Don't Get Rid of Stock Options. Fix 'em

Stock options are under attack, victims of what investors see as executive abuse and accounting lies. A bipartisan Senate bill aimed at closing a corporate tax loophole would seriously curb companies from offering options. The International Accounting Standards Board and Financial Accounting Standards Board back the legislation. The Council of Institutional Investors also believes options are out of control, and its members may vote to restrict them. Good intentions notwithstanding, stamping out options would be economically self-destructive. Options are essential to America's special brand of democratic capitalism, motivating entrepreneurs to take risks, getting people to work harder, and spreading the rewards to greater numbers. What's needed is reform, not abolition.

Stock options give people a stake in productivity and profits that they would not normally have. It's probably no accident that the productivity surge of the 1990s in the U.S. coincided with a dramatic increase in the use of options. It didn't happen in Europe or Japan, where options are rare.

Of course, it turned out that some corporate managers misused options. They resorted to accounting tricks to pump up earnings, then cashed out their options early, leaving employees and other shareholders in the lurch when prices fell. Some companies allowed CEOs to quietly exercise options without revealing it to other shareholders. Others failed to attach rigorous performance goals to options grants in the first place. Options became an entitlement to the upper managerial class. This must all change, and boards of directors should do the fixing.

It's true that companies can claim a tax break on stock options they issue and don't have to charge them against earnings as part of compensation expenses. But until they are exercised, options remain imaginary costs that are difficult to value. And the Securities & Exchange Commission already requires companies to make guesstimates in footnotes on the hit to earnings from options. The SEC should go further and insist that investors get a reasonable picture of the dilutive effects of options on shareholder earnings and how buyback plans to pay for options could affect future cash flow.

Fostering risk taking, boosting productivity, and spreading the wealth are good economically and socially. When properly used, options can promote all three. The U.S. needs more stock options, spread more widely and tied more closely to performance. The Senate has it wrong.

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