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How To Make Stock Options Work Better and Prevent Abuses

Bruce Brumberg

August 2002

Our financial markets on their own have already helped us win a few battles against perceived stock option problems. But we are going to lose the war unless we stop our fixation on stock option accounting, accept the power of the forces lobbying to defeat expensing, and face up to what really bothers us.

Thank You, Enron

Enron serves as a powerful warning for investors about the need to diversify. It's an equally strong symbol for the compensation committees of boards, and for the professionals that design equity compensation plans, that the era of "good feelings" about stock options has ended. Arguably, boards now have a fiduciary duty to more closely scrutinize future stock option grants and justify "super sizing" with more than the standard proxy statement cookie-cutter language.

Whether or not you believe stock options played the leading or supporting role in the unrelenting stories of corporate scandals, their association with this wrongdoing has tarnished them. Plus, the current bear market is naturally causing compensation packages to partially shift away from stock options.

It would be disappointing if the troubles with past grants to senior executives and the market slump discouraged companies from continuing to expand the use of options as an important long-term benefit for lower-level managers and key employees. Option grants (and employee stock purchase plans) for these workers make a much more positive impact on their lives than just piling on more grants to already very highly paid senior executives. On myStockOptions.com we regularly hear from middle-class workers who plan to use option proceeds to finance a down payment on a house (first ones, not tax-shelter mansions in Florida!) or fund other personal and family goals.

Jolt From Coke

Market forces and institutional investors, not mandates from the Financial Accounting Standards Board (FASB) or new laws from Congress, have led Coca-Cola Co., Bank One Corp., Washington Post Co., and other companies to expense stock option costs on their income statements beyond the detailed footnote reporting. Results from a flash survey conducted by the National Association of Stock Plan Professionals (see naspp.com), indicate that more companies will soon take similar actions.

Now the stock market can decide whether this non-cash charge really matters. For example, if Coke's competitors do not decide to follow suit, its stock price might do better. If every company in its industry follows suit, but no company in the computer software industry decides to expense options, then the stock market could punish the performance of these tech companies.

In addition, based on my discussions with staff in the finance and HR departments at major companies, the announcement by Coke is prompting all public companies to take a much more serious look at whether they should voluntarily expense options or provide extra disclosures. The summer 2002 fad in our executive suites has been running the numbers (not the jogging track) on expensing stock options under different valuation models.

The Real Enemy Goes Free

As someone who has spent most of his career writing about and analyzing the technical issues involved in equity compensation and securities disclosure, I'm amazed and amused with how an accounting rule has become front-page news and the cause célèbre for the most respected financial journalists in our country. The problem is that the fight for changing the accounting rule removes the spotlight from what really disgusts us: senior executives who profit from fleeting and false financial results.

We naturally want to hang a few accounting rules after all these scandals. But before we string this one up we'd better understand that the change would do nothing to prevent the identical stock option abuses from recurring. I'm concerned that we're worshipping a false god in our quest for easy solutions.

I've lived through this controversy before and many of the so-called reforms to control excessive executive pay. Without outlining their tedious history, most of the changes-from the $1 million compensation cap to increased disclosures of executive pay in proxy statements--either failed or had unintended negative consequences.

The Prescription

If we do not think market forces alone will remedy the abuses and we want to consider formal rule changes, below are a few ideas that could serve as a workable, yet meaningful compromise in the debate. These could perhaps return options to the role they were intended -- to provide senior executives, and workers, with a long-term incentive that correctly aligns their financial interests with stockholders:

Accounting Rules: Expense options granted to a public-company executive when they exceed $1 million (or some other amount based on grant date value) in any 12-month period, unless the options have index or premium exercise price, performance vesting, or similar performance-oriented provisions. This means that the options are valuable only when the market price of the company's stock exceeds those of competitors (and not merely rises along with the general market) or when the company reaches certain financial benchmarks. At a minimum, boards should design all mega-grants to include these features, even if expensing is not required.
Tax Code: Companies currently cannot take a tax deduction for compensation over $1 million to any executive, unless it's performance-based. Most options are "performance" pay exempt from this cap. Instead, for options and restricted stock to be considered performance-based, require them to have index exercise price or premium vesting provisions.
Securities Regulations: Return to some form of the rule that existed before 1991 that forced executives to hold their stock for six months after exercise. Should they sell the stock prematurely, they had to give any trading profit to the company.

Let's adopt some targeted reforms so that in the next bull market our senior executives really earn their option profits!

Bruce Brumberg is editor-in-chief of myStockOptions.com and co-editor of the Stock Plan Advisor newsletter, published by the National Association of Stock Plan Professionals. Bruce has edited, contributed to, and developed many publications, books, and videos on equity compensation, securities disclosure, and corporate governance. Reach Bruce@mystockoptions.com.

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