Companies Need Honest Accounting Of Stock Options
By Jerry Knight
Monday, June 24, 2002; Page E01
washingtonpost.com
In Washington and on Wall Street, the debate over how to account for the cost of stock options is over.
Wall Street has decided it's time to stop pretending that stock options are free and account for them honestly, which means deducting the cost of options from corporate profits. Washington, naturally, has come to the opposite conclusion. Legislation to require companies to come clean about options costs is dying in the Senate, done in by the same high-tech highwaymen who benefit most from hiding their high-priced incentive pay.
This diametric denouement arises because members of Congress are not in danger of losing their jobs for failing to clean up corporate accounting, but stock brokers are in danger of losing customers who buy the stocks of companies with bum bookkeeping. Nothing works better than economic incentives for keeping institutions accountable.
There is no better example of the lack of accountability in Congress than Sen. Phil Gramm (R-Tex.), who seems to be the leading opponent of accounting reforms. Gramm ought to be embarrassed to be involved in the issue, since his wife, Wendy, was one of the Enron Corp. directors who let the company get away with some of the most egregious corporate conniving ever seen. But Gramm is ready to retire. He is not going to run again, so he doesn't have to answer to the Texas voters who are outraged about Enron.
The one good thing about Enron is that though not many people understand the workings of Raptor and Condor and all the other investment schemes, everybody gets the message: Enron executives inflated the company's value and made more than $1 billion off their stock options.
Not all companies are as aggressive as Enron, but almost all of them account for the cost of their stock options the same way that Enron did, which means not deducting their cost from income. And all too many of them suffer from the same flaw: Stock options give executives an incentive to inflate their companies' stock prices.
As Federal Reserve Board Chairman Alan Greenspan has said, that perverse incentive is the unintended consequence of an innovation that was supposed to have exactly the opposite effect.
"Stock-option grants, properly constructed, can be highly effective in aligning the interests of corporate officers with those of shareholders," Greenspan said in a speech last month. Shareholders benefit when the price of the stock goes up, and for that, the executives are rewarded because the value of their options increases.
The system broke down, however, because while most shareholders invest for the long haul, most executives use their options for short-term gains.
In every new accounting scandal that breaks, the pattern is the same: Executives cook the books to run up their company's stock prices, then cash in their options and take home millions of dollars. And then the stock price tanks, leaving shareholders holding the bag.
As Bill Miller, manager of the Legg Mason Value Trust Fund -- the only mutual fund that has outperformed the S&P 500-stock index for 11 consecutive years -- points out, giving executives stock or options "aligns the interests of management, employees and shareholders. It aligns the interests when you get it. It's a conflict of interest when you sell it."
Miller suggests two solutions:
First, he says, don't let executives sell stock acquired through option exercises. "They should have to hold every single share."
His second suggestion is more radical: Ban stock options entirely.
"If options can't be accounted for honestly, then they should be banned," he said in a telephone interview before jetting off to Europe. "The accounting for stock options is dishonest. It's wrong. It ought to be stopped."
What's wrong is that corporations treat options as if they didn't exist. They are the largest source of compensation for many executives and some workers, but unlike paychecks, they don't show up as an expense on the company's books.
As a result, corporations act as if options are free. After all, they are only paper, not real money. Given a choice between paying people with cash or with funny money, corporations will go for funny money every time. And because it's only paper, they might as well be generous with it.
But options aren't free. Every time a company prints up a fresh batch of options and hands them out, it dilutes the value of the shares already owned by the stockholders. Every time a company lets an executive exercise options and buy shares at a bargain price, it loses the extra cash it could have gotten by selling those shares at the market price.
The usual excuse for not deducting the cost of options is that at the time options are granted, no one knows what their value will be when they are exercised.
Neither Legg Mason's Miller nor David Blitzer, the chief investment strategist of Standard & Poor's, buys that argument.
Corporations have no trouble valuing options when they want to claim a tax deduction for them as a business expense. Making them use the same values for tax and accounting purposes is one simple proposal now going nowhere in Congress.
"There is no good economic or disclosure reason" for not deducting options costs, Miller said. "To have companies argue that because options are hard to value, they shouldn't expense them, is ludicrous."
Accountants calculate values for things whose values are unmeasurable all the time. They have no trouble assigning value to loans that might not be collected, office buildings whose prices rise and fall with the real estate market and interest rates, and all kinds of contracts whose final value will not be known for years.
Calculating the value of options, in fact, is one of the great accomplishments of modern business mathematicians, Blitzer said. "There is very little in financial modeling that has been tested more than options pricing models. There have been a zillion PhD theses written on it."
Blitzer and his staff at Standard & Poor's have calculated how much stock options cost all the companies in the S&P 500-stock index. If the cost of options had been deducted last year, they would have reduced the profits of the S&P 500 companies by about 22 percent, Blitzer figures.
That's particularly high, because corporate profits were low last year; normally options eat up 10 percent to 15 percent of total S&P earnings per share.
Deducting the cost of stock options is part of a technique Standard & Poor's uses to calculate "core earnings" for corporations, which basically factors out all the funny stuff companies do to make their books look better.
S&P has gotten lots of feedback on its "core earnings" plan, Blitzer said. "Options are the one item . . . that the vast majority of people commenting on our plan agree on. I don't think anybody has really given us an impassioned plea not to treat options as an expense. Nobody will make an intellectual argument that options aren't an expense."
Intellectual arguments, of course, have little to do with what gets done in Washington. It is the campaign contributions and lobbyists for high-technology companies that are responsible for blocking reform of options accounting. To hear the high-tech execs tell it, Silicon Valley would become a wasteland and the Dulles Corridor would go back to dirt farms if companies had to deduct the expenses of stock options.
"High tech doesn't have any special status in the world," responded Legg Mason's Miller. Capitalism functioned just fine before stock options became the coin of the realm.
Miller said that in his business, the mutual fund industry, options were banned because of abuses 70 years ago.
"The abuses that are happening right now are at least as egregious," he said. "I don't see how it can be good public policy to have a regulatory ban on granting stock options for mutual funds companies, but to say they are good for other types of companies."
Miller has started using his clout as a mutual fund manager to try to block corporate stock option plans, which generally must be approved by a vote of shareholders. The California Public Employees Retirement System, which is the nation's biggest pension fund, is also pursuing that strategy.
Though he doesn't have much good to say about stock options, Miller said he believes in corporate democracy. "We need corporate democracy. Not plutocracy. Not management by central committee or Politburo. If owners [shareholders] want to give everybody in the company stock options, as long as the account for it properly, that's fine with me. I wouldn't vote for it, but it's fine."
"A far better way to motivate people would be to give them stock," he said.
When companies give their employees shares, he explained, "It's valued today. We know exactly what it is." With options, nobody knows whether they are getting a lucrative bonus or worthless paper.
Just ask the thousands of employees of Washington high-tech companies who are holding worthless options. Many of them had to choose between taking a job that paid a good salary and taking one with lower pay and stock options, and they made the wrong choice.
"There is nothing that can be accomplished with options that can't be accomplished by giving employees stock directly," Miller said. "The only downside is that you actually have to account for it."
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