An AP article yesterday about CEO pay contained this startling statement, that I think is more important than anything else contained in the article:

And companies doled out more stock and options than usual because grants from the previous year had fallen so much in value that many people thought they’d never be worth anything.

Unfortunately, Rachel Beck‘s article chooses to focus on the entirely pedestrian observation that because the stock market has gone up a lot since spring 2009, when most CEOs received their stock option grants for the 2008 compensation season, the value of the stock options granted to them has also gone up a lot.

I’m not sure what else one can say to that, except “Really! No kidding?”

But the sentence I quoted speaks to an entirely unexpected and potentially controversial aspect of CEO compensation practices.

The whole point of granting CEOs stock options that are potentially worth tens of millions of dollars, or even hundreds of millions, is to make their self-interest coincide with stockholders’ interests. Once they own these stock options potentially worth tens of millions of dollars, creating value for stockholders also creates value for themselves.

However, this incentive scheme starts to fall apart if the board of directors starts clucking its collective tongue and going: “Did the poor little chiefie wiefie’s stock options lose lots of value then? Don’t worry, Mommy will kiss it, and make it all better.”

The whole point is that this significant component of executive compensation needs to be at risk, its value needs to fluctuate with the stock price. When the stock price goes up, the CEO is supposed to clean up; when the stock price goes down, he is supposed to take a beating. It’s only the potential beating that motivates him to work to improve the stock price.

So when companies start compensating CEOs for the decline in value of last year’s stock options, they are defeating the whole purpose of incentive-based compensation. Suddenly it becomes a heads-you-win and tails-we-make-you-whole proposition. Which makes it clear that these stock option plans have nothing to do with incentives; they are just another way to take more of stockholders’ money and tuck it into the g-strings of CEOs, and to do it in a way that stockholders can be deluded into approving.

If it’s hard to see any difference between this and ripping off stockholders, it’s because there isn’t any. And it’s not a minor racket, either. As the AP article tells us, stock compensation in 2009 constituted 58% of total CEO pay.