The Bear's Lair: Options-A Modest Proposal

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  Oct. 20, 2003 at 5:36 PM
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WASHINGTON, Oct. 20 (UPI) -- Like a vampire whose captors can't find a silver stake, un-expensed stock options still wander among us, distorting earnings comparisons wherever they alight. The Financial Accounting Standards Board has now announced it won't produce a definitive ruling on expensing stock options until the second half of 2004 -- presumably after, not before November 2, 2004. Wimps!

Intel, for example, reported doubled earnings in the third quarter, to the rapturous applause of Wall Street. Since Intel Chairman Andy Grove notoriously opposes expensing stock options, it is perhaps unsurprising that it was quite impossible to find in their third quarter statement how many options they had issued. However, one can be sure, given Grove's predilections, that it was plenty, and that Intel's earnings after properly expensed stock options would have been substantially lower.

Cisco, on the other hand, showed more restraint in its options activities in the year to July 31, 2003, issuing only 199 million options, for a total Black-Scholes value of $1,259 million (35.2 percent of reported net income) compared to 282 million options, for a total of $1,520 million (80.2 percent of reported net income) in the year to July 2002 and 320 million options, for a total value of $1,691 million (an infinite percentage of net income, since the company reported a loss) in the year to July 2001. It's good to know that the Sarbanes-Oxley Act and the corporate governance scandals have had such a major effect!

In an ideal world, Congress would be pressing the FASB hard to issue rules on options expensing that were simple, comprehensible, and loophole-proof. Of course, in the world we actually live in, there's an election coming up, and tech companies, the most egregious abusers of stock options, are among both parties' largest donors.

As has been well documented, large un-expensed grants of stock options are a rip-off of shareholders, causing earnings to be overstated and management to achieve huge rewards, while diluting existing shareholders' interest in the company, often far more rapidly than corporate earnings are adding to it. Cisco's stock options grants, for example, represent more than 2 percent of its outstanding shares in each year; the company consequently has to spend more money than it actually earns buying back shares in the market, at an astronomical real earnings multiple, in order to prevent existing shareholders from being diluted out of existence. In a market like 1999-2000, of course, Cisco can just issue more shares, whether for cash or for acquisitions, at even more astronomical multiples, thus raising the cash to buy its shares back. In the more subdued (yes, still) market of 2003, this is no longer possible, and hence Cisco's much vaunted cash "hoard" may suffer severe depredations.

As well as shareholders, however, the Enron case in particular, and Global Grossing, Tyco and countless other less well publicized cases in general, demonstrated that a major loser from stock options is the workforce, outside top management. Management leverages the company to the hilt, and engages in risky corporate strategies and dangerous acquisitions and diversifications, all to pursue the Holy Grail of rapid stock price appreciation that is essential if their stock options are to pay off big. Of course, in an economic downturn, this strategy has to go into reverse; the company is now over-leveraged and must slash its payroll and close operations as quickly as possible in order to avoid bankruptcy (or by order of the administrator after bankruptcy has occurred.) The major losers in this case are the workforce, who lose their job, their major source of income, and, in Enron's case, much of their 10(K) savings, and must now enter into a prolonged and often futile job search in a deep economic recession. The gains of top management in 1997-2000 have been paid for by the job losses of the workforce in 2000-2003, far greater than in earlier recessions since at least 1979-82.

There is a solution to this, modeled on the solution some years ago when top management were found to be taking huge pension contributions, unrelated to the pension contributions made on behalf of the rest of the workforce. If management wants to award itself stock options, and can arm-twist the FASB into allowing them to pretend to stockholders that they are not being robbed, fine. But in that case, they must give employees outside top management the same stock options rights that they have, in terms of options issued per dollar of base salary.

One additional wrinkle. Non-management employees (but NOT top management itself) must have the right to choose either call options, like top management, or put options. Put options, the right to sell shares at a fixed price, can in a bear market be described as Oscar Wilde's favorite investment; it was Wilde who said "It's not enough that I should win. Others must lose."

In either case, the options must be over the same number of shares and exercisable over the same period as top management's options. If top management call options are issued at the day's prevailing share price, so must the employees' put options; if top management's call options are issued at a 20 percent premium to the prevailing price, then employees who choose put options will have an exercise price at a 20 percent discount.

Naturally, if the company is well and conservatively managed, the share price can be expected to rise over time and so the call options will be worth more than the put options. Those employees who believe that the company is well and conservatively managed will naturally choose call options, and will share alongside top management in the company's success.

However, what about the employee who does a good job driving a truck, working on the assembly line or managing accounts receivable, and wishes to keep his job, yet doesn't himself significantly affect the company's results and can't help nursing a (doubtless unreasonable) suspicion that top management are a bunch of testosterone-filled halfwits who are trying to gouge out 7, 8 or 9 figure payoffs in the bull market before leaving shareholders and employees in the lurch when the crash comes. He chooses puts, not calls. Clauses in the legislation will prevent the HR Department from telling his boss when he does this, and prevent his boss from firing him if he finds out.

Under this proposal, if the employee is correct in his doubts, the rent checks during his long period of unemployment after the company crashes will still get paid. His put options, acquired when the stock is riding high, will be worth a great deal when the company crashes, so he will be covered against the risks of management's shenanigans.

Let's take an Enron example. Kenneth Lay, with a base salary of $1 million (the maximum allowable for tax deductibility under 1993 legislation) is awarded 100,000 options on Enron stock at $50 per share. Joe Sixpack, who drives a truck for Enron's pipeline company Internorth, has a salary of $50,000, so he is awarded 5,000 options. He chooses puts.

Six months later, Enron is trading at $80. Kenneth Lay's options are worth $3 million. Joe Sixpack's are worth nothing. But he still has his truck, his job and his $50,000 salary.

Twelve months later, Enron goes bankrupt. Kenneth Lay has previously cashed out his options, but as his remaining options are worthless, his net worth is now in eight figures, not nine.

Joe Sixpack at this point exercises his puts, and makes $50 times 5,000 or $250,000. Of course, he loses his job, but it's most unlikely that a good truck driver like Joe will remain unemployed for a full five years, so when he gets a new job, maybe he can buy the boat he always wanted. A fair reward for the harassment of working for a sleazeball like Ken Lay.

The level of employee interest in a company's put options would of course be a key item of information for analysts -- like options in general, this would be disclosed in the small print of the company's 10-K report to the Securities and Exchange Commission. A sharp rise in put option activity would be a very useful sell signal, as it would indicate that the employees as a whole were of the opinion that management had finally flipped its lid and was pushing the company towards bankruptcy. Of course, there would be regrettable cases where the company was in trouble and employees, mostly holding put options, stood around like New Yorkers at a suicide yelling "Jump, Jump," but hey, that's capitalism.

Naturally, it is likely that any such legislation would cut back sharply the volume of stock options issued, as company managements became fearful of employing tens of thousands of people, all of them willing their corporate demise. Which would be the object of the legislation in the first place.

Jonathan Swift, in his original "Modest Proposal" of 1729, advocated breeding unwanted babies as a food source. Over at the American Enterprise Institute and the U.S. Chamber of Commerce, I'm quite certain this "Modest Proposal" will be received with an equivalent degree of shock. However if integrity is to be restored to the system, some such outrageous scheme may be necessary.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

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