Option Abuse: What to Do?

Mr. Kaplan, the head of Audit Integrity, is deeply disturbed by a Wall Street Journal article, “Companies Say Backdating Used in Days After 9/11” (March 7, 2007). Many companies rushed to grant options then claiming happenstance or rationalizing the action as a way to motivate executives in a difficult period.

With the statute of limitations approaching, SEC Chairman Cox has yet to decide who was damaged and what penalties might be placed on the companies involved. Further, is it fair that the costs come from the shareholders? Further he points out that the companies that were the worst offenders under-performed, despite of rich management compensation.

Mr. Kaplan believes that the individuals who did the backdating should pay and not the shareholders.

Self-dealing is built into the system. The trick is to make it unprofitable. Specialists on the NYSE are supposed to go against the trend in a strongly declining market. In times of huge declines, a great deal more money is made by specialist firms going with the trend than against it. Were these violators frog-marched, bound and shorn to the bar of justice? No, but the rules were changed to prevent these huge market declines, with methods, such as trading limits, developed on the commodity exchanges.

First, managers do back-date options and have done so for so long that it could be interpreted as a ‘custom and usage’ issue. The people responsible for preventing it are the Board of Directors, specifically the Audit Committee which has the means of enforcement through Internal Audit. Board members have insurance, and the ability to fire, then sue the people in question for misfeasance, say. In practice, there has very little disgorgement seen, though Mr. Kaplan mentions one, Ryan Brant. Board members also know that trouble can ruin their career: witness Judge Webster.

Note that the article mentions accounting charges, but does not say very much directly about specific market value losses associated with these adjustments. The nine companies’ equally weighted total return from October 31, 2001 to December 29, 2006 of the nine companies* was 59.16% well below the Russell 2000 return of 96.71% for the same period.

I would take another tack. The reason that the returns were lower for these companies was not only poor management, but also over-compensation by stock options which proved to be very dilutive on exercise. Think about it like this. Let’s say a company has absolutely stellar performance on a FCF or EVA measure. Then see what happens to share price when there is a lot of dilution through option exercise. I haven’t looked at the specific instances, but I would suspect that management might be more concerned about increasing volatility, hence potential option value, rather than growing share-holder value.

If for no other reason than bad publicity, many companies have stopped using option incentive plans. Others monitor option grants very closely, at the director level, to prevent dilution and protect shareholder interest. I believe that stock options and defined benefit plans are a thing of the past, and will disappear.

At one time, compensation related contingent liabilities were a popular vehicle for both firms and government. The promises were of negotiating value now, but would not become due for many years. Social Security is the best known instance. When it began, in the 1930’s almost no one lived to be 65, so the promises were cheap, and best of all not easily measured.

What we will finally see is a pay-as-you-go system for management compensation. Rather than a deferred liability you will see the cash expense recognized when the benefit is conferred. Service buyers will find it much more difficult to pay a cash price for what had been in the past potentially empty and costless promises.

I personally liked the Stern Stewart programs that put stock in a leveraged fund that vested benefits only after a certain period of time. Other things will work well depending on the management goals and characteristics of the industry in question. The one place they will remain key is in start-up ventures before an IPO where the employee is sharing part of the founders’ risk.

I believe that options, defined benefit pension plans and other arrangement that create an open-ended future liability will disappear, except in certain circumstances. Improved methodology and better systems show potential costs more accurately than before. With better information, the public realizes the need for legal protections, which turn such rights into actual rather than contingent obligations.

-----

*”The nine companies known to have backdated in the fall of 2001 are Affiliated Computer (ACS), Broadcom (BRCM), Brocade (BRCD), Corinthian Colleges (COCO), KLA-Tencor (KLAC), Monster Worldwide (MNST), Progress Software (PRGS), Take-Two Interactive (TTWO), and UnitedHealth (UNH).”