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Investors push for halt to options gravy train

By Mike Ross

Friday 20th September 2002

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Free options, re-priced options, swaps on options ­ the menu for executive remuneration has never been so tasty. It's a far cry from the days when those in charge took deferred shares, receiving nothing until outside shareholders got paid.

The backlash has started. Accounting regulators are looking to force disclosure of the true cost of stock options.

In the 19th century, joint stock companies took off in the capitalist world, offering the best medium for turning investors' stray pennies into productive pounds. But careful investors had to be convinced it wasn't just a con, with entrepreneurs behind the scheme ripping out personal profits and leaving nothing for investors.

One method of convincing the public that company management would give priority to investors interests was to issue management with deferred shares. The right to a dividend was deferred, ranking behind promised payments to outside shareholders.

In modern parlance, investors would hold participatory preference shares, entitled to a preferred dividend plus a share in further profits and also entitled to share in surplus assets on liquidation.

But that's not the way it works in the 21st century. Executives load their remuneration with options, pretending these align management interests with shareholder interests.

If this is alignment, then the interests of the New Zealand Rugby Football Union is aligned with the interests of its Australian counterpart. They both play the same game, under the same rules, but it is how you use the rules that count.

Shareholders are now waking up to the fact that payment of executive remuneration in stock options results in a transfer of wealth from investors to management ­ a transfer that goes unrecorded and unrecognised.

Options are usually given away for nothing but they are not costless. In the US, eight executives hit the jackpot in 2001, each pocketing in excess of $US100 million from the exercise of share options.

Top dog was Oracle's Larry Ellison, who collected $US706 million. His salary for the year was nil. He exercised one tranche of options in January 2001, cashing 23 million options in one week for his $US706 million. The following month Oracle announced it would not meet profit forecasts. The share price tumbled.

The cause of so much investor angst is not so much the existence of stock options but how they are used and abused. Too often, executives carry no risk. If share prices fall, the exercise price gets reset. If issued options finish out of the money, they are swapped for fresh options on more favourable terms.

If there is a sudden spike in share values, executives are permitted to exercise options early. And if that is not enough, executives pockets are refilled with further options to replace those exercised prematurely.

If executives have to pay hard cash for options and they are feeling pinched, the company will lend them the money. If the options finish underwater and the loan cannot be repaid, no problem ­ the company forgives the loan.

There is no risk for executives in these arrangements. These deals give them a free ride. Canny executives also manage to diversify their option portfolio, receiving options not only on the parent company's stock but also on the stocks of listed subsidiaries. With little luck, this deal proves to be a double winner. Even if only one bet comes home, the rewards can still be handsome.

Payment in options has allowed US executives to garner a whacking 15% of all equity in listed companies. The pretence is that this big slice of equity is payment for stellar performance. The cost is kept well hidden.

There is no cash cost to the company on the issue of options but there is an economic cost to existing shareholders. Every option exercised dilutes the equity interest of existing investors. More and more of the pie gets spirited away by management.

Naïve investors would expect the value of executive stock options to be recorded as an expense, the same as wages paid to employees on the shop floor. It isn't. Too hard to value, executives say.

The US Federal Reserve estimates the failure to expense stock options has overstated average annual earnings for US companies by three percentage points over the years 1995 to 2000: from a normalised 5% to an overstated 8.3%.

Management doesn't object. Overstated earnings boost share prices and help get their options in the money.

In New Zealand, the cost of executive stock options do not have to be expensed. Note disclosure only is required. The International Accounting Standards Board is pushing forward on a project to force companies to expense executive stock options.

In the US, some companies are pre-empting the regulator. The lead is coming from companies who have Warren Buffett on the board: Coca-Cola, the Washington Post and Gillette. They plan to expense options even though it is not mandatory.

Mr Buffett, a trenchant critic of the misuse of stock options, thus earns his reputation as the investor's friend.


Mike Ross teaches commercial law at Unitec business school.

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