- The Washington Times - Wednesday, July 16, 2003

Microsoft’s decision to issue stock rather than stock options to employees is a hugely positive development for the U.S. equity markets and the U.S. economy.

There will be stragglers, and there will be companies that never follow Microsoft’s lead. But Microsoft’s action means corporate America has crossed the Rubicon and headed for the end of the era of stock options as a major factor in corporate governance. Already, DaimlerChrysler has announced it may follow Microsoft’s lead.

The financial press have grasped that Microsoft’s move is a very significant event but don’t recognize why this is so or just how constructive a development this is. “The golden age of stock options is over,” says the Wall Street Journal in almost melancholy tones, suggesting the main driver of the change is the likelihood that Microsoft won’t grow as fast in the future as it has in the past.

Far from it. Compensating employees with stock rather than with stock options represents the third epoch in compensation philosophy in the postwar period, and like the previous new epochs will be a big long-term plus for the markets. In the first era, companies paid their executives compensation that was modest by contemporary standards and featured few monetary incentives.

Managements emphasized job security and non-cash perquisites, including the tax-deductible “three-martini lunch” that so enraged Jimmy Carter.

This structure for rewarding executives made some sense in the period when income and capital-gains tax rates were asphyxiating, with federal income tax rates as high as 91 percent until the 1964 Kennedy tax cut and still rising to a confiscatory 70 percent until the 1981 Reagan tax cut. One of the most memorable, and one of the last, dinosaurs of this Jurassic compensation era was Ross Johnson of RJR/Nabisco, as portrayed in the book and movie, “Barbarians at the Gate.” Mr. Johnson’s compensation was moderate, and he kept honest books. He also kept, at company expense, a private air force of corporate jets to ferry around RJR executives and their families and to fetch the Johnson family dog.

Sharp reductions in income and capital-gains tax rates and a widespread perception that managers lacked incentives to increase shareholder value led to the next era in compensation, the stock option era.

Options also gave a rational response to an undesirable feature of the tax code: the continued double taxation of corporate profits distributed as dividends. Compensation paid in stock would pay cash dividends. Options would not.

Options did have the intended effect of getting management to focus on share price. But options also have the structural problems that are now obvious: options didn’t reward steady, long-term gains in share prices or punish declines in share prices.

Many wasteful and inefficient uses of capital were soon wrung out of the system. Too many managements then turned to an approach of doing whatever it took to boost the stock price, even if no real shareholder value was created.

New employees in option-issuing companies wanted to make gigadollars in nanoseconds. Because companies have not been required to treat stock options as a compensation expense in calculating reported earnings, investors were treated to the bizarre sight of executive management claiming the options had no real value and therefore should not be viewed as an expense, then turning and fighting like wild animals for the largest possible allocation of options when it came time to divide up the compensation pie.

The tail wound up wagging the dog in situations like WorldCom, which became little more than an ongoing racket to create whatever fraudulent numbers would temporarily boost the company’s stock price and turbocharge the value of senior executives’ options.

The significance of Microsoft’s move has to do not just with the much-noticed size of its options program. The real significance, and the real reason Microsoft’s decision is a Rubicon crossing, is that Microsoft has been the most successful company on Earth over the last quarter-century.

There is no doubt that their earnings, cash flow, and cash stockpile are authentic.

Microsoft will now be a benchmark of real earnings. With Microsoft across the Rubicon, other companies will be under siege to follow MSFT’s lead.

First up under scrutiny will be some huge and controversial technology companies whose reported profits would be far lower or negative if they were forced to account for their options grants as compensation costs. Over time, it will prove as difficult for the CEOs of these companies to keep up their current practices as it proved for Ross Johnson and RJR-Nabisco to keep up theirs in an earlier governance era.

Holding the feet of such companies to the fire can only mean a more rational allocation of capital over time to enterprises that have genuine profits. And the move to stock grants instead of stock option grants is just one element of improved corporate governance. The increased payment of meaningful dividends thanks to the 2003 Bush tax cut will be a governance improvement, too. So would other reforms such as a ban on repricing options already issued and changes in SEC rules to give shareholders a real vote on corporate decisions such as the election of directors.

All that is an unambiguous, long-term positive for the markets.

James Higgins is managing director at Kudlow & Co. LLC in New York.

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