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C-suite addiction to stock options no bonus for shareholders

Chip Wilson, the founder of sports retailer Lululemon Athletica

Jeff Vinnick/The Globe and Mail

The shareholder revolt continues. This time, Lululemon Athletica Inc. is being sued by a pension plan investor over an executive compensation issue.

The Vancouver-based fashion company recently had to pull its black yoga pants off store shelves because they were unintentionally see-through. The recall represented about 17 per cent of all women's pants Lululemon sold in its stores and a bottom line loss to the company of roughly $40-million.

Less than a week before the company announced the recall, its compensation committee approved an increase of incentive bonuses to its executive by about one-third. In its lawsuit, the shareholder, the Hallandale Beach Police Officers and Firefighters' Personnel Retirement Fund, asks if the larger bonuses "damaged the company and its stockholders."

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Last week, I wrote about a group of pension plan shareholders who voted down a generous compensation package for the executive and board of directors at Barrick Gold Corp. I only briefly touched on stock incentives though, which can create entirely different headaches for governance.

In an effort to align the executive's interests to those of shareholders, executive compensation often comes peppered with incentive bonuses for meeting performance targets, generally in the form of stock options. A stock option gives an executive the right to buy shares of the company's stock at a guaranteed strike price for a specific time period of several years. The executive isn't obligated to exercise, or use, the options. If the stock goes up in price, the executive can exercise the options to buy at the strike price and sell at the market price, keeping the difference as profit.

This sounds reasonable at first, but the theory behind this pay structure doesn't always work out in the real world. Executives can benefit from rising share prices without having to buy stock with real money, as other shareholders do. More than half of executive compensation in Canada is now linked to exercising stock options. Most are immediately sold for cash. If the strike price is below market value, they are allowed to expire. But if trading above the strike price, they are, without exception, exercised.

While stock options are a no-lose proposition for those who get them, they are a no-win situation for existing shareholders. The shares usually come out of a company treasury, increasing the number of shares outstanding and reducing the value of existing shares. If a company didn't issue new shares from treasury, it could be using its profits to invest in the business.

On the other hand, if salaries are fixed and not based on performance, it is harder to pare back compensation. Though generally executives count on their paycheques in good times and bad, they should expect to do better when corporate profits or stock prices rise.

In Europe, attitudes to executive compensation are changing because of shareholder activism as well as actions by governments and regulators. Large institutional shareholders actively monitor executive compensation. The European Union plans to cap bankers' bonuses at twice their salary. Germany wants to require listed companies to set a wage cap and limit bonuses related to performance. France, Italy and Spain propose to give shareholders more say in executive compensation. Switzerland imposes criminal penalties on companies that pay signing bonuses or golden handshakes and has passed a referendum giving shareholders a binding say on executive pay.

Senior executives at Canada's largest publicly traded companies can expect tens of millions of dollars in annual compensation. CEOs of large successful companies in Europe and Asia get a fraction of that. This suggests the compensation explosion is not necessarily driven by the natural workings of the market.

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The Lululemon board, generally considered to be investor-friendly, says in its annual report that it "believes that one of its most important functions is to protect stockholders' interests through independent oversight of management." Investors are pushing for explicit links between pay and performance, but more importantly for transparency on how executive compensation is calculated.

You would expect to pay a high salary to get and retain talented people. The question that bedevils boards and shareholders, though, is how much is too much?

READERS: How should stock options be structured to protect investors and reward workers?

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