The Employee Ownership Update
June 29, 2006
A More Rational Reason for BackdatingPrevious installments of this column have reported on the backdating scandal, in which many companies are being scrutinized for grants of stock options that were either recorded as being granted at a prior date when the stock price was especially low ("backdating") or granted just before favorable news that would result in a higher stock price ("spring loading"). The effect in either case is to increase the option holder's profit by picking a day with an especially low stock price so that the option, being granted at that low stock price, will have a larger "spread" between the price the option holder pays and the market price at which he or she can sell the shares.
Microsoft is one of a number of companies that have said they had policies to price their options at the lowest price during a 30-day period. The company said it did so to prevent unfairness to its thousands of optionees, some of whom might be fortunate to get a grant at a low price and others who get their grants on nearby dates at much higher ones. Micosoft discontinued the practice in 1999 and restated its financials. Like other companies, Microsoft said it believed that the practice did not require an accounting charge. Micrel, another company following the practice, said its auditor, Deloitte & Touche, first told it that the practice did not require a charge but years later changed its mind. Micrel is being investigated for its practices (Microsoft is not because it disclosed it in 1999 and restated its financials) and is suing Deloitte.
The practice raises an important issue with options as a broad-based ownership plan. The most important element in valuing options is volatility. Companies with very volatile stock prices are rewarding employees, in large part, simply by letting them exercise an award at the highs while ignoring the lows. Employees could profit considerably from options even if the company's price underperforms the market. Volatility also introduces a lottery effect into incentive compensation for the very reasons that concerned companies like Micrel and Microsoft. In others words, to some extent, employees are being rewarded not for anything they have collectively done but for an entirely extraneous series of events.
Study Finds Expensing May Affect Stock PricesAn analysis by Credit Suisse of the 236 S&P 500 companies for which First Call included consensus analyst estimates of the impact of options expensing on share prices found that for most companies, the impact was small and short-lived, but for the 47 where it was "material" (causing a decline of 5% or more in earnings), share prices fell on the day before the consensus was revised and continued to underperform the S&P 500 by about 2% for 20 days after the estimates were announced ("Options Expensing: Maybe It Does Impact Stock Prices"). Of the S&P 500 companies, however, 181 did not have their options expense included in First Call estimates (the remaining 63 companies had expensing included in their estimates, but not during the study period). The study shows that these companies tend to be the ones with the highest options expense impact. The authors suggest this may be because these companies are pushing their "pro forma" earnings estimates (that is, earnings minus what the company argues are charges unreflective of long-term performance) much harder, and analysts are going along.
The authors note that it is not certain that the stock price movement is specifically related to expensing; other factors cannot be ruled out. They do not report what percentage of the companies followed the pattern or whether the 2% difference was largely the result of outliers. But they do believe the number is large enough to suggest a pattern.
A New Take on Why Executive Pay Is FailingIn "Why Executive Pay is Failing" in the June 2006 issue of the Harvard Business Review, NCEO member Stephen O'Byrne of Shareholder Advisor Services and S. David Young, an accounting professor in France and Singapore, present a new take on problems with pay at the top. The ostensible goal of executive pay is to link pay to performance. In practice, however, they argue that the primary focus of compensation is "to ensure that managers are paid more or less in line with their peers." The result is that pay is decoupled from performance. Much of executive wealth is in the form of equity. Companies have tended to increase the number of equity awards when pay drops below peers and decrease the number of new grants when the existing awards are performing well. In a study of 702 public companies between 1995 and 2004, the authors found that two-fifths of the incentive pay at companies is not linked to shareholder wealth per se, but growth.
O'Byrne and Young argue that trying to maintain competitive pay levels might seem simply a response to market conditions. But, they say, the result is to overpay underperformers and underpay those performing very well. Their argument is bolstered by the fact that executive turnover has increased significantly in recent years despite the rapid increase in executive pay.