Stock Options Under Attack

Nobody wants to be heavy-handed, least of all the guardians of the capital markets. The very thought of a blanket ban on anything is enough to make them recoil. They prefer regulations, guidelines, and the current rage: publishing best practices - which boils down to policing wrongdoing with peer pressure and disapproving glances.

Most securities cops takes their jobs seriously, but they're torn by the double edge of their mandate: to deter abuses and punish wrongdoing, but without obstructing the free market. Like the permissive parent, terrified of squelching their precious child's creativity, they fall into a self-defeating trap. By setting only fuzzy rules with uncertain consequences and inconsistent enforcement, they sow confusion among executives and cynicism among investors. Companies say they're drowning in costly and pointless red tape, and the public thinks corporate crime rages on unimpeded anyway.

Sometimes it's better just to put your foot down. It's not elegant, but it has the benefit of clarity. And when it comes to the use of stock options, the gold mine that has enriched the world's executive class by untold billions over the past few decades, it's time to say "no." It's time to ban stock options as a perk for corporate insiders. No more studies. No more changes to the accounting rules. No more incomprehensible footnotes. Call 'em illegal, and be done with it.

Options are inherently flawed because they distort the risks and rewards of owning stock. The deal works like this: each year, a company issues an executive the right to buy stock at a future date for a set price. So, let's say you get an option to buy your company's stock for $10. You wait for a year or so until the option "vests," by then hopefully the stock has gone up to, say, $20. You exercise your option to buy at $10, turn around and sell the stock into the market at $20, pocket the difference and go yacht shopping. This simple transaction has unleashed tens of billions of dollars into CEO bank accounts in recent years.

Executives insist that options are a great incentive, ensuring corporate managers stay focused on the stock price, and thus the shareholders. Sounds great, except executives holding stock options have none of their own capital at risk. If the stock goes down, and your options are considered "underwater," you may miss out on a windfall, but since you paid nothing for them in the first place, you've lost nothing. Heads the insiders win, tails the shareholders lose.

For many executives, even those odds aren't good enough. When hundreds of tech companies saw their stock prices collapse in 2001, rendering their options worthless, many appeased their executives by "re-pricing" options - changing exercise prices and vesting periods to yield another hefty payday for insiders while ordinary investors licked their wounds. Others simply signed deals with banks, trading options for cash. This little trick was called monetizing, and although perfectly legal, it meant insiders had already hedged against the crash of their company's stock, and investors were none the wiser.

There's no shortage of staunch capitalists opposed to this kind of gerrymandering. Paul Volcker, the renowned former chairman of the U.S. Federal Reserve, abhors options because they emphasize short-term stock movements at the expense of the long-term health of the company. Corporate sage Warren Buffett objects on the grounds that options provide a benefit to executives that isn't available to ordinary investors. Both are valid criticisms, but they miss the more fundamental problem exposed over the past few years: options are ripe for fraud.

U.S. regulators are currently investigating the widespread practice of "backdating" - retroactively manipulating the date of options grants to maximize the payout for executives at the expense of shareholders. Among the hundreds of companies under investigation is Canada's own tech titan Research in Motion. Already, dozens of executives have taken the fall for this, and the staggering costs are just now coming into focus. In October, Andrew McKelvey, chief executive of Monster Worldwide, stepped down over allegations surrounding tens of millions of dollars in options grants he collected. Last week, Monster said it had understated its options costs by US$339.6 million over six years.

Home Depot has said it too under-reported the cost of its options program - by about US$200 million over 25 years. But, they were quick to add, it was all an innocent mistake. One suspects that if Home Depot made some other $200-million mistake, like say, buying too many garden hoses, to the tune of $7 million a year for a quarter-century, heads would roll and quickly. But when it comes to options, everybody is expected to shrug and say, "Well, at least they didn't do it on purpose."

The latest twist in this saga comes courtesy of the U.S. Securities and Exchange Commission, which has found that some companies tinkered with options dates, not to wring more money for executives, but to help them avoid income taxes.

Enough. If you want to keep executives focused on the interests of shareholders, pay part of their annual salary and bonus in stock and require them to hold that stock until after they quit or retire. It's not elegant, but it's clear and it's fair. And executives, like children, sometimes need a firm hand to guide them.

Maclean's January 1, 2007