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Wave Goodbye to Options
By Stephen J. Butler |
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A few weeks ago, I outlined what I felt were the three major factors contributing to the soft underbelly of the stock market. Stock options, excessive executive compensation, and accounting malfeasance are the three major culprits in the minds of most observers. Fundamentally, of course, it has been an unsupportable bubble of market values that has imploded, but stock options and their faulty accounting methodology supplied that bubble with more hot air than our love affair with technology would otherwise have generated.
Executive compensation and accounting treatments involve vast slippery slopes that are a challenge to confront with legislation, but stock options are simple. We can just say "No." Speaking for the roughly 100 million American taxpayers and voters who now own mutual funds and stocks, we all recognize that we are adversely affected by this unusually imprecise compensation tool.
What everyone seems to forget is that public companies, for the most part, can offer options to their employees by just buying them in the public options markets. At the Chicago Board of Options Exchange (the CBOE,) we can all buy a wide variety of options on just about any major U.S. Company. Any company that feels strongly about having its employees aligned with corporate interests and a rising stock price can just offer to pay for some options and give them as taxable income to deserving employees. Because the option is priced by a free market economy, all the questions about future value and taxation are between the employee and his tax return. The corporation and its stockholders are out of the loop.
The public market for options is created by existing stockholders who say, for example, "I will sell you the right to buy my $10 stock anytime over the next three years at a price that is two dollars higher than the stock sells for right now. For the right to buy 100 shares at $12 anytime up until, say, July 31st of 2005, I will charge you $500." If the stock actually does rise to something like $20, the option holder might exercise his right to buy 100 shares at $12 and simultaneously sell them for $20 and pocket what would have been a $300 profit. You'll recall that he paid $500 for the option to begin with, so the 100 shares of stock have to rise to $17 (a $5/share gain) before he has recovered his $500 and starts making any money. A $300 gain on a $500 investment, however, is a 60% return in just three years.
The person who sold the option loses out on the $8 gain on the stock because he was forced to sell at $12. However, he did get to pocket the $500 cost of the option so he earned the equivalent of a $17 selling price. People who make their stock available for option writing generally make money in the aggregate because the majority of options are never exercised and they get to keep the money.
Corporate option grants are different than options sold in the public markets. When it comes time for a corporation to make stock available because an option grant is "in the money" and a candidate to be exercised, it is we mutual fund investors (and stockholders) who effectively provide the stock gratis. Nobody is paying us any $500 option fee. Unbeknownst to us from a practical standpoint, the companies we effectively own just issue brand new stock. Therefore, what we thought was our collective 100% ownership suddenly becomes 80 or 90 percent ownership as the company's value is diluted by all these new shares. In the old days, this was called "watering stock" which was a reference to a deceptive practice in the cattle business that made cows heavier and worth more money.
The giant magnifying glass focused on options today is exposing the fact that they are not used to create financial opportunity for vast numbers of the American workforce. The bulk of all options issued go to a few key executives. These are the people who can influence how a company manages its earnings, and they have a powerful incentive to do everything possible to inflate stock prices.
In effect, options are a form of leverage. If a stock doubles in value, the return on an option's price can be far greater than 100%. Financial history teaches us that leverage can lead to very destructive behavior, and this explains why, after the crash of '29, the brokerage industry established limits to the extent to which stocks could be bought "on margin" or purchased with borrowed money. After the crash, we decided that we would legislate the extent to which investors could borrow to buy stocks, because the resulting volatility penalized all investors and destroyed confidence in the markets.
Corporate-sponsored options that dilute ownership and lead to various forms of pathological corporate behavior should just be banned at this point. Arthur Levitt, the former head of the SEC says that his greatest mistake was the decision to cave in back in 1994 when he responded to pressure from Newt Gingrich, of all people. This marked the end of the SEC's attempts to demand more transparent reporting from the accounting profession, and control of option reporting went out the window.
I agree that options are difficult to expense because they might turn out to be worthless, but this is a weak argument for allowing something to persist that can destroy so much value with little or no advance warning. Therefore, a prudent step would be to do away with them altogether. Private companies, of course, can always issue options that would be fully disclosed if and when the company ever went public. Public companies, if they feel compelled to include options as a compensation component, can just purchase them on the open market from existing stockholders. The only options that would disappear are the ones that cause all the problems...namely, the huge option grants that go to a few key executives. For the 100 million of us saving for retirement, this would not be a big loss.
Unfortunately, we have little political leadership on this issue at the moment. Barbara Boxer has come out in favor of the status quo while Diane Feinstein is "thinking about it." Meanwhile, at the SEC, none of the other four positions beyond the chairman have been approved by President Bush yet because he is forced to include two Democrats. Several key actions by the SEC have reached a stalemate because Harvey Pitt, a former advocate of the accounting industry, has had to recuse himself and he is currently the only member of the board. This void has lead to some cases being thrown out which should have been prosecuted. When it comes to an issue that has cost us all a great deal of money, there is clearly a leadership vacuum.
What seems to be at work here is what I would call, "the politics of selfishness." Legislators from both parties are sensitive to where their campaign contributions are coming from. The president and vice president seem to have their own past problems with corporate accounting issues. We retirement investors and voters need to make it easy by letting them all know that options need to go. It is an elegant, concrete solution that everyone can understand. The alternative is to argue for the next ten years about how they should be expensed, and that reminds me too much of the "shape of the table" discussions during the Vietnam War.
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