Don't Throw Out Options Because Investors Took a Bath

By Laura D'Andrea Tyson

In the 1990s, U.S. companies fell in love with stock options as a way to reward their top leaders and to align their interests with those of shareholders. Options encourage risk-taking by providing considerable upside potential while limiting losses. In such a world, options are a powerful incentive to act in ways that maximize the value of shares and thus serve the interests of shareholders.

Granting options to motivate risk-taking, leadership, and hard work captured the spirit of entrepreneurship, the belief in the efficiency of the stock market, and the commitment to shareholder value that characterized American market capitalism in the '90s. By the end of 2001, 90% of large U.S. companies issued stock options, more than 10 million American workers received them as part of their compensation packages, and options accounted for about 60% of CEO pay.

Now, however, in the wake of the sharp drop in the stock market and Enron Corp.'s spectacular collapse, Americans are questioning the wisdom of stock options. Stories have proliferated about how top management sold options at peak market values in companies that have since failed, such as Enron and Global Crossing Ltd., leaving shareholders and employees empty-handed. And there is mounting concern that existing accounting regulations allow companies to use options to manipulate financial statements and mislead investors about earnings trends.

Under current accounting rules, companies are required to disclose stock options when granted but are not required to expense and deduct them from current earnings. For more than a decade, the accounting community has argued that options should be "expensed" because they are just another form of compensation. According to this argument, failure to subtract this compensation cost from pretax profits has increased reported earnings, distorted financial statements, and encouraged a misallocation of capital. But both theory and evidence indicate that the situation is more complex than this superficially compelling argument suggests.

First, if options are more effective than cash compensation in aligning employee and shareholder interests, then an option grant will have a greater effect on shareholder value than a cash compensation payment of the same size. The negative, or dilutive, effects of options on shareholder value will be offset in part by their positive effects on expected future earnings. Treating options just like cash compensation, as an expense against current earnings, fails to account for such incentive effects and, thus, is misleading.

Second, current accounting rules already require the disclosure of enough data on options to allow the investor community to assess both their dilutive and their positive incentive effects on a company's stock. According to recent research, share-price movement in response to disclosure information on options indicates that investors are making appropriate adjustments.

Third, the expensing of options poses formidable technical challenges. A cash compensation package has a certain value whose effect on corporate earnings is certain. The value of a stock option plan depends on the plan's vesting and exercising periods, the volatility of the underlying stock price over the life of the option plan, and the timing of decisions to exercise their options. So requiring the expensing of options could have the unintended effect of making corporate financial statements more misleading.

The controversy over the proper accounting treatment of options has diverted attention from a more important problem. Options are supposed to align the interests of corporate managers and shareholders. Something is amiss when insiders can reap huge gains from their options while shareholders are losing their equity stakes. Securities & Exchange Commission Chairman Harvey L. Pitt observed recently that corporate officers should be required to demonstrate sustained long-run growth prospects before they can exercise their options. As an example of this approach, Boeing Co. has introduced performance units that are convertible to common stock only if Boeing stock appreciates annually for five years. And options are supposed to reward business leaders for higher stock values caused not by a stock market bubble but by company actions that create the fundamentals on which sustainable shareholder value depends.

To make options reward long-term performance resulting from improved company fundamentals rather than overall stock market trends, options packages would have to be structured differently. For example, options could be designed to pay off only if a company's stock outperformed the overall market or a peer group of companies over some period of time. Unilever has introduced a promising options plan that embodies this approach.

America's love affair with stock options, like its love affair with the stock market, may be over. But the basic logic behind options as a way to align the interests of shareholders and company decision makers is sound.

Laura D'Andrea Tyson is dean of London Business School.

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