Vexing Options Accounting scandal fallout could mean positive changes for workers and investors
Hal Plotkin, Special to SF Gate
Monday, February 25, 2002
The golden era of virtually unlimited stock options for top executives may finally be drawing to a close, thanks to the recent accounting scandals at firms such as Enron and Global Crossing.
Several proposals for reform are in the works. Some involve federal legislation, which may or may not pass. Others entail voluntary steps companies could take to regain the confidence of investors who’ve grown weary of being taken for suckers.
Many top tech executives are fighting these reforms, branding them draconian, counterproductive and even anti-American. Nonetheless, it’s likely we’ll see more stable, successful companies and fewer flash-in-the-pan operations if effective reforms are enacted, either voluntarily or by government fiat.
Many people who haven’t received stock options have only a vague understanding of how they work. The concept is pretty simple: A company will grant an employee the right to buy a certain amount of its stock at a fixed price over some prescribed period of time. If the stock value goes up past that set price, the employee can pocket the difference by exercising his or her options and then selling the stock on the open market. Conveniently, many companies also have arrangements with brokers who lend employees whatever cash they need to exercise their options in exchange for a small portion of the proceeds when the stock is sold, usually the same day.
Stock-option programs have become increasingly popular with tech firms in recent years. But they have a growing legion of detractors who say stock-option programs have in some cases become little more than corporate tax-avoidance schemes that inflate reported earnings, create unnecessary volatility in the stock market and pose hazards to the long-term financial viability of firms that rely on them too heavily.
Thanks in part to lobbying from Silicon Valley tech executives, companies don’t have to include the costs of granting stock options in their expenses when they calculate their annual earnings, even though they can deduct those costs from their taxes. The result, critics have long contended, is hugely inflated earnings numbers. The reported profits of many firms that grant stock options would be significantly lower if those costs were not excluded.
The most sweeping suggestion for reform comes from U.S. Sen. (and former presidential hopeful) John McCain (R-Ariz.) and Capitol Hill colleagues Carl Levin, Peter Fitzgerald and Richard Durbin. They want to force U.S. companies to deduct from their earnings the cost of any stock options they grant if they deduct those costs from their taxes.
If McCain’s proposed reform becomes law, it would dramatically drive down reported earnings at many major tech firms, and tech stock prices could plummet as a result. But once that carnage is over, McCain says, investors would be left with earnings numbers that more accurately reflect actual corporate performance rather than creative accounting of the kind that contributed to the most recent boom-and-bust stock market cycle.
Those pushing for change note that there are real costs involved whenever companies grant stock options. Any stock granted to employees, for example, is not available to be used in mergers or acquisitions or for other corporate purposes. What’s more, by flooding the market with options, a company can also dilute the value of the shares it already has in circulation, which over time helps undermine a company’s ability to maneuver.
Artificially inflated earnings numbers also make business conditions appear rosier than they really are. That, in turn, helps create the bubble effect in the stock market. As the Enron example proved, however, accounting gimmicks can’t permanently disguise true underlying business conditions. Sooner or later, most pyramid schemes collapse. And typically, it’s the smaller investors who are left holding the bag.
Given the stakes and the financial muscle of McCain’s opponents, however, his accounting-reform legislation may well be doomed.
In fiscal year 2000, for example, according to a recent report in The Chronicle, Microsoft claimed $2.07 billion as a tax benefit from granting stock options.
If the company had instead deducted the total value of that compensation, including its associated wage-related corporate taxes, it would have cost Microsoft an extra $16 billion, according to an article in The Register, a British newspaper. The difference would have wiped out Microsoft’s approximately $9 billion-dollar profit in 2000 and turned it into a $7 billion loss.
Likewise, the San Jose Mercury reports, Yahoo’s 2000 reported profit of slightly over $70 million would have morphed into a $1.3 billion-dollar loss if the costs of its stock options were not kept off its books. The same is true of many other leading tech firms.
You can easily imagine what might happen to tech stock prices in such an environment, particularly if the McCain reform is implemented all at once.
Supporters of stock-option accounting reform want to make those changes now and get the pain over with quickly, so the stock market can rebuild on a more honest and secure financial footing. Reform opponents, however, seem to have the upper hand at the moment, as they are armed with bigger campaign-contribution war chests. No one knows how much more heat it will take to break the current stalemate on the issue, which has been quietly raging — mostly behind the scenes — for several years now. A few more accounting scandals, and we might be there.
In the meantime, more immediate reforms could come about as a result of growing pressure from disgusted investors, both individuals and mutual fund money managers.
In particular, the savviest investors are beginning to realize that the most generous executive stock-option programs can have unintended negative effects on long-term corporate performance. When top executives know they can cash out their stock options imminently, they have a powerful incentive to make the company’s numbers look good, even if doing so sabotages the long-term viability of their operations. (One commonly heard CEO joke: “In the long run, we’ll all be dead, so who really cares?”)
This is not to say that tech executives are uniformly evil or corrupt. But they are human, which makes them prone to the same failings and greed as the rest of us. The only real difference is their ability to exercise that avarice by plundering corporate wealth rather than through more prosaic forms of robbery, such as sticking up a convenience store.
That’s one reason many once-venerable firms often end up eating their seed corn, firing essential employees or harming vital relationships and research efforts on which their futures depend. A lot of damage can be done if an executive’s most important goal is to make next quarter’s numbers look good.
If they’re smart, the best-run companies will start addressing these concerns on their own, if only to regain the investor confidence they need to get their stock prices rising again. One method being talked about involves “clawback provisions,” which would require an executive to give back any profits he or she received from selling stock if the stock falls below a certain level within two or three years after the executive has made the sale. The idea is to harmonize the incentives top executives have with those of investors and employees, who want to see a company stick around not just for the next quarter, but for the next decade or more.
Other voluntary reforms could involve paying top executives more in salary and less in short-term options. Instead, executive options would vest over much longer periods of time — decades or more — with top executives taken out of key leadership roles well before the bulk of their options mature. That way, no executive would ever have a reason to manipulate corporate performance for his or her personal gain.
Fewer stock options for top executives won’t necessarily mean fewer stock options for workers. Most individual workers usually can’t sabotage a company’s long-term prospects for personal gain the way a handful of top executives can, which is why it would make sense to redistribute the stock options normally awarded to top executives to line workers, where the options would provide the type of incentives they were originally designed to create.
None of these reforms are inevitable. But one hope is that increasing numbers of skittish investors might start asking tougher questions about how executives are compensated and what effect those practices have on the long-term prospects for their investments.
Personally, I know I’d be more eager to invest in a firm where workers have more stock options and top executives have fewer reasons to undermine their own organizations.
That may be a pipe dream. But if it happens, we might want to make Enron’s Ken Lay Man of the Year.
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