Thursday, August 17, 2006

Stock option backdating: apparently companies also think you are stupid

On Monday, the Wall Street Journal’s David Reilly reported that many of the companies that most vociferously opposed the Financial Accounting Standards Board’s proposal that stock options be expensed are the same companies now caught up in the options backdating scandal. Why is anyone at all surprised?

FASB is the U.S. accounting standards-setting body, and it has for several years now proposed that stock options — the rights companies give some employees to buy company stock at some future date at a given price (usually today’s price) — be recorded on a company’s balance sheet as an expense. Stock options exploded in popularity during the 1990s, and originally were designed to serve two purposes. First, the allegedly align the interests of management with those of the shareholders who own the company but are not in a position to exercise day-to-day oversight over how the company is run. Share options, in lieu of cash, serve as an incentive for management to see that the company does well (as reflected in its stock price), since the options are worthless unless the company’s stock increases above the “strike price” at which the options were issued (which, ideally, would be above the stock’s current price). Share options are also given out by cash-poor start-ups to a wide range of employees (not just managers), as a way of convincing these employees to take a chance on the company in exchange for a very high potential payoff if the company does well.

When an employee or manager exercises a stock option, the company must either sell the employee stock from the company’s treasury shares (shares of the company held in reserve and not sold to the public) or first buy shares from the public to sell to the employee. In either case, this is a cost to the company, since the company could otherwise sell the treasury shares to the public at the going rate, or else the company is buying at the going rate and selling to the employee at a discount. If these are treasury shares, there is an additional dilution of existing shareholder interest in the company, since treasury shares typically cannot be voted by the company.

“Expensing” these stock options would require companies to deduct the future value of these shares (adjusted for the time value of money) from the company’s current profits. Companies that traditionally have used stock options objected to the FASB proposal by saying that, at the time the options are issued, the expense to the company is uncertain. Who knows how much the company is going to fork over to pay for them, and when (if ever)? In addition, they claimed, expensing stock options would make start-ups appear to be deep in debt because of these future expenses, and thereby confuse investors’ pretty little heads. This would thereby discourage their use, to the detriment of America’s high-tech industry. Better to just note the stock options in an accounting footnote, since investors are smart enough to know what these mean (even if they aren’t smart enough to know what they mean if you were to just put it in the actual financial statement).

However, there are techniques for measuring the present value of a stock option, including one that won its creators the Nobel Prize for economics (the Black-Scholes Model). And, as Warren Buffett famously said, if stock options aren’t compensation, what are they, and if compensation isn’t and expense, what is it?

Anyway, after being shot down in Congress in the 1990s, FASB got its way after Enron and Worldcom. Now, as the WSJ reports:

  • In 2004, a KLA-Tencor Corp. executive told FASB that there was no way for her company to issue options in a way that would benefit executives in a non-transparent way. In another letter to FASB, Maureen Lamb, then a vice president of finance, wrote that while there were flaws in the accounting rules for stock-based compensation, and that "the politically charged belief that the blame lies with executives unwilling to give up their ill-begotten compensation is backward and unproductive." Ms. Lamb added that "KLA-Tencor does not currently have the ability to issue any equity-based compensation other than at-the-money stock options [i.e., at current market prices]." This past June, a committee of company’s board reached a preliminary conclusion that the price dates for certain grants likely differed from recorded grant dates. In other words, the options likely weren't "at-the-money" at all, and should have been expensed even under the old FASB rules.

  • Patrick Erlandson, chief financial officer at UnitedHealth Group Inc., wrote in a June 2004 letter that "expensing stock options does not provide financial statement readers with the most appropriate reflection of the economic impact of stock-options grants on an entity's financial statements." Just recently, however, UnitedHealth disclosed that its options-grant practices are the subject of an "informal" SEC inquiry and that the IRS has requested documents regarding the options.

  • Macrovision Crop. wrote FASB in 2004 to say that those favoring the FASB proposal "seem to do so for the wrong reasons." "They tend to focus on corporate greed," the letter said. "Stock options in themselves do not make people corrupt.” This past June, of course, Macrovision disclosed that the SEC had requested information about the company's options practices since 1997; later that month the company said it was subpoenaed by federal prosecutors.

  • Nathan Sarkisian, chief financial officer at Altera Corp., wrote in a June 25, 2004, that the difficulty in assessing values needed to expense options would result in an "opportunity for creativity for those who might push the envelope.” This past May, Altera said the SEC and federal prosecutors are looking into its options-granting practices and that there are problems with options granted between 1996 and 2000. It expects to restate nine years of financial results.

None of this should surprise anyone. All of the arguments against expensing stock options are predicated on the idea that investors are too dumb to understand the complexities of how companies are run. But if this were true, it calls into question the whole foundation of the U.S. disclosure-based approach to securities regulation. If investors really are this dumb, a better approach might be merit-regulation, whereby the SEC would decide for investors whether a company’s business model and financial health were sound enough for investors to put their money into it. If, however, investors, in aggregate (even if not individually), are not so dumb, they will recognize that stock option expenses do nothing to effect the actual cash flow of a start-up. Even if the actual expensing calculation is wrong, investors will soon learn to discount this error appropriately, since the error will apply universally.

The lesson here is that when a corporate executive opposes something because “it will just confuse investors,” run and hide your wallet.

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