The focus on stock options as a source of corporate misbehavior is fairly recent, but the problem that options are designed to solve is nearly as old as economics itself. In the mid-1700s, Adam Smith noted a troubling aspect in the growth of the early "joint stock companies," or what we call public corporations. Smith had already figured out that markets work best when everyone can pursue his own self-interest, so he had to ask himself what would prevent a manager of one of those joint stock companies from pursuing that personal interest when it was contrary to the interest of stockholders. In a free market, Smith concluded, these newfangled stock companies would work only in a few small and simple market niches, where the manager's actions could be readily routinized and his decisions easily monitored. That way, the manager would have to think about the shareholders, because they could keep close tabs on him.
Smith's prediction about the future of publicly held companies was off-target, but the question he posed hasn't gone away. It didn't matter much at a time when most public companies were still run by their founders or their families; but by the 1920s, most heirs had hired outside managers, and America came to call itself, with some exaggeration, "a nation of stockholders." So, when the Depression came and people asked what had gone wrong with capitalism, a lawyer-economist team of Adolf Berle and Gardiner Means reopened the discussion that Smith started.
In The Modern Corporation & Private Property—a book hailed at the time by the historian Charles Beard as "the most important work bearing on American statecraft since the immortal Federalist"—Berle and Means found new facets in the old problem. As loyal New Dealers, they argued that the rise of professional managers had given business executives de facto power to appropriate shareholder assets. Some appropriation of assets was only rational, since executives would have little incentive to improve a company's performance if all its profits went to shareholders. The way to save capitalism, they argued, was not to bar managers from pursuing their own interests but to regulate their doing so.
Berle and Means' basic economic analysis, that the "separation of ownership and control" in large companies helps determine how they behave, still survives. By the early 1970s, this insight had become its own subject of economic inquiry, called "agency theory." Agency theory also grew out of information theory, when economists thinking about how much it costs to provide people the information they need to make informed economic decisions noticed a basic inequality. In all large companies, the executives have all the information, and shareholders have to depend on them to share it. Agency theory, in effect, restated Smith's puzzle: how to get a manager (agent) to act in the best interests of shareholder-owners (principal) when the agent has both more information and different interests than the principal.
It's obvious where this logic leads: Align the interests of executives and shareholders by granting them options to buy shares at potentially large discounts. It's a sweet deal for executives—stocks usually rise when the economy grows, which it usually does; and if the stock falls, you just don't exercise the option. And if executive options succeed in getting managers to act in the shareholders' interests, they're a good deal for them, too.
Agency theory provided the economic rationale for executive options, but it was their tax and accounting treatments that virtually guaranteed their ubiquity. Options are tax-free to managers until they exercise them. They're also cheaper than cash salaries to the company, because firms can't deduct ordinary salaries over $1 million. Then there's the bookkeeping: Since options don't have to be recorded as expenses, either when they're granted or exercised, a company can pay its executives with vast numbers of options without ever reducing its reported profits.
And ubiquitous they have become. Stock options began to appear in the 1950s, when they were generally modest in size. But once agency theory spread from business schools to business practice, the proportion of top managers receiving options jumped from 30 percent in 1980 to 70 percent in 1994. And their size was no longer modest: By the turn of the century, the typical CEO of an S&P 500 industrial firm was receiving options worth $30 million, while his financial sector counterpart was receiving ones worth $55 million a year—more than 30 times his salary.
While many businesses see options as a free form of compensation, agency theorists showed that the cost falls on stockholders—no surprise there—whose shares are diluted when executives cash in options. This cost is far from trivial: The outstanding options of an average large firm today are equal to more than 5 percent of its total stock. Take into account options approved for granting in the future, as well as those already granted, and they equal 13 percent of all outstanding shares.
Is that too much? The problem, for economists at least, is that there's no way to determine how many options it takes to align the interests of an executive and shareholders. Provide too many options and a manager may focus too much on boosting the share price at just the right moment. Provide too few and he may not care enough about the share price at any time.
What economists do know is that the full flowering of option compensation changed corporate behavior generally as economics expected. For example, agency theory predicts that executives with tens of thousands of options will increase their prospective wealth by cutting dividends and repurchasing outstanding stock, and that's just what happened in the 1990s. Of course, that behavior could confirm the economic validity of options, if it also increased shareholder value. And in at least one way, this change did appear to serve shareholders, who pay ordinary income tax on dividends but only the lower capital gains tax on any extra appreciation from corporate stock buybacks.
Economics also predicts that a stock option's value will increase with the stock's volatility, and that also happened in the 1990s. Think about Wal-Mart and AOL. Over the last three years, Wal-Mart shares have moved from just under $40 to just over $70, trading in a median range of $50 to $60 more than 65 percent of that time. Over the same period, AOL stock has varied from under $10 to over $95 and traded in the $40-to-$60 range less than 45 percent of the time. If you're an executive with 100,000 options and some discretion over when to exercise them, AOL's volatility offered opportunities for much greater gains than Wal-Mart's stability.
As for the big question of whether options ultimately improve a company's performance, sorry, but there isn't any consensus among economists on that yet. One thing economics can do, however, is refute the argument that firms shouldn't publicly report the value of their option grants. The gap between the interests of a company's managers and shareholders depends crucially on managers having much better information about the company. All information about executive compensation and its possible future costs to shareholders should obviously be accessible and—here's a leap—understandable. Now, it's true that it's difficult to determine an option's correct value. But there's a second-best solution here, which is to get all firms to use the same rules to value their options—that is, as an accounting convention. Do that and it won't matter anymore whether firms formally record those options as expenses.