowered base salaries and began handing out large grants of stock options to executives. Importantly, because of arcane accounting rules, these options actually cost the companies nothing and never directly effected profits. Corporate reformers failed to consider how stock options would change CEO behavior. Options allow recipients to buy company stock at a specific price. So option holders make more money as the price of a company’s stock goes up. When the bulk of your compensation becomes tied to options, which are increasingly valuable as a stock’s price appreciates, you suddenly have a powerful incentive to drive your stock higher by any means, if only for a short time. Relying on options as the primary form of executive compensation encourages all kinds of questionable practices that will inflate revenues and cover up costs. One shouldn’t be totally surprised, therefore, that Adelphia Communications’ executives inflated numbers and hid personal loans; that Xerox executives overstated their company’s revenues; that HealthSouth’s CEO instructed company officials to circumvent a large write-off that would seriously reduce earnings and batter the company’s stock; or that senior managers at Enron grossly manipulated sales and expenses to make their company look highly profitable when it was actually losing money. All these executives’ compensation packages were heavy with options. Their actions were consistent with a reward system that provided huge payoffs for executives who could make their companies look profitable for at least long enough for them to execute their stock options and make hundreds of millions of dollars for themselves. Meanwhile, Krispy Kreme’s CEO—Stephen Cooper—is paid by the hour. That’s right, he’s paid $760 an hour for running the company. You might think that’s quite a wage rate, but his $1.52 million salary (based on a 40-hour workweek) pales in comparison to the $475 million Bernie Ebbers (Worldcom Ex-CEO) or the $325 million (Enron Ex-CEO) Ken Lay earned.