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Stock Option Pricing: Sloppiness or Crime?

Posted on Tuesday, Jan 9th 2007

What is clear is that shareholders pay the price.

by Dominique Trempont, Guest Author

Hundreds of public companies that have reported “improper dating” of thousands of stock option grants over the last decade. Dozens of high visibility CEOs, CFOs and general counsels have either resigned or been fired as a result.

The temptation is to jump to conclusions and assume that these companies willingly committed fraud by picking favorable grant dates for the board of directors, for management and for employees, costing shareholders millions. I am on the board of two public companies and my observation is that, in the vast majority of the cases, the issue is not criminal fraud in nature but rather sloppy documentation and lack of clear rules.

Stock options are granted to recruit employees, retain them and reward their performance. Stock options are a critical equity building incentive in a world where people are asked to excel, work very hard and build a retirement “cushion” that is not provided for by their company or the government.

In the past, these grants did not generate an accounting charge because they were purely equity based and no cash outlay was involved.

I used to recruit executives and grant them stock options; these grants would be authorized by the board of directors and the “strike price” would be defined on the day of the board approval. I worked with my executive team to grant stock options to employees, and then present a consolidated total to the board for approval. The strike price was made official on the day of the board approval.

The rules were fairly loose and subjective at the time: for example, if there was minor unfairness that needed to be corrected in the option grant between two employees of similar contribution and performance, CEOs would typically authorize these minor changes, without going back to the board. It was also common practice to “fish” for a day with a favorable stock price to lock in the strike price. The philosophy was: it does not hurt anyone (including shareholders) and it provides the incentive to employees in an economical way. No more.

A couple of years ago, after the Enron debacle, the SEC demanded that stock options become a part of compensation and of the cost of doing business: a charge was to be recorded in the financial statements. In particular, the SEC wanted to ensure that CEOs could not grant stock options at a lower price than the market price, without immediately triggering an accounting charge for the difference between the stock price on the day of the grant and the strike price.

This rule change put an end to the subjective part of this process and changed forever the requirements for formal documentation, date recording etc.

As a result, two things happened. In a few cases (dozens?), some CEOs and senior executives lost their jobs over their greed and questionable compensation manipulations. The vast majority of public companies suddenly found themselves with some weak documentation to support their stock option dates and prices, four, five, six years back. Hundreds of public companies had to stop reporting their financials to the SEC and shareholders, had to stop any acquisition with stock, had to stop granting stock options and had to incur massive legal and accounting fees for a period as long as six months.

What is not fair is that this rule change was retroactive. All it did was to enable unscrupulous lawyers to get rich by stimulating lawsuits, supposedly on behalf of shareholders. This retroactive rule change created a windfall for law firms and accounting firms to defend companies, review internal documentation, emails, signed documents, etc.

On the positive side, this rule change provides clear standards and rules, going forward.

On the negative side, who ends up paying for this? Shareholders, the same shareholders that the SEC wanted to protect. The retroactive nature of this rule change is likely to cost billions of dollars to companies and to shareholders. In addition, these new accounting rules continue to drive financial reporting further and further away from the economic reality that shareholders need, to assess business profitability and financial performance. In fact, most Wall Street analysts back out this kind of accounting non-cash charge to evaluate the true profitability of a business. Not every shareholder has equal access to the real numbers as they may not have access to the analysts. Furthermore, forcing companies to account for the cost of stock options is likely to drive companies to grant fewer stock options to fewer employees, which could weaken their performance over time and negatively impact shareholders altogether.

All in all, it is good that the SEC continues to clarify the ground rules on internal controls and financial reporting to shareholders. It is good that the SEC is firm with executives who violated the laws for their own profit.

For many companies, the issue however, is not crime or fraudulent financial reporting. The issue is that based on new rules and looking back with those new-rule lenses, the documentation processes were not tight enough. The punishment seems to be out of whack with the fault for a vast majority of these public companies. What I object to is that these option pricing laws have been enacted retroactively, with a different set of rules and regulations. They are unnecessarily making class-action lawsuit attorneys rich at the expense of shareholders.

I felt that someone should say this, considering the feeding frenzy and the vengeful witch-hunt that I am now witnessing in the press.

Related Articles:
US Scrutinizes Options Grant to Jobs (WSJ)
Inside Jobs (WSJ)
Top Lawyer Known For Her Integrity (Merc)

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