Shareholders Balk at Shift in Executive Incentive Plans : Compensation: Angry investors are increasingly challenging the trend to grant more stock options. Companies defend the move as linking pay to performance.

At Paramount Communications’ annual meeting in Madison Square Garden last month, shareholder Philip Goldstein, owner of about 1,000 shares, lambasted Chairman Martin S. Davis and the company’s board of directors.

“You are insulated,” he railed. “You are being arrogant in your power.”

Goldstein was protesting Davis’ handling of the vote on a proposed executive stock option plan. Paramount’s suggested grant of nearly 6 million shares to top executives was resoundingly approved by more than 90% of the shareholders. But Goldstein’s dust-up with the chairman illustrates the rising tensions between shareholders and companies over incentives granted to top executives.

Public resentment over ballooning pay packages has spilled over from its peak last January, when President Bush took dozens of executives on an official visit to Japan, to the spring season of annual meetings. Now critics are honing in on incentives such as stock options and restricted stock--even more than salary and cash bonuses--as the vehicles by which paychecks spiral ever upward.

Stock awards are the fount from which gush big bucks, such as United States Surgical Chairman Leon C. Hirsch’s $120-million package of options and Coca-Cola Chairman Roberto Goizueta’s $81-million grant of restricted stock. Six other companies--AT&T;, Equimark, Merrill Lynch, Paramount, Philip Morris and Westinghouse--ladled out 300,000 shares or more to their CEOs this spring.

Options are also the fastest-growing component of compensation. According to the Hay Group, a Philadelphia consulting firm, long-term incentives accounted for a third of total CEO pay in 1991, or about $500,000 out of a typical $1.7-million salary, compared to only 8%, or $58,000, out of a comparable $725,000 salary in 1985.

Although shareholders are prohibited from meddling with a board’s decisions about executive salaries and bonuses, their approval is required for stock options. Even in today’s heated atmosphere, with large pension funds such as the California Public Employees Retirement System (CalPERS) pressuring companies to link pay with performance, most stock-option plans coast through unchallenged.

But some shareholders are cautiously flexing their veto muscle. According to the Investor Responsibility Research Center in Washington, an independent agency that researches proxy voting issues at 1,500 companies, the percentage of shareholders voting against proposed stock-option plans has been inching up since 1988, when only 3.5% disapproved, to 12% in 1991.

The organization says normally conciliatory shareholders balk at several points: if plans are too generous; if a company’s performance is mediocre; if the options “dilute” shareholders’ holdings by significantly reducing earnings per share or voting power, or if the plan confers special deals not available to all shareholders, such as repricing options at a lower cost.

Dissidents were bolstered last February by the U.S. Securities and Exchange Commission when it turned up the burner on the compensation-committee hot seat by allowing shareholders an advisory vote on compensation. The SEC also proposed that companies assign a value to executive stock options the year they are granted; corporations now treat options as if they have no value until they are exercised.

The SEC’s valuation proposal would lead to more publicity on the humongous one-year figures so detested by executives when they are calculated by critics such as Graef Crystal, adjunct business professor at UC Berkeley. So the Business Roundtable, a blue chip lobby of 200 big companies, immediately countered with a plan to smooth out reporting over the years options are held. Congress, meanwhile, is considering legislation that would force companies to value options and cap senior executives’ rewards.

In this roiling atmosphere, news of another generous season of options is having roughly the same effect as gasoline poured on a fire.

The original purpose of stock options is the essence of simplicity: Small awards were introduced in the 1950s to hire, hold onto and motivate top managers. Plans vary, but generally they offer key executives the right to purchase stock up to 10 years after the date granted. The exercise price is usually the stock’s market value on the day of the grant. The hope, of course, is that motivated chieftains will pull out all stops to ratchet up the stock price, thus ensuring happiness for other shareholders.

The problem is that a multitude of bells and whistles have been attached over the years that remove risk, thereby insulating top executives from the ravages suffered by fellow shareholders. Says Ann Yerger, senior analyst with Investor Responsibility Research: “Institutions are opposed to gimmes and freebies, such as options priced at a less-than-fair-market basis. They want to see plans structured fairly.”

One plan that raises hackles these days is Westinghouse Electric’s award of 700,000 shares to Chairman Paul Lego. The Washington shareholder-advisory firm of Institutional Shareholder Services has issued a “proxy analysis” to its institutional-investor customers advising them to vote against two director nominees on the company’s management-compensation policy committee at the annual meeting on April 29. They are Robert W. Campbell, former chairman of Canadian Pacific Ltd., and Rene C. McPherson, former chairman of Dana Corp. and former dean of Stanford’s graduate business school.

Writes Institutional Shareholder analyst Kirt A. Nelson, “We understand that withholding votes for directors is a very serious matter. But . . . we see no other choice.”

What happened at Westinghouse illustrates big-shareholder objections. A diversified conglomerate headquartered in Pittsburgh, the company stumbled badly in recent years because of losses in a financial-services unit, Westinghouse Credit Corp. Stung by investments in real estate and highly leveraged corporations, Westinghouse Credit was forced to charge off $2.66 billion against earnings in the past two years. Last year the write-off caused parent Westinghouse Electric to lose $1.9 billion on revenue of $12.8 billion.

In deference to the poor results, directors eliminated Lego’s 1991 bonus, which cut his cash compensation by more than $1 million to $677,083. But what they took away with one hand, they apparently gave with the other: 350,000 shares at an exercise price of $28.56, or fair-market value, in April, and another 350,000 in December at fair-market value of $16. The second grant required no holding period, and thus could be sold immediately for cash.

Since Westinghouse’s stock had dropped by $15 between April and December, Institutional Shareholder concludes that the second grant effectively replaced the first, which had been rendered valueless. The firm also believes that the second batch of options was designed to provide instant cash lost by the canceled bonus.

Using a widely employed technique for valuing options, called the Black-Scholes pricing model, Institutional Shareholder assigns a value of $6.8 million to the grant, an amount it deems “excessive, especially given the company’s recent performance.” The report concludes that the real value of Lego’s 1991 compensation package is $7,482,548.

Edwin F. Goff, Westinghouse director of total compensation management, defends the December options as “positive reinforcement at an extremely difficult watershed point in the history of Westinghouse” and maintains there is no connection between the two grants.

Other companies have heard the message and heeded its call. After CalPERS, the $68-billion gorilla of institutional investors, complained to United Airlines about outsize compensation for Chairman Stephen M. Wolf last year, he turned down a bonus for 1991 and took home a modest $575,000 salary. Though Wolf received options on 225,000 shares, two-thirds of those carry an exercise price above market value.

Many observers approve of plans like United’s because they provide incentive. Ideally, big investors champion an exercise price greater than the amount a shareholder can earn on a risk-free investment such as a Treasury bill.

Why do directors play fast and loose with options? Analysts blame the Financial Accounting Standards Board. Under accounting rules now, executive salaries and bonuses are treated as expenses, therefore their costs reduce profits. But no matter how big the option grant, earnings are unaffected. That benefit is amplified by tax treatment: Once an option is exercised, it becomes a deduction for the corporation.

The Financial Accounting Standards Board is reconsidering its regulations, and Sen. Carl Levin (D-Mich.) has introduced a bill that would require companies to reduce reported profits by the value of options granted.

Finally, many options are exercised only after an executive has retired, which means shareholders learn of their value only if he remains a corporate officer and his compensation is reported in the proxy statement. Philip Morris, for example, rewarded retiring chief Hamish Maxwell with 500,000 shares worth more than $10 million last year.

Contented shareholders are the best insurance against backlash. Despite the headlines surrounding Coke’s huge grant to Goizueta, little opposition exists because Goizueta has created about $50 billion in wealth for shareholders during his 10-year stewardship.

Similarly, few grumbles are heard about the biggest award ever, 4 million shares in 1990 to Anthony F. J. O’Reilly, the successful H. J. Heinz chairman, or this year’s gift to Hirsch at U.S. Surgical based in Norwalk, Conn. Hirsch has presided over an explosive leap in the surgical product maker’s market value to $5.8 billion this year, from $400 million in 1988.

Studies show that well-structured plans are an effective leadership incentive. Harvard Business School professors Michael C. Jensen and Kevin J. Murphy disclosed in a 1990 Harvard Business Review article the results of a statistical analysis of pay policies at nearly 2,000 companies: the larger the share of stock controlled by the CEO and senior management, the more powerful the link between shareholder wealth and executive wealth.

Analysts believe that the most successful stock option plans combine two features: They cost the executives some amount of money to exercise and require them to hold onto the stock rather than cash it in to invest in a diversified portfolio.

With big investors, the SEC, Congress and the Financial Accounting Standards Board scrutinizing option plans, observers suggest that the odds are high that abuses will eventually be corrected, probably through tighter regulation.

Ralph Whitworth, president of the United Shareholders Assn., which represents 60,000 small stock owners, believes that concise proxy disclosures will speed reform. “Disclosure will prompt a great deal more accountability,” he says. “I am optimistic the SEC is committed to pushing its proposals through.”

Shifting CEO Pay Total CEO pay is up. . . Total compensation (in millions)Shifting CEO Pay . . .but it’s paid over a longer-term 1985 Base salary: 52% Annual bonus: 22% Long-term award*: 8% Benefits: 16% Perquisites: 2% 1991 Base salary: 35% Annual bonus: 22% Long-term award*: 31% Benefits: 11% Perquisites: 2% * Projected present value Source: Hay Group, Executive Compensation Database