Simon Caulkin
Stock options have become the Nineties way of rewarding top managers. But as the number of options being granted has exploded, so the boom in share prices has inflated the value of those options.
The sheer volume of stock options has achieved such scale that it threatens to undermine the validity of company accounts and distort the objectives according to which companies are, or should be, run. And as the stock-option blister swells, it adds to the very escalation of share prices on which the rise in the value of options is founded: the circle is complete.
Put simply, stock options confer the right to buy a company’s shares in the future at or near the ruling price today.
The scale of options and their value is staggering, particularly with the bull market having hauled the Dow Jones industrial average from 840 to more than 9E000 in a decade and a half. Look at some of the statistics.
More than 10% of all United States shares are earmarked for company stock-option schemes, mostly for top executives. They are worth $70-billion – more than 1% of gross domestic product.
According to Business Week, chief executive officers of 365 of the biggest US companies took half their average $7,8- million remuneration last year in the form of options. And stock options are the fastest-growing element in executive pay.
Other figures show that the average stock and option holdings of the top 200 US CEOs is now $57-million.
Some of the amounts handed to individual managers defy belief. Last December, Walt Disney CEO Michael Eisner exercised 7,3- million options worth $400-million. And that was on top of a further $591-million already stashed away.
The scale of options in the United Kingdom is smaller than in the US, and in South Africa it is a small but burgeoning trend to retain highly skilled staff. Anne Simpson, joint managing director of Pensions and Investment Research Consultants, notes that mild institutional disapproval has not been enough to hold back a huge new wave of share-option schemes among big companies last year. Reports of the death of share options are greatly exaggerated, she said.
Share options are a sublime example of capitalist inventiveness -essential to stimulate risk-taking and ambition. But dectractors take a different view: they insist that share options conceal a transfer of wealth to management on a truly epic scale.
How this came about is a cautionary story of corporate power and accounting cowardice.
One of the basic principles of accounting decrees that all costs, including the costs of employment, are charged to a company’s profit-and- loss account.
Stock options, partly because their initial significance was small and partly because the grant of an option appears to incur no immediate cost to the company or its shareholders, have never been subject to this provision.
A US company can claim tax relief when one of its employees exercises an option (uses the option to buy a new share at a knock- down price). That boosts net earnings. But the actual cost to the company and its shareholders of having to sell a share at a price below market value doesn’t have to appear in the profit-and-loss account.
The full scale of the giveaway has been computed by London research firm Smithers & Co. It estimated that for 100 of the largest US companies, reporting the true cost of options would have reduced published profits by 30% in 1995 and 36% in 1996. The figure for last year is likely to be even higher.
According to their calculations, some of the US’s high-tech stockmarket stars actually made a loss when stock-option costs were taken into account.
The logic of share options is to give managers an option to share in shareholder rewards and persuade them to act in the interests of shareholders. But there is no evidence that increased management ownership leads to superior financial performance. High levels of management ownership are not a magical prescription for high levels of performance, concluded a recent US study.
At the same time, the concentration of option power gives a tiny group of executives a strong incentive to drive the share price up by any legal means. The power of this incentive is illustrated by the merger of two US banking giants, Travelers and Citicorp. On the day the merger was announced, an exuberant Wall Street rewarded the CEOs of the two companies by increasing the combined value of their stock holdings by an eye-popping $315-million in one trading session.
There is evidence that executives with large option holdings attempt to push stock prices up by doing more share buy- backs, and more buying and selling of companies, than their optionless competitors.
International companies argue that they have to offer these packages to attract high-calibre executives.
Pensions and Investment Research Consultants’s Anne Simpson wants UK companies, as well as disclosing the costs of such schemes, to submit executive pay to annual votes of shareholders and to require top managers to buy shares with their own money, as other employees must do. At least UK companies are not allowed to offset options against tax, as US firms can.
Simpson says: “The blank cheques are still being written.” Around 100 major companies have introduced new stock-option schemes, even though, as a British accounting academic points out, they are highly tax-inefficient, both for companies and individuals. They do it, he says, only because “directors simply don’t want to admit how much they are earning”.
Personal disposable incomes for 1996 were probably 2% to 3% higher than those officially recorded, the London research firm Smithers estimates. So inflationary pressures may have been understated, while the effect of any major stock-market correction will be correspondingly amplified.
The stock-option phenomenon has the bizarre consequence of making real profits highly sensitive to a company’s share price, rather than vice versa. As this becomes recognised, investors could become warier of those high-tech companies where stock options are most prevalent and profits most overstated.