Man Without Qualities

Monday, July 22, 2002

Confusing Options

In the ongoing Congressional brouhaha over executive options, some public discussion has become rather confused, at least in the opinion of the Man Without Qualities. It is in my view worth noting that the following are quite different criticisms of such options:

1. Not expensing options on company balance sheets allows companies to overstate earnings, leading to overpriced stock.

2. Executives compensated and incentivised with stock options will tend to engage in fraud and deceptive practices in order to boost apparent earnings and therefore the price of the stock. The executives will exercise their options and dump the stock while the market is artificially hot.

3. Because option holders enjoy the up side of stock price fluctuations, but not the down side, executives compensated and incentivised with stock options will tend to take more risk than the shareholders would like. This is sometimes called the "non-alignment (or disalignment) of interests" argument because it is based on the non-alignment of shareholder and option holder interests.

While reasonable minds may disagree, each one of these arguments is unpersuasive.

The first criticism fails because, as many people have now pointed out, it is well-known fact that once options are disclosed, investment professionals will simply evaluate the effect of the options on the company's financial condition by using any number of many, many methods of valuing the options. It is not that some of these methods are right and others are wrong. Rather, some methods are more appropriate than others under different assumptions. More Than Zero has made a similar point. To take a simple example: If the options have an exercise price of $1.00 and one assumes stock price will trade around $0.90 indefinitely, the value of the option will be very different if one also assumes either:

(i) that the stock will be highly volatile (in which case it will often be above $1.00, and represent a real dilution prospect and therefore a cost, to the company), or

(ii) that the stock price will always range between $.88 and $.92, in which case the option is worth zero, and the company faces no real expense.

How a particular analyst views the likely volatility of the company's stock under whatever circumstances the analyst is interested in will be key. For example, if the analyst is looking at hostile take-over scenarios, high volatility is likely. If a tender is unlikely, volatility will be determined by other market factors. This example varies just one assumption but implicitly uses the same methodology. But methodologies can also be properly varied, especially between the long and short term.

Simply put: Whatever number is used to reflect the expense of the options in the company’s balance sheet - no matter what that number is - will be wrong. So why do it? One can, of course, make certain "reasonable' assumptions about the factors most often used to value options in common methodologies - which amounts to saying that one assumes the future will be like the past - and require companies use a particular methodology and plug in such standard reasonable assumptions. That would probably produce the most "misleading' set of financial statements of all. Similarly, it is not that hard to imagine analogous "overstatements" of corporate earnings of unlimited degree and extent that do not represent any deception of the market at all and which should not be corrected simply because it is better to describe them in other terms and let the analysts evaluate their significance for themselves.

Nor does the second criticism really hold up. As a preliminary matter, it is worth noting that this incentive will exist if the prosperity of an executive is effectively linked by any means to the value of the corporation’s stock in a way that allows the executive to sever connections with the company and take the accumulated value away. So unless an executive is to become an indentured servant, it is not possible to solve this problem and still have the executive care about share value. Moreover, contrary to recent media coverage, there does not seem to be a very strong correlation between executive options and the recent spate of documented accounting scandals. Consider this formulation of the problem, by the op-ed writer for the New York Times article linked above:

Options, which are not counted as an expense and thus inflate earnings, bring with them a powerful incentive to cheat. They hold out the promise of wealth beyond imagining. All it takes is a set of books good enough to send a stock price soaring, if only for a while. If real earnings are not there, they can be manufactured — for long enough, in any case, for executives to cash out. This, in essence, is what happened at Enron, WorldCom, Xerox — indeed, at quite a long list of companies.

Except that nobody is saying that the scandals at WorldCom or Xerox were in any way connected with executives of those companies fraudulently inflating their stock prices so the executives could dump their option stock. Nor has either of the Adelphia or Global Crossing disasters been tied to "option dumping." For example, in 2000, Mr. Winnick, or companies he controlled, owned 78.9 million shares of Global Crossing stock as well as 8.56 million options. So if there was an incentive to boost the stock price at Global Crossing, it is hard to say that options – rather than simple stock ownership – were the cause of it.

In fact, the problems at Adelphia and WorldCom appear tied to the ways their executives were buying company stock, not dumping it. The Merck pseudo-scandal has not been assigned that likely causation. Not even the Im Clone disaster has been tied to options. The SEC and the Justice Department are reportedly investigating whether Computer Associates wrongly booked more than $500 million in revenue in 1998 and 1999, a time when three senior executives were enriched via stock payouts from the company – not options - that were triggered by stock price milestones, but that stock has for the most part not been sold. At Tyco, Mr. Kozlowski and other individuals have lots of problems, and some analysts and investors wondered if Kozlowski had approved some of the same accounting tactics as those allegedly used by Enron – but the “wondering” has not matured into serious civil or criminal charges. Further, if there are problems at Tyco, they are probably tied up with Kozlowski's sale of about $300 Million in company stock to the company prior to 1999 - a potentially dangerous issue, but not the same as option dumping. Problems at Qwest may be option-related, and Mr. Nacchio engaged in some alleged option dumping (although he denies that). But even here one has to contend with the fact that Mr. Anschutz was in ultimately charge there and he owned a 301 million-share stake in Qwest, where he sold about 3.3% of this stake during the questionable period. That doesn't sound like an option-driven problem.

Of the now rather long list of large companies tainted by accounting scandals recently, few other than Enron are even allegedly the product principally of option dumping. Of course some of these companies employed executive stock options - but that has not been reported as a major cause of the alleged scandals. So it's not surprising that the Times op-ed piece just omits the actual names on that "quite ... long list of companies" that have succumbed to this particular temptation. But it is Enron that caused the initial uproar, which may be why this criticism has gained currency. It is just hard to find a real pattern of executive options being the major issue with these companies, even assuming for the sake of argument that their irregularities are as serious as their critics contend.

It is also worth noting that this New York Times article says that that the accounting "fraud" suggested in that article has been going on for TWENTY YEARS AND THROUGHOUT THE MARKET. The reader can evaluate that probability for herself.

What is correct is that during the dotcom run up, many holders of executive options became fabulously rich by dumping option stock in companies with no earnings The shareholders in those companies eventually more or less lost everything, and that rankles still. But that's not today's problem - and there have been surprisingly few claims that the dotcom companies actually defrauded their investors. After all, each one of those IPO prospectuses pointed out the dotcom then going public had no earnings and a highly speculative "business plan." But this was a point made widely during the run up itself.

One might also point out that the great majority of companies using executive options have not been accused of improprieties. So if the incentive is so strong, why were more companies not affected?

Until there is some clear, widespread evidence that executives compensated and incentivised with stock options will tend to engage in fraud and deceptive practices there seems to be no reason to jump to that conclusion. After all, there are a great many anti-fraud and anti-insider-trading laws already on the books. Why assume the balance between the two sets of incentives (that is, incentive to cheat from options meets incentive not to cheat for fear of getting caught and punished) has been upset to the point it needs drastic overhaul? True, there may be a need to reassure the markets. But there is also the serious risk of overkill and overregulation, which is probably an even bigger risk to the markets. And let’s not forget that really serious restrictions on options could be a dagger pointed at the heart of the venture capital industry – thereby risking serious damage to one of the American economy’s greatest assets.

The third criticism is more subtle and interesting - but also ultimately unpersuasive in this crude form. For one thing exactly the same argument can be made about stock with respect to debt. Consider a company financed partially with a loan for, say, $100 Million. Suppose the directors perfectly represent the shareholders' interests. Suppose the company has two possible business plans: Plan A, which will yield exactly $100 Million and has a 100% chance of succeeding (that is, it's low risk), and Plan B that has a 50% chance of making $200 Million and a 50% chance of making $0 (bankruptcy). It is obvious that the board will choose Plan B, since the value of this Plan to the shareholders is $50 Million (.5 chance of success X [$200 Million return - $100 Million loan]) , where the "low risk" Plan A is worth nothing. But the lender would clearly prefer Plan A, since that Plan has a 100% chance of repaying the loan.

Does anyone think that this kind of "non-alignment of interests" argument as between debt and equity means that companies should not have both debt and equity? Of course not. Lenders protect themselves in such cases by including covenants in the credit agreement and structuring the loan in clever ways. Similarly, the structure of the option plan will be determinative in the executive option case.

But, more importantly, why should this third criticism matter much in the debate over legislative action. Yes, executive options can disalign shareholder and executive interests in the same way equity and debt holders are somewhat disaligned, and the interests of founders are somewhat disaligned from those of later shareholders. But most people understand that the founders, shareholders and debt holders also have many interests in common. Such disalignment is a factor for the investors to consider - not the Congress.

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