Stockholders should force options to expire

Institutional managers can no longer afford to ignore what I believe is a ticking time bomb on corporate America’s balance sheet: The soaring use of executive stock options.

Part of the problem is the nature of the options themselves. Options provide corporate managers with incentive-related increases in stock market prices rather than increases in the fundamental value of the enterprise. And in this great bull market, the rewards are staggering. Compensation of chief executives, largely through stock options, has risen to 419 times the compensation for the average worker, compared with 85 times in 1990 and just 40 times in 1980. At some point, this extreme distortion of traditional norms alters the nation’s social equilibrium.

rising tide lifts even leaky boats

Yes, stock options align the interests of management and shareholders. But consider these negatives: First, the very relationship between stock price and stock value may be distorted, as I believe it is today. Second, despite the fact that any business which merely reinvests all or part of its earnings should grow in value during any given period, options offer a free ride to managers who put up no capital and take no risk. Third, a rising stock market, unlike the proverbial rising tide, may not lift all boats equally, but it provides enormous rewards even to those who manage companies whose stocks lag behind the market. Fourth, even if the stock market were deemed the ultimate arbiter of success, it rewards any success, irrespective of performance relative to a company’s peer group.

In short, the fact that there is no “hurdle rate” for the prices at which options are exercisable fails to provide valid incentives and creates rewards where there are no risks.

The amount of potential earnings dilution is huge. One analyst estimates that reported earnings on Standard & Poor’s 500 stock index would be reduced by 50% when diluted by the exercise of existing options, raising today’s adjusted price-earnings ratio to more than 60 times. Corporate shareholders are giving too much, and getting too little in return.

The most ominous aspect of the flawed option process is only now rearing its ugly head. Time and again, when a corporation’s stock price tumbles, management reprices the options, all in the name of continuing to assure that its executives have incentives that are attainable. Understandable as it may be for corporate executives to see things in this way, the question is: What would an owner do?

Is it fair to the stockholders — any more than to a sole owner of a corporation — to engage in wholesale repricing at a new low price, perhaps in a stock whose shares are temporarily depressed, or even the stock of a company whose prospects have remained stable over a decade but whose stock price has merely soared with a soaring market or plunged with a plunging market? When, as, and if, the stock market takes a big tumble, the trickling stream of option repricing in recent years will become a torrent. If unopposed by stockholders, it will result in material earnings dilution, likely exacerbating the market decline. Institutional investors, beware. Indeed, be aware enough to tackle the issue head on.

Mr. Bogle is founder of Vanguard Group in Malvern, Pa. This article is excerpted from his address before the New York Society of Securities Analysts late last year.