Weighing Options

JIM LEHRER:

Finally tonight: The stock options debate, and to Margaret Warner.

MARGARET WARNER:

Federal Reserve Chairman Alan Greenspan said today that "infectious greed" gripped corporate America during the stock market boom of the '90s, and that's because, he said, so many executives and managers were receiving stock options as compensation.

ALAN GREENSPAN:

The highly desirable spread of shareholding and options among business managers perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising. The incentives they created overcame the good judgment of too many corporate managers. It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously.

MARGARET WARNER:

Many American companies, particularly high- tech firms, grant stock options– more than $160 billion worth in the year 2000, according to one study; triple the amount just three years earlier. Another study said four in ten large companies now grant options to their workers. A stock option gives an employee the right to buy shares in company stock sometime in the future at a preset price. If the stock rises in the meantime, the employee pockets the difference when he or she exercises that option. Companies are not required to count options as expenses against earnings.

MARGARET WARNER:

Senator John McCain tried, but failed, to change that. His amendment to a corporate reform bill to force companies to count options as expenses never came up for a vote last week.

SEN. JOHN McCAIN:

The fix is in, as we say all too often in the sport of boxing. The fix is in, and we will now have cloture invoked and there will not be a vote on stock options.

MARGARET WARNER:

The "fix," in his words, reflected heavy lobbying by technology companies against a change in the law that would dramatically affect their financial statements.

If options were counted as expenses, according to one brokerage firm, Intel last year would not have earned 19 cents a share, but 4 cents a share. Another brokerage firm said Cisco Systems' total income last year would not have been $4.6 billion, but $2.7 billion.

Whether Congress acts or not, some firms have decided to make the change on their own. Sunday, Coca-Cola announced it would begin treating future stock option grants as employee compensation. The "Washington Post" company followed suit the next day. Greenspan said today that the private-sector financial accounting standards board, or FASB, also might step in to issue new standards.

SEN. PHIL GRAMM:

Do you believe that Congress ought to vote on the issue of setting an accounting standard with regard to how stock options are treated?

ALAN GREENSPAN:

Well, I frankly don't think that one needs to do anything, as best I can judge what's happening. My own impression is that FASB will rule in a manner which, I think, from listening to what the various discussions are… in a manner which would appropriately expense stock options, which I think is a very important issue.

MARGARET WARNER:

Greenspan also predicted more companies would make the change voluntarily, as Coca-Cola did.

MARGARET WARNER:

So is Alan Greenspan right? Should companies count options as expenses? We join that debate with Rick White, president and CEO of TechNet, a national association representing more than 300 senior executives from technology and investment firms — He's a former Republican Congressman from Washington State; and Jennifer Arlen, a professor of law at New York University, specializing in securities fraud and business crime.

Let's start, before we get into the accounting issues, to both of you, starting with you, Rick White, just your view on whether this practice of granting so many stock options is healthy for the companies involved and for business as a whole.

RICK WHITE:

Well, I think it's clear and, frankly, I think there's a consensus that stock options are general is a good thing. We want employees to have a piece of the action, to feel like they're committed to the company.

And so I think stock options in general are largely considered a good thing. There have been some abuses, as Chairman Greenspan said, and there should be some ways to deal with those abuses. But what we're concerned about is if you start by expensing stock options, you end up making the whole system much more difficult to implement.

MARGARET WARNER:

Jennifer Arlen, do you agree that options in general, at least, are healthy because they give employees a stake in the company and the company's success?

JENNIFER ARLEN:

(network audio difficulty) Managers who work hard for the firm get to participate in the profit. But the amount of options we've seen goes way beyond what is probably appropriate. But the only way to know whether the options are too high is to ask the shareholders. And the only way to ask the shareholders is to tell them what the options are costing them and let them choose. And we can't do that unless we expense stock options.

MARGARET WARNER:

So… I'm sorry, we had a little audio problem with you, but what impact would it have, then, if companies were required to, essentially, deduct the cost of options from earnings?

JENNIFER ARLEN:

My impression is that having to deduct options will result in executives receiving fewer options. This would not be the case if executives are getting the right amount of options. Shareholders would say "Well, listen, this cost is worth it to us, you're doing such a wonderful job." The expensing of options will only hurt executives if the shareholders look at the cost and say "it's not worth it, you're not doing enough for us."

MARGARET WARNER:

What about that, Rick White?

RICK WHITE:

I agree with about 80 percent of what the professor is saying. I think you have to make sure that shareholders know what the option packages are. Frankly, I think you should make sure that shareholders approve stock option packages, at least for executives.

The concern we have is that if you deduct these charges from companies' earnings, you'll artificially make earnings look lower than they actually are. The fact is, you know, when somebody gets a stock option, the company's cash doesn't go down, its assets don't go down, nothing changes except the future distribution of stock on shareholders. And so it's entirely appropriate for the shareholders to have information about what that future delusion might be, but it's frankly misleading.

If your company makes a profit of a million dollars this year without stock options it has a profit of a million dollars, it has a million dollars in the bank. If it grants a whole bunch of stock options, it still has a million dollars in the bank. So to artificially deduct something from that I think would be a mistake.

MARGARET WARNER:

Explain this a little further. Let's say an employee is granted the option to buy ten shares of the stock at $50 and four years later he or she exercises that option, only on the market that stock now is worth $60. He or she makes a $10 per share profit. Who pays for that differential?

RICK WHITE:

Well, the employee has to buy the stock at the $50 number, then sell the stock on the marketplace if they want to. They're certainly entitled to hold the stock if they want to. So other investors who decide that $60 is the right price pay that and so the employee gets the benefit out of the marketplace. There hasn't been any payment from the company whatsoever and the company's assets stay exactly the same as if this transaction has never happened.

MARGARET WARNER:

Jennifer Arlen, do you agree that there is no direct cost to the company?

JENNIFER ARLEN:

No, I couldn't disagree more. The cost to the company is the value of the options themselves. The question is, how much money could the company have made if it had sold the options on the market instead of giving them to the executives? If it's the case that had the company sold the options on the market they would be worthless, then he's right, giving the executives options cost the company nothing.

But if people expect the company's stock to go up, then the company could have made money by selling the options on the market, and that's what it costs the company: The value of the options had they been sold on the market. And that's a real cost. And the company's balance sheet should reflect that cost. They've given something up.

MARGARET WARNER:

Rick White?

RICK WHITE:

No, it really isn't a real cost. It's not the sort of cost that we normally account for. It's not money or assets taken out of the company; it's an opportunity cost and in economic analysis, that's certainly one way to look at it.

But from an accounting standpoint, the assets of the company haven't increased or diminished whatsoever. They still have the same amount of cash, the same amount of assets and, frankly, they still have the same amount of stock outstanding. It's just when it's exercised later shareholders may have a slightly different percentage based on the exercise of these options.

So really I think it's misleading from an accounting standpoint to say there's a cost here that ought to be accounted for, like the cost of writing a check.

MARGARET WARNER:

Professor Arlen, do you think if companies were forced to make this change, would we see a lot of major restatements of companies' balance sheets?

JENNIFER ARLEN:

Well, it depends on whether we make this prospectively or retrospectively. Assuming we do it prospectively, I expect that many companies will reconsider their current balance between options and cash bonuses and also will lower executive compensation.

But at existing options levels, yes, I think many companies will have lower reported earnings than they have now and whether they have lower share prices or not depends on whether shareholders understood how much companies were paying their executives in options or not. If shareholders already understand this, it shouldn't affect share price at all.

MARGARET WARNER:

What do you think would be the effect, Rick White, on the earnings, particularly, say, of a lot of companies in the high-tech field?

RICK WHITE:

Well, what we're particularly concerned about is the effect will be is that companies can no longer give options to rank-and-file employees. The problem we have is that if you have to deduct these… some number accounting fees options from your earnings, a company that just gives these options to the top five executives, or the top twelve executives doesn't take a big hit to its bottom line. There isn't… even if they're highly compensated, it's not a huge number.

But if you give options to 20,000 employees, you spread it out among your employees like we want to encourage people to do, then that's a big number. And so your stock always looks worse than the guy down the street who does the wrong thing and just gives it to the top executives. That's what we're trying

MARGARET WARNER:

So you're saying…

RICK WHITE:

It's the ability to motivate all your employees.

MARGARET WARNER:

It would have a real effect on the bottom line, at least for some companies, or would appear to?

RICK WHITE:

Yeah. If you expense your stock options, that means you deduct some number and of course it's very difficult to figure out what that number should be. But you end up deducting some number from your earnings if you have a lot of stock options. If you're a company that limits them to just the senior executives, you don't have as many and you don't have to deduct as much as so your earnings looks better. That's the concern we have.

MARGARET WARNER:

Professor Arlen, do you see it that way, that if companies were forced to do this that it would be the average employee that would take the hit versus the big executives?

JENNIFER ARLEN:

No, I don't. I mean, the average employee is getting a relatively small amount of options and the truth is that part of what's going on, which he even suggested earlier is that options do come out of the pocket of shareholders because it will affect share value.

So it's important for companies to be honest about how much they're spending on compensation whether for executives or for their lower-level employees. And I don't really believe that the lower-level employees are the ones who will get hurt. It will be difficult now to award tens of millions of dollars a year to executives in options, if not more than that, right? And those are the options that will be cut back on, not so much the lower-level employees.

MARGARET WARNER:

So, Rick White, I know you watch Congress very closely as a former member. Do you agree with Chairman Greenspan's prediction that either this financial accounting standards board will move to institute this change or do you agree that a lot of companies will do this voluntarily if Congress doesn't act?

RICK WHITE:

Well, I agree with Chairman Greenspan's statement that Congress shouldn't decide this accounting rule. I mean, I think that's the last thing in the world a body like Congress can really determine accurately. They're not accountants so that's not the right place for them and I think he made that very clear today.

I think what I hope will happen is that FASB will take a careful look at this and consider lots of different things that they have to consider, including the effect on the economy and the effect on our ability to encourage people to take risks and innovate. So I think the jury is still out on exactly what FASB would do.

In terms of other companies, you know, you have to make a distinction between companies who really live or die based on whether they can innovate and take risks and have entrepreneurship and companies in more established industries. If you looked at Coca-Cola, for example, you know, they've got the formula for their product that's been locked in a safe if in Atlanta for 120 years. They're an established company. They have a little different way that they have to motivate their employees.

For a technology company who has to kind of reinvent the technology every year otherwise they go out of business, it's really vital to maintain that entrepreneurial atmosphere, that willingness to take risk and innovate and be creative. And that's why our people feel so strongly that they have got to be able to give people a stake in the company in order to be able to continue that.

MARGARET WARNER:

And, Professor Arlen, your prediction — do you think companies will do this voluntarily or do you think this financial accounting board will do it?

JENNIFER ARLEN:

We'll I'm not sure whether either will do it. I think it's critical that companies be able to pay options and shareholders, fully informed will certainly let them, they just may not let them at the same level.

Whether or not FASB will do this really depends on how much pressure the institutional investors put to bear on them. I see no reason why, for example the SEC cannot say that to do appropriate full disclosure you have to disclose your options expenses. The IRS, by the way, allows expensing of options. That's effectively an accounting rule. Why shouldn't the SEC also step in and say….

MARGARET WARNER:

On that note

JENNIFER ARLEN:

if you want to deduct it on your taxes, do it for us, too.

MARGARET WARNER:

Sorry to interrupt you but we have to leave it there, we're out of time. Thank you both.