Stock Options Under Scrutiny

Executives Caught in Conflicts of Interest

WASHINGTON, D.C., APRIL 27, 2002 ( Lavish stock option grants to executives are increasingly the target of criticisms from financial analysts. The U.S. Senate Finance Committee is now examining a bill, sparked by the Enron collapse, which would increase the costs to companies of granting options.

“Stock options are a stealth form of compensation because they do not, under current accounting rules, have to be shown as an expense on the corporate books,” Senator Carl Levin stated. “The result is a misleading picture of a company´s finances,” Levin explained in an article published April 8 by the Christian Science Monitor.

Options were originally thought of as something positive, giving managers a stake in the firm´s future and converting them from being mere managers to having a big part of their wealth linked to the company´s financial health.

An option normally gives its holder the right to buy a designated amount of company stock at some future date, or over a period of time, at a price fixed on the day it was issued. Thus, during past years, when stock prices were continually on the rise and option grants were generous, executives stood to reap high profits. If, however, stock prices fall, options become worthless.

The 1990s market boom converted many executives into multimillionaires, thanks to options. But disenchantment with the creation of a new super-rich class of executives led to questions about methods being used to guarantee ever-higher stock prices, necessary for options to be financially attractive.

An obsession with share prices has led some executives to act “improperly, and perhaps illegally,” observed the Washington Post in a March 24 analysis of options. And even at companies that did not go this far, the Post said that executives have reported a “general fixation on daily and weekly stock-price movements,” which leads to a concentration on short-term strategies, “sacrificing the long-term interest of shareholders and employees.”

During the last decade, the Post noted, options went from representing 5% of outstanding shares to 15%. By last year, options accounted for 60% of the pay package for the typical corporate chief executive officer.

Many companies defend options, the Wall Street Journal noted March 26. Among the advantages cited is that employees are given a financial interest in ensuring their companies´ success.

But the Enron scandals helped to give options a bad name. It turned out that Enron Chairman Kenneth Lay realized $123.4 million from exercising stock options in 2000. Less fortunate were the vast majority of shareholders and employees who lost the bulk of their Enron investments and retirement savings.

The Journal also noted some accounting problems related to options. When companies give employees a large portion of their pay in options, current rules don´t require them to report this as a cost, as with other forms of remuneration. Companies could therefore give executives rich packages of options, without reducing profits. One measure being debated by the U.S. Senate would change this, obliging companies to treat options as an expense.

Not counting options as a cost has significantly boosted company profits, at least on paper. According to Bear Stearns, Oracle´s operating income was $933 million higher for 2001 than if it had given cash instead of options to its employees. And Citigroup, whose chairman Sanford I. Weill realized $15.9 million from exercising options last year, boosted its operating income for the year by $919 million by not including options as an expense.

“Perverse effects”

Alan Greenspan, Federal Reserve chairman, has come out on this matter, saying that the current use of options has “perverse effects” on corporate accounting that must be reformed, the Financial Times reported March 23.

Research by the Federal Reserve estimates that the substitution of option grants for traditional cash salaries and bonuses added about 2.5% to corporate earnings at the largest U.S. companies from 1995 to 2000.

Commenting on the accounting rules, Warren Buffett, well known for his success in picking stock-market winners, admitted that options can have a positive effect in motivating employees. “But they also should account for this expense just like any other,” he wrote in the Washington Post on April 9.

Buffett declared that he is normally against Congress´ meddling with accounting standards. But in this case, he contended, “Congress fathered an improper standard — and I cheer its return to the crime scene.”

Another problem regarding options has been the temptation to manipulate the release of information in order to enable executives to cash in on their options. Some companies have released inaccurate earnings statements, with executives then selling large amounts of stock at the resulting higher prices. Only afterward is the financial information corrected. This has happened at companies such as Oracle, Sun Microsystems, Xerox and many other major technology firms, the New York Times reported April 7.

“Management interests in too many cases have become misaligned with investor interests,” said Alan Beller, the director of the corporation finance division at the Securities and Exchange Commission.

At Xerox, for example, in 1998 and 1999, then chief executive Paul A. Allaire made about $16 million selling company shares that were trading at more than $50. But just a few weeks ago Xerox agreed to restate its earnings back to 1997 and to pay a $10 million fine for inaccurate accounting. By then the stock was selling at $10.52 a share.

At Oracle, chief executive Lawrence J. Ellison in 2001 made his first sale of company stock in almost five years, for a gain of almost $900 million. Only five weeks later he admitted the company´s profit would miss its estimate, and the stock dropped 21% in one day.

Debate over solutions

Not all agree with the Senate proposals on the laws governing options. Damon B. Ansell, vice president for policy at Americans for Tax Reform, argued that they would lead to tax penalties on a greater proportion of earnings for all companies, good and bad.

Writing in the Washington Post on April 18, Ansell maintained that any measure that reduces company profits will harm companies, and the investments made by shareholders. Higher taxes will also reduce the number of jobs and the quality of benefits offered to hardworking Americans, continued Ansell.

The Financial Times pointed out April 19 that supporters of changes to accounting rules differ on what changes should be made. Opinions vary as to whether the cost of options should be counted when they are issued, or when they are exercised.

A possible solution, according to the Financial Times, is that change will come from accounting standard-setters, particularly the International Accounting Standards Board. The board is planning to issue a draft proposal for a global standard on stock option accounting soon.

Apart from fixing accounting rules on options, questions also arise about social justice. John Paul II noted in his encyclical “Centesimus Annus” that the Church has consistently defended the right to private property. The Pope also recognized the positive role of entrepreneurial ability, business freedom and the market.

But he drew attention to another long-standing principle, namely, that material goods have a social dimension and owners of private property cannot remain indifferent to the needs of others.

Stock options may well have a positive role to play in today´s economy. But ample evidence exists showing too many people have overlooked social responsibilities in the rush to play the market. Now is a good opportunity to rethink how to achieve a better balance between rewarding executives for a good job and looking after the interests of the wider community.

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