There is a mighty storm brewing over stock options. The dot-com blowup, the tech meltdown, Enron, and much that has gone wrong with the economy is being blamed on options. Warren Buffett doesn't like them. Federal Reserve Chairman Alan Greenspan is against them. Congress is preparing legislation that might torpedo them. But before the stampede against stock options gets out of hand, it would be wise to ponder the possible cost of giving up one of the best instruments for rewarding risk in our entrepreneurial society. Some action may be necessary, but the real problem lies less with the options themselves than with those who bestow them and their reasons for doing so.
Take executive compensation. BusinessWeek's latest survey shows that in 2001, a year of anemic growth and falling stock prices, more than 200 boards of directors decided to reward CEOs for their desultory performance by swapping out-of-the-money, high-priced options for lower-priced ones. In effect, they repriced exec options to soften the pain of falling equity prices. Shareholders, of course, had no such recourse. This practice angers Buffett, and rightly so. So does that of companies loaning CEOs hundreds of millions of dollars to acquire stock, and forgiving the loans if things go sour. The goal of giving options to managers is to align their performance and interests with those of shareholders. But boards have misused options to reduce the risk that executives take.
Boards have made matters worse by so lavishing options on executives that they now account for a staggering 15% of all shares outstanding. As the BusinessWeek survey shows, CEOs long ago ceased working for pay alone. Now they labor for tens and hundreds of millions of dollars, made possible by mammoth options grants. As CEOs suffered their first double-digit pay decline in seven years in 2001, Oracle Corp.'s (ORCL ) Lawrence Ellison exercised 23 million options in a single week in January, gaining him $706 million. He has millions of options left, thanks to Oracle's generous board.
Congressional critics of options say they are used by companies to avoid taxes. Thanks to differences between tax laws and accounting rules, companies don't have to report options as an expense on their profit-and-loss statements, yet they can deduct them as an expense from their taxes when they are exercised. Corporate tax avoidance is an important issue, but any loss in corporate tax revenue from options is more than made up for in the personal income taxes paid by individuals exercising options. Some 40% of all federal income tax is paid by the top 1% of taxpayers. Indeed, much of the budget surplus in the '90s came from taxes paid on options exercised. Hurt options and you hurt federal tax revenues.
The most serious criticism of options is that they inflate earnings. The Fed believes that by not expensing options, corporations were able to add three percentage points to their average annual earnings gain from 1995 to 2000. Operating earnings would have grown an average of 5% during this period, not the reported 8.3%. At a time when investors are demanding quality earnings, this is serious. Congress is proposing to expense options as they are issued. This could solve the problem, but the cost would be high. There is no way of measuring the true worth of options when they are issued. Putting a high price on them would deliver a serious hit to the bottom line and lead companies to stop issuing options. A better alternative would be to expense options over time as they are exercised. This brings tax law and accounting rules into alignment and smooths out the impact on earnings.
Boards of directors don't have to wait for legislation to begin acting more responsibly. They don't need Congress to end swaps and repricing, stop personal loans to CEOs, and curb the issuance of gigantic options grants to top execs. It's not options, but egregious behavior, that has done serious harm to Corporate America.