When good options turn bad

Sure, let's punish stock-option-scamming CEOs and tighten up options accounting. But when options benefit everyday employees, they're worth defending.

By Scott Rosenberg

Jul 17, 2002 | In the 1990s stock options were viewed as the American economy's special sauce -- blending management, employees and stockholders together into one happy, productive, profitable community of ownership. Now, in what seems like the wink of an eye, stock options have turned rancid, and politicians, pundits and even some companies are disgustedly spitting them out.

The case against stock options today is irrefutable on its own simple terms. Yes, massive grants of stock options to corporate officers created an apparently irresistible incentive for book-cookery. Yes, there is something hypocritical in the double standard that has allowed corporations to earn tax deductions from the exercise of stock options without ever having written them down as an expense on their books. Reform is needed.

But are stock options just another relic of dot-com bubbleheadedness to be tossed in the trash like so much Enron stock? As the anti-options steamroller gains momentum, it's worth taking some time to dig into the details -- because, as with every corporate finance story, the details are far more double-edged than any headline or news summary can ever convey. And if Congress isn't careful about those details, it could end up crippling the socially useful role of stock options as a wealth-sharing tool -- while leaving CEOs free to continue to rake in unconscionable sums of money.

When companies grant stock options, they offer the recipient the right to buy a number of shares of the company at the company's stock price at the time of the grant (the "strike price"). Such grants typically have a "vesting period" of several years during which the options become available for the recipient to "exercise" them -- to buy the shares from the company at the strike price. The options are "in the money" if the company's stock price goes up, because recipients can buy the share for less than it's worth -- then sell it at a profit, or hold it if they think it will keep going up. Options are "underwater" -- and worthless -- if the stock price falls below the strike price.

The act of granting stock options doesn't cost a company any cash outright, which is why it sometimes seems like minting money out of thin air. Of course, someone pays. When an employee exercises an "in the money" option, several things happen: He pays the company some cash for the shares (the strike price), so the company pockets some money. He's also increasing the number of total shares on the market, thereby diluting the value of every other shareholder's shares. (The same-size pie -- the market worth of the company itself -- is divided into more, thinner slices.) Finally, under current law, in many cases the company takes a tax deduction on the difference between the share's strike price and the market price.

At the end of the day, then, the employee's happy -- he's made some money. The company's happy -- it has pocketed some cash and saved some tax dollars. The general stockholder might not be so happy if he knew the full story. Most typically, though, he doesn't: Until recently, disclosure of stock-option information was spotty, and the tables that report on outstanding stock options are usually buried at the back of annual reports and presented in a less-than-instantly-comprehensible fashion. The market receives only slow updates on the vital datum of total number of outstanding shares.

Of easy reforms to the stock-option phenomenon, then, this is one that rarely gets the spotlight: Require companies to provide accurate, complete and truly timely information on the granting and exercise of options. (Hey, they can put it on the Internet.) That alone would keep the market cleaner by giving it better information.

Instead, the push today is for a reform that would require companies to "expense" stock options when they're granted. The trouble is, calculating the option's worth is tricky: Its ultimate value is wildly variable depending on whether the stock goes up or down over time. Accountants have complex models they can use to estimate the options' value; or companies can set up a system like Coca-Cola's, under which investment banks will be invited to bid on the options in order to set their fair price.

Either way, it seems to me, instead of providing a clearer window on the state of a company's financial well-being, we end up with yet another layer of opacity in the world of corporate accounting -- and another dark and confusing corner of the ledger, in which unscrupulous accountants can twist and bend numbers till they scream for mercy.

I can see a lot more sense in the proposal, by Sen. Carl Levin, D-Mich., and others, to make companies "expense" options at the time employees exercise them, if the company is also taking a tax deduction for that same expense. Though this idea has been fiercely opposed by the business lobby and some of its friends in Congress, including Sen. Joseph Lieberman, D-Conn., its logic is hard to knock. It doesn't involve inventing numbers the way expensing-at-options-grant does. It would reduce reported earnings per share for companies where lots of options are being exercised, and that is arguably an appropriate signal to send to the market.

So what's not to like? Unfortunately, take away the favorable tax treatment as an incentive to grant options, and a lot of companies would simply say to hell with it -- forget stock options altogether. While a nation justifiably angered at America's business leadership in the wake of Enron, WorldCom and Co. might well say "Good riddance," the real losers could turn out to be rank-and-file employees rather than well-heeled corporate officers.

Next Page: How to distinguish between "good" and "bad" options

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