CEO option grants seen harmful

LOS ANGELES (Reuters) - A big package of stock options is no substitute for actual ownership when aiming to encourage chief executives to take prudent risks that provide reliable stock returns, according to a new study.

CEOs whose compensation packages include a large percentage of stock options tend to make risky decisions that generate big share price losses more often than big gains, said study authors W. Gerard Sanders of Brigham Young University and Donald Hambrick of Penn State University.

Proponents of stock option awards say they attract and retain talented executives, and give managers a vested interest in the company's future stock performance.

But the study's authors say they are hardly effective in boosting company results.

"While they were implemented as a substitute for stock ownership, they don't mirror stock ownership because they have no downside," said Sanders, associate professor of strategic management at Brigham Young.

"It's somewhat akin to walking down the Strip in Vegas and handing money to a gambler and... promising to share only the upside," he said.

The study of 950 companies, randomly selected from the Standard & Poor's 500 Index, as well as mid-cap and small-cap indexes, is to be published in the October-November edition of the Academy of Management Journal.

A stock option gives the holder the right to buy a number of shares at a preset price for a specified period.

Stock options as an executive compensation tool reached their pinnacle of popularity in the late 1990s before losing ground in the dot-com meltdown.

Executive stock options have also been tarnished by the recent scandal over backdating and other methods of manipulating grant dates to inflate their value. Scores of companies have launched internal probes or are the subject of official investigations.

The study authors tracked corporate results between 1993 and 2000, examining the relationship between the percentage of CEO compensation given in options and each company's investment and financial performance.

The average percentage of CEO compensation comprised of options among the companies was 25 percent, said Sanders.

The professors found that CEOs with a higher proportion of stock options presided over companies with higher investment spending and more extreme stock performances.

Overall, big losses were more common than big gains when CEOs were given high levels of options pay.

In companies where options constituted half or more of a CEO's pay, 10.1 percent sustained extreme shareholder losses, while 6.8 percent enjoyed large gains.

"There are only a few hitters who when they swing for the fences get a home run," Sanders said. "The options don't motivate them to look at the downside."

Company performance improved, on average, as stock option use declined, Sanders said.

Companies with "options-heavy" CEOs had an average annual shareholder return of 26 percent versus 36.5 percent for companies run by "options light" CEOs during the study period.

Extreme shareholder losses occurred at only 2.5 percent of the firms where stock options made up 20 percent or less of CEO pay, according to the study.

While some companies have walked away from option compensation in recent years, it is still widely used as a compensation tool, Sanders said.

"You can make the inference... that firms would be better off if they use moderate levels of stock options," Sanders said. "It's fair to say from our data that going very heavy with options is likely to have a negative effect on the health of the company."