South-Western College Publishing - Economics  
Executive Options Are Like Medicine: We May not Like Them, but They're Usually Good for Us
Topic Utility and Consumer Choice; Labor Markets
Key Words stock options, executives, backdating, incentives.
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Reference ID: A148421832

News Story Recent scandals involving the "backdating" of stock options for executives has called the use of stock options to motivate top managers into question. This article suggests that, while some people have used the incentives for their own gain, we need not throw out the entire system when the system itself isn't flawed.

In cases involving the work of one individual for another's benefit, known as principal/agent models, economic theory suggests the use of two different constraints: a participation constraint and an incentive compatibility constraint. Participation constraints induce the agent to actually undertake the work, and incentive compatibility constraints induce the individual to engage in effort leading to high returns for the principal; thinking about the principal's financial interest in addition to the agent's own. Following this type of compensation model, companies began widely using stock options as deferred compensation in the 1990s as firms sought to align top corporate executive's (the agent's) incentives with those of company shareholders (the principal) of the company. However, some executives began using these programs for their own gain regardless of company performance. Some managers even began "backdating" the options, writing them as if they originated when stock prices were very low rather than on the date when the executive was hired. As a result, executives who backdated the options received instantaneous bonuses just for agreeing to work.

While backdating options is, at best, unethical and at worst fraudulent, using equity compensation still provides appropriate incentives to business executives. The new Sarbanes-Oxley Act (SOX)-a series of accounting and finance practices laws--will force firms to account for options more quickly, assuming that the SEC and other government agencies enforce SOX. Further, other forms of equity compensation--such as providing restricted stock rather than common stock--may allow firms to align incentives without providing any avenue for unethical behavior on top executives' part.

Ideally, such payments reflect the principal-agent model, in which CEOs work as stockholders' agents. Stockholders can't observe CEOs' day-to-day managerial efforts, only stock performance. Thus equity owners want CEOs to engage their efforts to ensure high returns. In order to induce the agent to engage actively in such efforts, top managers need incentives to reward their efforts. In these cases, stock option awards-and the stock values used-- should be made public in advance of the option's start date. If the efficient-market hypothesis is accurate, then the stock price will reflect the information that this particular CEO has a stock option. Then the truly productive CEO will be rewarded, while a more unproductive one will not. And that's the way the system should work.

Discussion Questions:
1. Does the practice of backdating stock options violate the incentive compatibility constraint of a principal/agent model, or the participation constraint? Why?
2. Part of the article suggested that the practice has become one of "everybody does it." Does that make backdating stock options a prisoner's dilemma solution? Why or why not?
3. Does the fact that such backdating of options is considered illegal under Sarbanes-Oxley guarantee a reduction in its usage?
Multiple Choice/True False Questions:
1. True/False. In a model of principal and agent, the corporate executive would be the agent to the shareholder's principal.

2. An example of an incentive compatibility constraint in a principal/agent model such as the one described in the article would be:
  1. High salary.
  2. Equity-based compensation.
  3. Use of corporate jet.
  4. Private car.
3. An example of a participation constraint of the principal/agent model such as the one described in the article would be

  1. High salary.
  2. Equity-based compensation.
  3. Use of corporate jet.
  4. A and C.
Source "Taking Stock of Options." The Economist. July 20, 2006.
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