The former CEO of Wachovia raked it in when shareholders prospered and took a hit when they didn't, which is as it should be and why stock options work: They make an executive feel the pain when performance is terrible.

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Whatever you might say about Kennedy Thompson, the former chief executive officer of Wachovia, he’s a prime example of how executive pay is supposed to work.

Rake it in when shareholders prosper, take the hit when they don’t.

During his tenure as CEO, which began April 18, 2000, and ended with his ouster June 2, Thompson was given many opportunities to become rich. But due to his company’s deteriorating performance, he blew most of them.

Between April 18, 2000, and the close June 2, Wachovia’s annual total return was negative 0.8 percent. That compares with a return of 1.3 percent a year for the Standard & Poor’s 500 Index and 2.4 percent for the KBW Bank Index of 24 major banks, including Wachovia.

At the end of the day, there really aren’t any big differences among these figures. All constitute poor performance.

Focusing on narrower time periods, Thompson did well for a while. Although Wachovia delivered a 32 percent total return in 2003, its best relative performance was a year earlier when it was 19.5 percent. In that year, it beat the S&P 500 Index by 42 percentage points and the KBW Bank Index by 30 points.

Hitting bottom

Then the bottom started to drop out. Wachovia’s edge over the two comparator groups disappeared by 2005.

In 2006, the Charlotte, N.C.-based bank underperformed both groups by an average of four percentage points. And in 2007, with a negative total return of 30 percent, the company underperformed the S&P 500 Index by 35 percentage points and the KBW Index by eight percentage points.

From Dec. 31 to the close June 3, the company delivered an annualized total return of negative 70 percent.

Thompson’s base pay, which was $1.09 million in 2007, wasn’t enormous. His bonuses, before the implosion, were another matter.

His best year

In his best year, 2004, Thompson received an annual bonus of $7 million. Last year, he received no bonus, not too surprising in light of the air that is now evident in previous profit statements.

Then there are the free-share awards. Between 2000 and 2007, Thompson received stock worth $36 million at the time of the awards.

In the last few days, some have called this severance, but that, in my opinion, is wrong. When those free shares were granted, they were counted as compensation. They shouldn’t be counted a second time.

The only clear element of severance that Thompson has received is a payment of $1.5 million.

Where Thompson got nailed was on stock options, a mainstay of his compensation package.

From 2000 to 2007, Thompson exercised options covering 111,000 shares, giving him gains of just $2.1 million.

But at the end of 2007, he was sitting on unexercised options covering 4.5 million shares.

Assuming he didn’t exercise any options after Dec. 31, all of those options are now underwater. Because Wachovia’s shares have fallen so much, those options probably will still be underwater when their 10-year terms expire, assuming normal future returns for the stock.

On Feb. 19, though, Thompson received three more option grants, totaling 1.5 million shares. Keep in mind that this was after Wachovia stock had fallen more than 39 percent in the previous 12 months.

The first of these grants, covering 328,000 shares, was like his previous grants in that its strike price was set to equal the closing price on the grant date.

But the second grant, covering 538,000 shares, carried a strike price 21 percent higher than the market price. And the third grant, covering 627,000 shares, carried a strike price that was 42 percent above the market price.

Grants underwater

Those three grants also are underwater now. But projecting to the end of their terms, using normal growth assumptions, the first and second grants will produce gains of about $3.2 million.

Thompson is, to me, a walking case study of why stock-option grants are better than free-share grants. They make an executive feel the pain when performance is terrible. Think of how much more money Thompson would have today had he received huge free-share grants in place of stock options.

It would have been even better had Thompson received no free shares and had to take all his long-term incentives in stock options.

The bottom line is that Thompson performed poorly for his shareholders. Though he will remain a wealthy man, he was, by the standards of his fellow CEOs, severely punished. That’s the way it should be.