How Stock Options Became Toxic - 17 March 2010, Huffington Post

http://www.huffingtonpost.com/dr-philip-neches/how-stock-options-became_b_500732.html

Written by:  Dr. Philip M. Neches

When we decry over-sized CEO compensation in today's Corporate
America, it is mostly stock options that draw the public's ire. They
drive corporate leadership towards ever shorter time horizons in ways
that run counter to the interests of customers, employees, and
shareholders. Many people are now mad as hell and want it changed. But
it wasn't always this way, and it's worth taking a moment to reflect on
how it got so bad.

Before World War II, corporate executives earned large salaries, but
typically had no ownership interest in their enterprise. Owners
complained that the managers ran the company for the benefit of the
managers, not the owners. Then people had the bright - and obvious -
idea that if the managers were also shareholders, their interests would
become more aligned. Executives and shareholders would start to think
the same way about key trade-offs: growth versus dividends; risk versus
reward; short-term versus long-term.

Thus it became commonplace that at least the senior executives of
corporations would get part of their compensation in company stock. By
the 1980's, the most effective form of "equity compensation" became
stock option plans. The tax code and the accounting standards of that
day made "incentive stock option" plans pretty much a no-brainer. The
company granted the employee an option to buy the company's stock in the
future at a price that reflected the value of the company on the day
the option was "granted." The employee had to stay with the company for
the rights to actually buy the stock to "vest." Also, the longer the
employee stayed, and the better the company did, the higher the price of
the company's stock when the employee finally exercised the options and
sold the stock, so the more the employee made.

The employee was rewarded for loyalty and productivity, sometimes
lavishly. Stock option exercises could be life-altering events for
people. Some retired early to start their own businesses, change
careers, or simply relax. Lower level stock option holders could earn a
nice nest egg for purchasing a home or sending kids to college.

The best thing was that the employee participated in the upside of
the fortunes of the company without being exposed to any downside. If
the company did poorly, the options might be worth less than the
company's current share price ("under water"). But the company's
fortunes could improve. If not, the employee could walk away with his
or her salary, but without any loss or liability from the stock options.

Companies, particularly start-ups, benefited because they could
deliver significant compensation without spending precious cash. For a
start-up that had to manage cash very frugally, this was key to
attracting experienced talent away from larger companies with better
benefit plans and higher salaries.

Ultimately, the company had to record a compensation expense when the
stock options were exercised. Public companies reported the
accumulating liability in a footnote to their balance sheet. But unlike
salary increases or bonuses which send cash out the door, stock option
exercises bring cash into the company.

But wait, it got even better. Companies often lent the employee the
money to exercise the stock options, encouraging them to hold the stock
even longer. The tax code totally encouraged this by treating the gain
from the date of option grant to the date of option exercise as ordinary
income, but treating the gain from option exercise to share sale at
lower capital gains rates. If the employee held the stock for more than
a year, that became long-term capital gain rates, which are the very
lowest in the tax system.

So the tax and accounting rules encouraged and employee to wait as
long as possible to sell the shares. In the mean time, owing the shares
gave the employee a very real sense of economic destiny linked to the
long-term fortunes of the company.

In the 1990's, all this started to change. First came "back-dating"
scandals. The bigger the gain, the bigger the reward to the employee,
so why not pick an earlier date when the company stock was even lower to
start the process? The gain, particularly the part taxed at maximum
rates was bigger, so where was the harm to the public? The real
objection is that it just wasn't honest, and that started a wave of
changes to stock option treatment by the tax code and accounting
standards bodies.

The first option to go was the comfortable form in which the employee
did not have to pay taxes on the gains until the shares were sold.
That kind of option was not totally abolished, but it was put under so
many conditions and restrictions that it has become useless,
particularly for senior executives.

The exercise of the stock options always creates a "taxable event."
In the old days, the taxpayer did not have to cough up the ordinary
income tax until the shares were sold, usually many years later. Now,
under most stock option plans, the exercise event creates a liability to
pay up in the very same tax year as the exercise. And the company can
no longer loan that money to the employee. Ouch!

Next, the Financial Accounting Standards Board forced a change on
public companies, having them record the estimated future compensation
expense on the day of option grant. Never mind that the value of that
compensation depends on the stock price in the future, which by
definition is unknown. So whatever is on the books, it is almost
certainly wrong. But there it must be, per FASB. And it reduces the
company's reported earnings, even though it costs the company no cash.
In fact, the ultimate exercise of the options will bring new cash into
the company.

Instead of holding the options and shares until retirement years in
the future, the employee now is compelled to exercise the options and
sell the shares immediately - often the very same day! The options
become less a long term incentive and more of a short term bonus.

Corporate boards compound the problem when they stick with stock
options instead of moving equity compensation to other forms, like
restricted stock programs. While no program available to a company
today is as attractive to employees as old incentive stock options, at
least they do a better job of aligning management interests and
shareholder interests than what stock options have become.

Other boards make it even worse by shortening the vesting periods, in
effect encouraging ever shorter-term thinking. It has gotten worse
across Corporate America, but no industry has gone as far to the short
term extreme as the financial services industry. However, boards are
simply responding to how the investing public reads the financial
statements. If granting options creates an expense this year, why not
let the executive get the stock this year and bring in the cash from the
exercise?

But for the executive, the best way to make a gain on the stock
options without taking horrendous personal risks is to see the company's
share price go up in the short run, then exercise the options and sell
the stock. It is almost all taxable as ordinary income. The incentive
for the executive is the same as if he were paid a cash bonus for short
term increases in the company's stock price. But it is better for the
company, because instead of sending cash out as a bonus, the company
gets cash in for exercising the options. The shareholders are "paying"
through the dilutive effect of more shares being issued, but they don't
care, because the price of their shares has increased.

For both the company and the executive, bigger is better. Hence the
positive feedback loop of ever increasing stock option packages. Until
we have reached absurd levels where a CEO can make 2,000 times as much
as an entry level employee.

There is a funny rule about compensation plans. People actually do
what the plan incentives would have them to do. Same with the tax code.
So the short term thinking and extreme risk taking on Wall Street is
not an accident. The CEOs did what they were paid to do. They will
continue to do it as long as that is how their compensation is designed.
They would be fools to do otherwise.

There are plenty of culpable parties in the recent financial fiasco.
But don't pin all the blame on the CEOs. Corporate boards share a lot
of culpability, along with Congress for changing the tax code and the
accounting standards bodies for the unintended consequences of their
actions. The problem will not submit to a simple, quick fix. The
underlying structure needs reform, but in subtle, interconnected ways
that make good policy, but poor political theater.