Expensing Stock Options to Curb Abuses of Executives May Hurt Only Their Employees

Normally, when the captains of entire industries line up almost unanimously on one side of an issue, writing op-eds in all the newspapers and convening in herds to testify before Congress, the right-thinking impulse is to sprint to the opposite side on the assumption the public is about to get skewered.

Occasionally, however, one must concede that they have a point.

In recent months, chief executives of corporations in general, and high-tech companies in particular, have become keyed up about the idea that they should assign a money value to stock options granted to officers and employees and deduct it from their reported profits, a process known as expensing.

Right now, stock options don’t cost the issuing company anything until they’re exercised by the employee and converted into stock or cash, which can happen five to 10 years after they’re granted. This peculiarity has encouraged companies to view options as the equivalent of free money, which has led to a whole raft of abuses. The question is whether the proposed solution won’t do some mischief of its own.

There are, undoubtedly, some good reasons for a change. As Nell Minow of the Corporate Library, one of the nation’s leading shareholder advocates, told me, fixed-price options -- which allow holders to buy shares at a set price within a certain span of time and the type most commonly granted to workers -- are the only form of compensation not expensed. This encourages companies to overuse them when other devices may be better at motivating recipients to serve their companies better.

Leaving options off the income statement, furthermore, distorts the financial picture by reducing a potentially huge category of compensation to a footnote. And it’s clear that the investor community favors the change. “Only an ostrich would think we would continue with the old system,” Minow says.

Indeed, the Financial Accounting Standards Board seems determined to issue a pertinent rule soon. Several major corporations, such as Coca-Cola Co., have said they will take the charge even without an FASB rule.

But there are good arguments against recording options as a charge against current income, which would distort the financial picture in its own way (even if it’s a politically correct distortion).

Because the value of options is dependent on a host of unpredictable factors -- by my count the prevailing pricing formula, known as the Black-Scholes model, incorporates seven variables and two theoretical assumptions -- deducting the value from cash earnings is like deducting apples from oranges. Minow and others point out, accurately enough, that most income statements already incorporate plenty of similarly abstract assumptions, but I would debate whether adding another one to the pile is a step in the right direction.

Unequal Damage

Because some companies have been more generous with options than others, their financial picture would suffer disproportionate damage. Microsoft Corp. has calculated that its reported net income in 2000 through 2002 would be reduced by nearly $6 billion, or 24%, if it had to expense options. (The company, which recruited talented engineers for years by paying them below-market cash salaries and making up the difference with lavish option grants, also has started disclosing potential shareholder dilution from unexercised options.)

But by far the most troubling argument against expensing options is that making their cost prohibitive might provoke companies to scale back their grants to the rank and file. CEOs, perhaps sensing that this gives them a populist wedge on the issue, have made no bones about it. At a recent Senate hearing, Intel Corp. CEO Craig Barrett warned that it would mean that “stock options will only be offered to the most senior managers, if at all.”

Of course, this is a concern only if you buy into the notion that employee stock ownership is a good thing from both the workers’ and employers’ standpoint. That notion was once taken as an article of faith, but in light of recent dismal events in the stock market and corporate boardrooms, perhaps it needs reinforcing.

“There’s a fair amount of evidence that a company’s performance is better” when it sponsors a broad-based option grant program, says Douglas Kruse, a Rutgers professor who is coauthor of the recent book “In the Company of Owners,” a sort of bible of the virtues of employee share ownership. Kruse and his coauthor, fellow Rutgers professor Joseph Blasi, cite evidence that companies with broad-based options programs generate higher average shareholder returns over time than those with programs more concentrated among corporate brass. They’re also associated with a more participatory culture in the workplace, which also is good for employees.

That’s important because the impetus for the option-expensing drive arises not from misgivings about employee share ownership, but from the derelictions of corporate bosses.

Real Issue Is Greed

Options are at the heart of the obscene pay packages that some carried home during the boom years. Most of the enormous gains executives reaped by exercising options on millions of shares were generated not by their companies’ exceptional performance -- some turned in mediocre records or worse -- but because during the late bull market even average equities soared. It’s true that boards were lulled into making outlandish option grants to top executives because of the illusion that the options were free, but the real issue was greed, not accounting.

And history tells us that efforts to constrain executive pay have almost always failed. No matter what rules are imposed, CEOs will find a way to subvert them. Blasi and Kruse say they’ve studied data culled from 50 years of surveys by the Conference Board and found that every time Congress has tried to rein in executive compensation, companies have found a way to make top executives whole.

Sometimes reform campaigns fall victim to the law of unanticipated consequences. That happened in 1993, when Congress tried to place a ceiling on executive pay by eliminating the corporate tax deduction for all salaries over $1 million, unless the excess was contingent on meeting performance goals approved by shareholders.

Apparently it occurred to nobody that this was the equivalent to telling a 6-year-old that he can have “up to” three Oreos for dessert. Predictably enough, every CEO in America concluded that he or she had a divine right to at least 1 million Oreos a year and opened negotiations from there. (There are statistics showing that the sharpest executive-pay boom in history occurred in the years after 1993.) As for performance standards, these are typically set as stringently as the requirements for membership at Costco.

In reviewing the CEO’s record, therefore, the directors are free to praise the executive’s “considerable progress” in “achieving strategic priorities,” glossing over how, say, annual profit fell by 23%. Then they can award him a $4-million bonus on top of his $1.5-million salary. (I quote from the 2003 proxy regarding Coca-Cola CEO Douglas Daft.)

So expensing options probably won’t achieve its main goal of throwing a lasso around greedy executives. The ultimate question is whether making options more costly will lead companies to scale them back for the average worker. On this I’m prepared to take Intel’s Barrett and his fellows at their word. They’re the ones making the decisions, and they ought to know.

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Golden State appears Mondays and Thursdays. Michael Hiltzik can be reached at golden.state@latimes.com.