Options are frequently re-priced in line with the decline in share prices, thus denuding them of their main incentive. In other cases, fast eroding stock options motivated managers to manipulate the price of the underlying stock through various illegal and borderline practices.
Stock options now constitute about 60 percent of the pay of Fortune 500 executives. Whitney Tilson of Tilson Capital Partners notes in "The Motley Fool" that the hidden dilution of corporate equity caused by stock options inflates the stated profit per share.
In the United States, stock options are not treated as a business expense. Payment of the strike price by employees exercising their options augments cash flow from financing activities. Companies also get to deduct from their taxable income the difference between the strike price of the options and the market price of the stocks. As a result, overall earnings figures are exaggerated, sometimes grossly.
"The Economist" quotes studies by Bear Stearns, the Federal Reserve, and independent economists, such as the British anti-stock-options crusader, Andrew Smith.
These show that earnings per share may have been inflated by as much as 9 percent in 2000, that options amounted to about 20 percent of the profits of big American firms, three quarters of the profits of dot-coms, and that the distorted tax treatment of options overstated earnings growth by 2.5 percent annually between 1995 and 2000.
The Federal Reserve concludes: "... There is presently no theoretical or empirical consensus on how stock options affect ... firm performance."
Towers Perrin, a leading global management consultancy, spotted a trend: "(There is) a move by employees towards placing greater emphasis on long-term incentive plans ... (This is) creating new international currencies in remuneration ... (There is) a rapid, worldwide growth in stock option plans ... Regardless of the type of company, stock options are much more widely used than performance plans, restricted stock plans, and other long-term incentive (LTI) programs in most countries."
Stock options are now used not only to reward employees, but also as retention tools, building up long term loyalty of employees to their workplace. Multinationals the world over, in an effort to counter competitive pressures exerted by their U.S. adversaries in the global labor market, have resorted to employee stock options plans (ESOP).
Vesting periods and grant terms as well as the events, which affect the conditions of employee stock option plans -- in short, the exact structure and design of each plan -- are usually determined by local laws and regulations as well as by the prevailing tax regime. Contrary to popular mythology, in almost all countries, options are granted at market price (i.e., fair market value) and subject to certain performance criteria "hurdles."
Eligibility is mostly automatic and determined either by the employee's position or by his reporting level within the organization. Management in most countries was recently stripped of its discretionary powers to allocate options to employees -- the inevitable result of widespread abuses.
Ed Burmeister of Baker McKenzie delineates two interlocking trends in the bulletin "Global Labour, Employment, and Employee Benefits": "Two common trends are the broad-based, worldwide option grant, such as recently implemented at such companies as PepsiCo, Bristol-Myers, Squibb, Merck, and Eli Lilly & Co., and the extension of more traditional executive stock plans or rank-and-file, payroll-based stock purchase plans to employees of overseas subsidiaries. Employers are also beginning to implement stock-based incentive plans through use of offshore trusts.
These trends have led to increased scrutiny of equity-based compensation by overseas taxing and regulatory bodies. Certain trends, such as the relaxation of exchange and currency controls in Europe and South America, have favored the extension of U.S.-based equity compensation plans to overseas employees."
Granting stock options is only one of the ways to motivate an employee. Some companies award their workers with stocks, rather than options, a practice known as "non-restrictive stock bonus."
Others dispense "phantom stocks" or "simulated equity plans" -- using units of measurement and accounting whose value corresponds to the price fluctuations of a given number of shares. Yet others allow their employees to purchase company shares at a discount (section 423 stock purchase plans).
David Binns, associate director of the Foundation for Enterprise Development describes novel solutions to the intricate problem of customizing a global stock options and equity plan: "Often the companies provide international staff with a 24-hour loan facility whereby they can direct a designated stock broker in the U.S. to give them a loan sufficient to exercise their options. The broker then immediately sells enough shares to pay off the loan and transaction fees and deposits the remaining shares in the employee's account.
"Another approach to international equity plans is to create an "International ESOP" in a tax-free haven. Each of the company's international subsidiaries are given an account within the trust and each participating employee has an individual account with the appropriate subsidiary. The subsidiary corporations then either purchase shares of the parent corporation based on profitability or receive grants of stock from the parent and those shares are allocated to the accounts of the participating employees. The shares are held in a trust for the employees; at termination of service, the ESOP trustee sells the employee's shares and makes a distribution of the proceeds to the employee. This has the advantage of alleviating securities registration concerns in most countries as well as avoiding certain country regulations associated with the ownership of shares in foreign corporations"
(Part 2 of this analysis will appear Wednesday.)