Phantom Stocks and Dividends: Executive Deception

People love to bemoan the supposed excess of corporate executives, especially in the wake of the major corporate scandals that have been front page news for the last few years. People say that executives are obese pigs feeding from the corporate trough, reincarnations of decadent Roman emperors gorging themselves on rampant profit, big-bellied Nash caricatures come to life, etc. Well, nobody actually says those things in those words, but that is the general sentiment. All things being equal, executive pay is the product of market forces and it is hard to argue with what the market is wiling to bear. Weak compensation committees on boards of directors may indirectly contribute, but that is the concern of the shareholders who elect board members, not John Q. Public. But all things are not equal and executives can and do use guile and omission to enrich themselves in ways that deceive the very shareholders they are supposed to be ultimately working for. Here is one such deceit.

Many corporate executives are paid partially in stock options. This, theoretically, aligns the incentives of the executive with the incentives of the corporation as a whole and its shareholders. The better the company does, the higher its stock price will rise, and the more money the executive can cash in his options for. For example, say Company ABC's stock price is $20 per share. An executive is issued 10,000 stock options priced at $20 per share as part of his annual compensation, optionable in three years time. At the end of those three years, ABC's stock price has risen to $30 per share. If the executive chooses to cash in his options, he effectively pays $20 to receive $30, a $10 profit. In this scenario, the executive makes $100,000 (10,000 options multiplied by the $10 increase over the option price). This is very simple stuff.

Sometimes, the options are issued not with a time constraint, like three years, but with a performance or market constraint. This means the options are not optionable unless some sort of performance or market outcome is reached. (and it also means these aren't strictly options, but they do have the same characteristic of only being worth anything under specific conditions). This ties the executive's pay directly to some specified goal. These are sometimes known as phantom stocks, because they don't really "exist" until the goal is met. If the goal is never met, then the executive never receives the stocks at all and gets nothing for that portion of his compensation.

But, crafty executives and rubber stamp boards of directors have found a way to ruin even this very specific incentivized compensation by creating phantom stocks that pay dividends regardless of whether the executive ever meets his goals. In some cases, phantom stocks paid out over $200,000 in dividends every year, completing defeating the original purpose of using phantom stocks.

Next time you are thinking of investing in a specific company, take the time to check out the company's yearly proxy statement, available for free on the SEC's website. Under new SEC regulations, the disclosure requirements for executive compensation have been expanded and particularized, making it easier for the average person to read and understand the convoluted structure of executive pay and making it harder for deceitful executives to hide the true nature and extent of their compensation packages.

  1. Equaling interesting is the back dating of stock options. Exceutives and Boards will use Stock Options as incentives, but will back date the options to a time when the stock price was lower than it was on the actual date the stock option was written. This can circumvent the company’s compensation policy and until recently federal regulators. The best part is, the whole issue was uncovered by a researcher from the University of Iowa; kind of a freakonomics thing.

    CNN Money article

    Ryan M
    September 12th, 2006 at 11:41 am

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