(Feel free to distribute) Expense those options!
By Stephen F. Diamond* As the dust clears from the collapse of Enron, WorldCom and Arthur Andersen, major structural change in the behavior of American corporations and financial markets seems less likely. The lobbying power of accounting firms, investment banks and large corporations appears to have convinced Congress that its best interests lies with the insiders in our economy not with the broader public interest. But there is one possible reform that still has a chance: ending the practice of granting absurdly generous stock option packages to top corporate insiders. The defenders of stock options argue that they help align the interests of inside managers with outside shareholders. This is a laudable goal, in and of itself. Share ownership in the last twenty years has spread to a wide percentage of the public. Millions of Americans, for better or worse, now look to the stock market as the source of their retirement income. Because no single shareholder can afford to monitor the behavior of corporate insiders, the public relies instead on institutions like the board of directors to protect their interests. Granting corporate insiders huge option packages has been one board tactic that allegedly motivates insiders to manage the corporation in the long-term interest of the public shareholders. But this argument is based on an important mistaken assumption that stock "options" are the same as stock. They are not. "Options" are different financial instruments from the stock that underlies the option and they are priced to reflect that difference. Stock is priced based on a long-term assessment of the potential earning power of a corporation. But stock options are priced to take into account a range of factors that includes the value of the stock but also the time to expiration of the option and, most importantly, the volatility of the underlying stock. Options actually increase in value with an increase in the volatility of the underlying stock. An increase in volatility increases the chance that the option will be "in the money" and hence profitable for insiders. Why should outside public shareholders care about this difference? Because an increase in the volatility of the stock is something that corporate insiders can manipulate by engaging in higher risk projects. The insiders can increase the value of their options by engaging in "all or nothing" gambles. After all, if the project is a success it might cause a huge increase in the stock price, with a gain to outside shareholders as well. The potential gain to insiders has been so huge in recent years that they have been tempted to engage not only in high risk projects but in manipulation of corporate earnings and other illegal activity that is, in essence, theft from outside shareholders and looting of corporate assets, an important public resource. If the insider bet is a bust the options expire with no loss to the insider while the outside shareholders will see a huge drop in the value of their shares. In fact, the insiders often walk away with luxurious golden parachutes, no matter what the outcome of their speculative activities. Dennis Kozlowski, the ousted CEO of Tyco, was set to earn $137,000 a year for life as a consultant and lifelong use of the corporation's fleet of airplanes! In other cases insiders have walked away with millions of dollars even as stock prices stagnate or decline, as they cash in on past options granted at steep discounts to the current price. Oracle CEO and Chairman Larry Ellison cashed in $700 million of options that were nearly a decade old in 2001. His sale came just in time, as Oracle stock plummeted from more than $34 per share to around $13 per share weeks later when the Company told the public that sales and profits were down. The stock of Standard Microsystems Corporation began the year 2001 at $20 a share and declined by almost fifty percent at one point only to finish the year at slightly below $20. Thus, a net goose egg for outside shareholders, but CEO Steven Bilodeau received a pay package worth more than $2.2 million including options and exercised older options for another $2.5 million. And, according to the AFL-CIO's Executive Pay Watch, a fifty percent drop in the 2001 price of the stock of Gap, the troubled clothing retailer, did not stop CEO and President Millard Drexler from raking in more than $9 million in total compensation including new stock options. Thus, insiders' interests are not aligned with those of outside public shareholders by stock options; they are, in fact placed at odds with each other. Despite this conflict, corporations can pretend that options are given away for free, since they are not required to charge the cost of the options as an expense item in company accounts. At the very least, options should be charged as a compensation expense to corporate income statements. Even more reasonable would be to get rid of options altogether and force insiders to hold restricted stock that they could only sell after leaving the corporation. This would put them much closer to the actual position of outside public shareholders. Public corporations should serve the public interest and the managers of public corporations must be reminded of this. *Stephen F. Diamond teaches securities law and corporate finance at the Santa Clara University School of Law. Stephen F. Diamond School of Law Santa Clara University [EMAIL PROTECTED]
