Fortunes made by stock options prompt scrutiny HOW SWEET IT IS


In February, when a top New York analyst was asked about Robert N. Elkins, he answered in three words: "Elkins is king."

What he was referring to was Dr. Elkins' successful reign as founder and chief executive of Integrated Health Services Inc., one of the fastest growing, most profitable companies in Maryland.

As it turns out, though, Dr. Elkins' Midas touch didn't stop there. According to documents filed by 95 public companies in Maryland, Dr. Elkins has also been crowned king of the stock option.

Indeed, thanks to 1.65 million options granted to him last year alone, Dr. Elkins, 51, could reap as much as $74 million over the next decade, according to figures contained in filings with the Securities and Exchange Commission. That does not include the $3.2 million in cash and stock he took home in 1993.

Dr. Elkins' stock option plan not only dwarfs that of the state's runner-up, Bruce L. Crockett of COMSAT Corp., but also exceeds the heads of IBM, Westinghouse and General Motors combined.

While the case of Dr. Elkins is certainly the grandest local example of an extraordinary compensation package, it is but the latest instance of why stock options nationwide have become the target of increased scrutiny.

Proponents of these delayed-pay packages say that they are the best way to link a CEO's pay directly to the future performance of his or her company's stock price. Beyond providing incentives to top executives, pay increases only come if the company, and shareholders, profit as well.

But opponents counter that many of the option packages have grown so out of proportion that the logic behind them has been lost.

"The numbers are obscene. I can't see why someone at that level should have the opportunity to make so much money," said Marvin J. Levine, a professor at the College of Business and Management at the University of Maryland in College Park. "There is no one who is ever going to convince me that the system that [granted Dr. Elkins the options] is a fair system."

Whether fair or not, the idea behind stock options seems simple enough.

A single stock option represents the right to buy one share of stock in the future at a particular price. If the stock rises beyond that price, then the person holding the option can profit. For example, if someone is issued a $10 option when their company's stock is trading at $10-a-share, and the stock rises to $15, they can make a sure $5 profit on paper by exercising the option. Of course, if a stock drops, options would be worthless.

But that's about the only time their value is obvious. In general, it is impossible to predict the value of an option with certainty. But because of SEC regulations, when a company grants options to a top executive, it must now give projections of how much the executive stands to gain. One such projection, assuming the stock will appreciate 10 percent annually, states the gain for Dr. Elkins at $74 million.

Mutual fund managers say a 10 percent stock appreciation is slightly below the average annual return of large stocks over the last seven decades. For midsized growth companies, like Integrated Health, the expected rate of return is higher.

"To me, 10 percent is not much of a hurdle," said Robert J. Sanborn, portfolio manager for one of the country's top performing funds, Chicago-based Oakmark Fund. "You are saying that if you only perform in line with the market, you get a huge payoff."

By the same 10 percent measure, last year's option package for Bruce L. Crockett, CEO of COMSAT Corp., could be worth as much as $16 million, GEICO Corp. co-CEO Louis A. Simpson's, $11 million, and USF&G; Corp. CEO Norman P. Blake Jr.'s, $9 million. For comparison, Louis V. Gerstner, CEO of IBM Corp., received one of the largest grants last year among big industrial companies and it could be worth as much as $38 million.

Other valuation methods, however, try to estimate the present-day value of the options, factoring in uncertainty about how the stock will perform. Using a second valuation widely used by compensation experts, Dr. Elkins' options were worth $16 million. Either way, Dr. Elkins is still the top in Maryland.

Accounting standards

Given the size of stock options these days, and their importance as part of compensation packages, the Financial Accounting Standards Board (FASB), the organization that determines accounting standards for company reports, has been considering forcing companies to treat stock options as an expense and deduct them from earnings. The move has sent a shudder through the business community.

Business leaders maintain the regulations would decimate start-up companies that rely on options to pay their best employees.

"The net effect of the rule is the use of options will be severely curtailed. It will affect small companies disproportionately," said J. Carter Beese, a commissioner of the Securities and Exchange Commission. Mr. Beese said the proposal would take away about 6 percent of all profits for the largest companies, but for smaller companies the effects would be worse.

"We are talking about an accounting change reducing the reported earnings of small firms by 50 percent overnight, and that will have serious economic consequences," he said.

Too little cash?

Opponents of the FASB rule, such as Mr. Beese, say smaller companies and start-ups have to pay with options because they have too little cash to pay big salaries. These companies also use stock options to motivate middle management and lower-level employees. The hope of a big payoff keeps talented people there, despite the risk the company will not survive, they said.

Small biotechnology and high-tech companies in Maryland have a lot at stake in the debate. For example, Oncor Inc. CEO Stephen Turner earned $244,000 in cash compensation last year, but his stock option plan could be worth as much as $1.7 million. Similarly, Genetic Therapy Inc.'s Chief Executive M. James Barrett earned $296,000, while his stock options could be worth as much as $1 million.

FASB officials, who have put off the rule changes for a year, say the reaction is overblown. They point out that options are the only form of pay that never appears on corporate income statements.

Diana W. Willis, who was in charge of FASB's effort to account for stock options, argued that stock companies now lose profits when they account for every other kind of pay and even when they donate options to charity. The sole exception is when those options stay in the hands of an employee.

"Whenever you start talking about people's compensation they get scared that it is going to require them to change the way

they are doing business," she said.

Princely sums

No matter what happens with the rules, many CEOs will continue command top dollars whether through options or other forms of compensation. And a CEO who can start a company and manage it well after it is established is a rarity.

"There is a very thin market for talent that can make high-stakes bets and make them right at every turn," said Michael A. Conte, director of the regional economics program at the University of Baltimore. "If we have a bidding contest for them with hundreds of companies and each with a lot of money to throw around, you can easily see how these people can command princely sums."

Consider the case of Dr. Elkins, a broad, wavy-haired former Boston psychiatrist who has lined his conference room with pictures of himself and political figures, including Hillary Rodham Clinton.

Integrated Health Services was once a struggling start-up. Dr. Elkins founded the company in 1986 and quickly came upon the idea of buying and converting nursing homes to handle patients who normally would be hospitalized long-term.

By 1993, the company had grown to $282 million in sales and, thanks to acquisitions and expansions in the past nine months, could top $500 million this year. Profits have been increasing almost as rapidly.

Charles W. Newhall III, a general partner with the Baltimore venture capital firm New Enterprise Associates and a member of the committee that set Dr. Elkins' pay, defended the stock options awarded him.

He said Dr. Elkins has been the reason for the success of the Owings Mills-based health care firm and that his compensation package is in line with his contributions.

"If he builds a $3 billion company, I hope he can make $50 million or $100 million, that's the way the world should work," Mr. Newhall said.

Dr. Elkins declined to be interviewed for this article, citing concerns that he might affect recent company stock and debt offerings.

Mr. Newhall points out that Dr. Elkins will only profit from the options if the company's success continues. "What you are doing is rewarding an entrepreneur through equity ownership in his company," he said.

But consultants and others said that many other things come into play when setting stock options. The size of an options package, they said, may be as much a function of the CEO's ego as any objective standard.

"What executives are looking at is the guy next door," said Jane T. Romweber, an Atlanta-based executive compensation specialist for Hewitt Associates. "There may be some company somewhere that has given its CEO a ton of options and then he says 'I have done just as well, I deserve that too.' What is enough in his eyes matters, and that often has no relation to the value of the company."

More art than science

Board members and former CEOs elsewhere say decisions inside the board room are more art than science. The compensation committee that sets pay is usually a three-person group of outside directors -- board members that do not hold executive positions with the company. They study compensation packages of other executives in the same industry with particular attention to those who head companies of a similar size and growth rate.

Mr. Newhall said the Integrated Health board commissioned a study that showed Dr. Elkins' pay package was on par with founders of other fast-growing health care companies nationwide.

The option package was designed to keep Dr. Elkins' percentage of ownership stable at a time when the company was engaged in large stock offerings, he said.

Mr. Newhall warned that if the FASB proposal were adopted, "the incentive for people like Dr. Elkins to do what he is going to do will be destroyed. It will kill the desire of entrepreneurs to build businesses."

But many of those who oppose the FASB proposal, still wonder whether the largest option grants are worth saving.

"The question is how much is enough," said George Paulin a compensation consultant with Frederic W. Cooke & Co. Inc. in Los Angeles. "Often executives can make money on options from market timing and from the sheer size of the grant. If I grant you 1.6 million options and the [stock] price goes up $1, you make $1.6 million without doing anything."


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