Options Time Machine: Money for Nothing (Market forecast by James Bell)

We couldn’t let 2006 go by without a new corporate scandal, could we?
This year has seen the revelation of executives receiving options grants at prices below the stock price on the grant date.
This is not fraudulent in and of itself, but the subsequent lack of disclosure of the practice in SEC and IRS filings makes it clear that these executives had their hands in the till at the expense of both stockholders and taxpayers.
Granting stock options to executives and employees has become quite common in the past few decades.
In this case, an option is the right, but not the obligation, to buy a certain number of shares of stock within a certain time period at a certain price, called the exercise price.
If the price of the stock rises above the exercise price over the term of the grant, the options become more valuable.
If the stock price is below the exercise price at the end of the term of the grant, the options expire worthless.
The philosophy behind this type of incentive compensation is that it aligns management’s interests with that of shareholders.
Both groups prosper as the stock appreciates.
Although there are some potential flaws in this arrangement, it has become de rigueur for executives of public companies to receive stock option grants as a large portion of their compensation package.
How is an executive option grant awarded?
Grants are usually made annually as part of a compensation review, or in the employment contract of a new executive.
Typically, the compensation committee of a company’s board of directors approves the size and terms of an option grant.
These options usually have a long time to expiration, often up to ten years, as well as a vesting schedule of a number of years.
This encourages retention as the executive will lose any unvested options if he or she leaves the company before the vesting date.
In almost every case, the exercise price of the option is the stock’s market price on the date of the grant.
This is referred to as an at-the-money option, meaning that on day one, the executive has neither a gain nor a loss on the option.
One reason for at-the-money options’ popularity is that since there is no gain in the option at issuance, companies did not have to record any compensation expense on the income statement unless and until the options were exercised, often many years down the road.
On the receiving end, the executive had no income tax liability on the option until it was exercised.
The accounting rules have subsequently changed, but at the time this was an effective, legal way to compensate employees, align management with shareholders and defer taxes.
The fraud that has made headlines recently involves executives receiving in-the-money option grants.
This means that at issuance, the exercise price is below the market price, so the executive has a built-in gain on the option.
If properly reported to shareholders and to the IRS, there is nothing improper about granting in-the-money options.
Because of the built-in gain, the company should record some compensation expense on the income statement filed with the SEC as well as pay appropriate payroll taxes.
Additionally, the executive would have to report the income to the IRS.
Because the companies did not want to report lower earnings, and the executives did not want to pay more tax, these in-the-money options grants were reported in filings as at-the-money grants, often by backdating the grants to dates at which the stock price was well below the price currently.
Recall from Finance 201 that there are more ingredients in determining an option’s present value than just price.
Time to expiration (in this case often up to ten years) and stock price volatility are also important components.
And it’s true that even an option deep in-the-money at issuance can wind up worthless by expiration.
But holding all other variables equal, the lower the exercise price, the more valuable the option.
There is no gray area here.
Executives knowingly tilted the economic odds in their favor and did not disclose it to the appropriate agencies.
How were shareholders disadvantaged? Beyond the lack of moral compass in the executive suite, there is an economic loss to shareholders.
Whenever an option is exercised, the executive in effect buys shares of stock from the company at the exercise price.
If the exercise price has been manipulated lower, the company receives fewer proceeds for selling the same number of shares.
The spread between the backdated exercise price and what the price was on the actual grant date times the number of shares purchased represents a dollar-for-dollar fraudulent transfer of wealth from the company shareholders to management.
Again, there is always the risk that the option expires worthless regardless of the exercise price, but backdating lowers that risk and besides, nobody manipulates an options grant with the notion that it’s going to be worthless anyway.
Not everyone owns stocks, but we all pay taxes. The government got shortchanged in this scheme as well.
By not reporting the in-the-money portion of the grant as compensation, payroll taxes as well as income taxes were avoided or deferred.
Options backdating seems to have been surprisingly widespread in the late 1990s.
The Wall Street Journal maintains a growing list of at least 85 companies involved in some way with the practice, many of them in the high tech sector.
Even household names such as iPod maker Apple Computer and HMO United Healthcare are under investigation.
How did the problem get so big?
Executive greed, of course, combined with complacent or incompetent boards who rubber-stamped management’s proposals.
This was also an era of euphoric stock returns in the tech sector, where shareholders with huge gains did not care much about the details and companies pulled out all the stops to attract and retain employees.
The fallout from this scandal is sure to include earnings restatements as companies go back and factor in compensation expense and tax liability.
In fact some companies face the potential of being delisted from the Nasdaq as they delay their SEC filings while researching this issue.
We have already seen management resignations, terminations, and a fugitive CEO leave the country rather than face charges.
Hopefully, standards for board competence and independence will be raised.
No doubt government will insist on more regulation and oversight as well.
Worst of all, expect further deterioration in the public’s trust of the executives managing our public companies and the boards of directors who nominally protect shareholder interests.
(James Bell, CFA, is vice president and assistant portfolio manager at Garrison Asset Management in Fayetteville. Contact him at [email protected].)