Throughout the past two decades, the influence of shareholders has grown dramatically as institutional investors and other shareholder legislative bodies became increasingly vocal and activist in exercising their ?ownership rights? over the decisions, policies, and governance of corporations. Shareholder antagonism over the hot corporate scandals appears to have further amplified shareholder activism, enduring or even accelerating the tendency of enhancing shareholder power.

Aligning the welfare of shareholders and managers has been a fundamental target of institutional investors and shareholder activists. To a considerable extent, that aim has been realized, since the hefty boost in executive pay since the early 1980s was caused first and foremost by striking increases in equity-based pay (especially stock options), which led to a nearly ten-fold increase in the rapport between top executive wealth and shareholder returns. Nonetheless, there has been prevalent concern (and outrage) among the press, shareholders, and the public that executive pay has become ?excessive? whilst also inspiring dysfunctional behavior. These concerns are targeted particularly at instances where large executive payoffs ? typically from option exercises or sales of company stock ? follow (or precede, in the case of the company scandals) poor corporate performance and declining company stock prices. The shareholder goal of ?turning managers into owners? is thornier to accomplish than it may appear. What is the best equity-instrument? Over what period should equity grants vest? How much should be granted? What pay designs play down risk-taking and gaming temptations?

Although there has been a recent budge toward constrained stock (stock that vests over time), the vast majority of executive equity grants have been in the form of stock options rather than stock. But if the chief goal of equity-based pay has been to turn managers into owners (who own shares, not options), why has pay been dominated by options instead of stock? Although such an explanation does not always sit well with economists trained to think that important economic decisions are affected by real economic (not accounting) factors, there is considerable evidence that the accounting rules are one of the dominant factors determining choices among equity-pay instruments. Current accounting regulations heavily favor stock options, because option grants create no accounting expense on company profit-and-loss statements while stock grants (and most other equity-pay instruments) do create accounting charges. As a result, equity-based pay plans are astoundingly similar across companies, with the vast majority of plans in the form of at-the-money options designed to qualify for the favorable accounting treatment. Discount, indexed or performance-based options, all of which have certain advantages, are rarely even given serious consideration by companies because they would lead to accounting charges.

Beginning in 2005, the accounting rules are likely to be changed, requiring options to be expensed, and this should have large affects on equity-based pay design. Whether companies will experience changes in corporate behavior is no more than a fallacy at this stage.

Nitish Benimadhu

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