How to Clean Up the Options Mess

When bulls stampeded down Wall Street, few investors cared how companies accounted for stock options. Chris Waldorf, a veteran financial analyst with Deloitte & Touche, was an exception. In the footnotes of an annual report of a company in which he had a small stake, Waldorf noticed the cost of that year's stock options came to half of net income. Yet none of it was charged against profit. "The footnote seemed so erudite and high-minded," he said. "But they were hiding something. I was extremely annoyed."

That was in 1999. Now, after the Enron affair and the nonstop orgy of options for so many U.S. executives, Waldorf feels even more keenly the sting of the smug reply he got when he wrote to complain. So he is pushing a two-step plan to clean up the options mess which, to him, amounts to so much "looting." His aim: to ensure an exec only gets paid when his company's stock does better than an equity investor might reasonably expect. As a member of the Association for Investment Management & Research's accounting policy panel, Waldorf is in a good position to help focus future debate over options.

Companies should explicitly disclose whether their stock option plans impose performance hurdles, Waldorf argues. Few now do. In a silent way, this lets execs take huge rewards for underperformance. Suppose an exec gets options on 1 million shares with a fixed exercise price of $100 a share (table). Even if the stock gains just 6% a year, by the fifth year the price would be $134, making the options worth $34 million--not bad for a poor showing. Investors could get more return at less risk on a corporate bond.

Investors would be better served if the options' exercise price rose yearly. For instance, options vesting after one year might have an exercise price 10% higher than the stock's price when they were awarded. This way, options would pay only for an exec whose stock beat the average return expected by equity investors. Waldorf's second idea is to encourage limiting exercise periods for vested options to a few months. By waiting years to exercise options, execs can be rewarded by the power of compounding even if the stock rises at subpar rates.

Waldorf's proposal--which is his, he noted, not Deloitte's or AIMR's--depends on reforming how companies account for options costs. Only by using fixed exercise prices can companies avoid charging the cost of options against earnings. "That's the simple, ugly reason" why more companies don't now include stock-performance hurdles in options plans, John Biggs, CEO of TIAA-CREF, the $270 billion pension and annuity manager for college employees, told me. Bills are pending in Congress to push companies to charge the cost of stock options against earnings. Whatever their fate, Biggs expects emerging international accounting rules eventually will force U.S. companies to treat options costs properly.

Biggs also chairs the compensation committee at Boeing, one of the few companies now subtracting options costs from profit. If others followed suit, he argues, they would not only gain flexibility by paying executives only for performance but also reputations for clear accounting. Neither he nor Waldorf sees reform coming overnight, or even this year. "Companies still have the mind-set of trying to hide everything," Waldorf told me. "But this time around, people are really fed up." Let's hope he's right.

By Robert Barker

    Before it's here, it's on the Bloomberg Terminal.