Stock Options Lavished on Executives Come Under Fire
Stock options, once considered a valuable tool to link the interests of corporate executives to those of shareholders, now are being examined as a potential culprit in the scandals plaguing corporate America.
From President Bush on down, critics are looking for ways to rein in the practice of providing top corporate managers with huge grants of stock options--which give the right to buy company shares at a set price in the future--after accounting upheavals at a series of major companies, including WorldCom Inc. and Enron Corp.
Although stock options clearly were not the only culprit in these scandals, many industry experts believe they provide a compelling incentive for managers to falsify earnings to keep Wall Street happy, the stock price up and manager paychecks rising at a rapid clip.
“Stock options have encouraged managers to take risks beyond what is potentially prudent,” said Robert Felton, director of McKinsey & Co.’s Seattle office. “Because they have so much at stake with these huge grants, options are also likely to have encouraged some managers to cheat and cook the books.”
About 75% of executive pay is made up of stock options rather than cash pay, said Peter G. Peterson, head of the Commission on Public Trust and Private Enterprise for the Conference Board. That creates a huge incentive to keep earnings up, even during a downturn.
At Enron, former Chairman Kenneth L. Lay exercised $180.3 million in options from 1998 to the end of 2000, and former Chief Executive Jeffrey K. Skilling got $111.7 million. During that period, Enron inflated earnings by hiding losses in off-the-books partnerships.
But stock options have plenty of supporters, who say cash-strapped companies need to rely on them to attract seasoned workers who otherwise would demand higher cash pay.
“I was a director of a small company that didn’t have any cash flow,” said Frank Vogl, vice chairman of Transparency International, a nonprofit group dedicated to stamping out corporate and political corruption worldwide. “The only way you can really pay your executives is through this promise of pay over time through stock options.”
The wave of corporate meltdowns has sparked an outcry for new rules or legislation to stop potential abuses and punish wrongdoers. Although few of these proposals have made it into formal legislation, more than a dozen ideas are being kicked around Washington, Vogl said.
On Thursday, Sen. John McCain (R-Ariz.) tried unsuccessfully to force a Senate vote on his proposal to require companies to account for stock options as an expense, while Sen. Barbara Boxer (D-Calif.) was holding a news conference with senior managers of pension funds, decrying the effect of corporate malfeasance on the retirement plans of the average American. Earlier this week, President Bush suggested a series of reforms, including prison sentences for cheating corporate managers and requiring greater disclosure of executive pay costs.
The current environment is a stark departure from the laissez faire attitude toward executive pay--and the general support for giving managers significant grants of stock options--during the 1990s, when the stock market was roaring ahead.
Companies were encouraged to lavish options on managers to ensure that executives were paid in accordance with their companies’ success. As stock prices rose, so would the value of management pay packages--a formula meant to drive long-term performance in the best interest of shareholders.
And lavish they did. From 1995 to 1999, the value of stock options granted to U.S. executives more than quadrupled to $110.5 billion from $26.5 billion, according to a study by the Federal Reserve Bank of New York. Although comparable data on the raw value of options granted in 2000 and 2001 are not available, all indications are that the largess continued.
A study issued earlier this year by the Investor Responsibility Research Center notes that companies granted more stock options in 2000 than they had in any of the three prior years on average. IRRC, which looks at stock options from the standpoint of how much they dilute the interest of public shareholders, notes that the average company has a 14.1% “overhang” from stock options. That’s how much the value of each shareholder stake in the company would be reduced in the future if all outstanding options were exercised.
At some companies, the dilutive effect could be far greater. At Irvine-based Broadcom Corp., for example, the future effect of exercising options could run as high as 83.5%, according to the IRRC. Broadcom has said the company’s strategy is to provide little in the way of cash pay, but substantial stock incentives to all workers. Still, such potential dilution provides little incentive to public shareholders, experts contend.
Much of the effect of stock option grants is hidden--disclosed only in footnotes to corporate financial statements. Some critics contend that’s part of the problem. Companies can write off exercised stock options as an employment expense--thereby reducing their tax bills--but they don’t have to include the cost of providing them on their income statements.
As a result, corporate boards have become increasingly generous, giving managers options on hundreds of thousands of shares at a time. As the public debate about the role stock options play in so-called “earnings management” schemes heats up, one solution has gained widespread support: requiring companies to expense stock options as they’re granted.
“Boards would be brought up short by the impact of expensing stock options on the earnings statement,” said Graef Crystal, a high-profile compensation consultant. “Right now, they’re still convinced that this is Monopoly money.”
However, the idea of expensing stock options is controversial, partly because there is no general agreement on how to account for the cost, said Tim Kochis, president of San Francisco financial planning firm Kochis Fitz. Options can be valued on the day they’re issued, when they’re exercised or by complex mathematical formulas.
Still, because options can have a huge effect on a company’s bottom line, momentum for reporting the cost as an ongoing expense is building.
Standard & Poor’s now expenses options when issuing “core earnings” reports on the companies it follows.
Securities analysts also are beginning to factor in the cost when issuing reports on the viability of various investments.
A study by Merrill Lynch Global Research finds, for example, that Microsoft Corp.’s profit would drop by 22% if it expensed options, but General Electric Co.’s profit would fall only 2%.
However, moving to a system in which options are treated as an expense that counts against current earnings is likely to take years, said Dan Marcus, a compensation expert with Mercer Human Resource Consulting in Los Angeles. The technical issue of how to value the options is simply too tricky to come up with a formula that works consistently, experts agree.
At the same time, options--particularly when provided to rank-and-file workers--are a valuable benefit that’s too positive to lose, said a spokesman for Boxer. Requiring stock options to be expensed is likely to restrict their use, and legislators such as Boxer believe that would be wrong.
Nonetheless, the momentum is there--fueled by big pension funds and institutional shareholders such as TIAA-CREF. The reason is not options, per se, but trust, some experts contend.
“There is a near hysteria about stock options--an almost Robin Hood mentality about taking them from the rich,” Kochis said. “This is not to limit executive pay. It’s just to let us know what the facts are so that we can make a reasonable judgment.”
Bloomberg News was used in compiling this report.
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Examining Stock Options
Major developments in the controversy over stock options:
July 2000: The International Accounting Standards Board issues a preliminary paper on option accounting.
September 2001: The IASB tentatively decides to require companies to account for stock-based compensation.
December 2001: Enron Corp. files for bankruptcy protection, igniting a controversy about the company’s executive pay arrangements.
February 2002: Sen. John McCain (R-Ariz.) and Sen. Carl Levin (D-Mich.) introduce a bill that would require options to be treated as expenses to qualify for favorable tax treatment.
March 2002: The Council of Institutional Investors, reversing an earlier stance, supports expensing of stock options.
July 11: An effort by McCain to force a Senate vote on expensing options fails.
Sources: Merrill Lynch & Co., Bloomberg News
