What To Do About Stock Options
05/03/02
by Paul R. Dorf
Comments by Paul Dorf, APD, Managing Director of Compensation Resources, Inc. regarding Federal Reserve Chairman Alan Greenspan’s latest comments on charging the cost of options on the balance sheet of companies that issue options
Upper Saddle River, NJ, May 9, 2002 -- The concept of charging the cost of stock options on the balance sheet has been presented before by the FASB, and is receiving considerable attention in the aftermath of the Enron collapse. However, FASB will continue to be faced with opposition to this change. Start-ups and large companies who use stock options as a major compensation device, as well as executives who want more options, are exerting tremendous pressure to avoid an accounting charge for options. Furthermore, President Bush indicated a few weeks ago that he would not support changing the current accounting for options.
Some of the issues that drive the Fed’s desired change:
1. Enron and WorldCom-type problems, where executives are getting and selling options while their companies are suffering financially. The executives benefit at the expense of shareholders and employees with stock holdings.
2. Huge options grants that are not reflected on a company’s balance sheet.
3. Companies that offset big losses of executive bonuses (due to poor performance) by awarding big option grants that pay off handsomely when the stock later moves back up in value.
4. Re-pricing of underwater options, which will cause significant negative accounting treatment. This aggravates shareholders who don’t receive the same benefit, as they had paid full market price for shares that are now worth considerably less.
5. Companies that use IRS loopholes to effectively “re-price” options, using tools such as the “6 and 1” exchange or restricted stock swaps. The employee stockholders are winners, but, again, at the expense of shareholders’ pocketbooks and sentiments.
6. Concern that less-than-scrupulous executives may try to manipulate the fair market value (FMV) of the stock to benefit themselves. This includes working to decrease the FMV before the option granting date in order to minimize the option strike price, thus increasing the size of option grants. Also, the use of creative accounting to inflate earnings thereby serves to drive up the FMV before the executives exercise their options.
Some of the possible and practical solutions that could be used solely or in combination to rectify some of these practices include:
1. Tying the option grants to achievement of pre-established performance measures. Although this may satisfy shareholders’ concerns that grants are only made when warranted by performance, this does have a negative accounting impact that is usually considered unacceptable.
2. A slight variation is to grant options with long vesting periods, but later accelerate the vesting, thereby allowing the executives to exercise the options when key results are met. This doesn’t cause the negative accounting impact associated with performance-based options.
3. Companies may impose a requirement that executives hold stock for extended periods after exercising the options. This ensures that the executives don’t buy and dump shares, which is often viewed as a precursor to the announcement of bad news and subsequent dropping of the stock’s FMV.
4. Stock ownership guidelines, which require the executives to own shares at a certain level, may also have an impact on their ability to sell stock, since they would have restrictions on getting additional options and/or cash bonuses. Options do not count as ownership.
5. The use of restricted stock instead of options does carry an accounting charge, but a restricted stock grant is fixed at the original price, and does not increase as the stock increases in value. These grants have vesting periods and could also have performance criteria added. Restricted stock can also be used as a sign-on bonus for new executives, and if the individual doesn’t work out (à la Michael Ovitz), then the company hasn’t lost out by rewarding a CEO who didn’t stay.
6. Instead of granting mega stock option grants at today’s low FMV, the grants can be made at different prices that are well above the current price. This practice may provide the motivation to work harder to increase the value of the stock and keeps the options from being of value unless the shareholders also benefit.
7. Companies may adopt guidelines so that boards will not grant options when company performance doesn’t warrant bonuses. The argument is that the company needs to retain key employees even in bad times, albeit with sufficient motivation to encourage success. However, if corporate performance continues to be poor, maybe the problem is better rectified with a new CEO.
