Full Disclosure On Stock Options

April 18, 2003
| By Katy Rent |
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GRAND RAPIDS — It turns out the captain may not always go down with his ship —not if he can, say, stay afloat on his stock options.

And according to a Grand Valley State University business professor, the CEOs of some of the country’s largest public companies are keeping a dirty little secret concerning just how many of those stock options they actually have.

That is a magical number the Federal Communications Commission (FCC) and Financial Accounting Standards Board (FASB) have been trying to get CEOs to disclose for quite some time now — and they have been successful, to a point.

“FASB came up with an idea eight years ago or so that companies should release or tell shareholders how many stock options they have given to the insiders or managers of the company as well as everyone else,” said Mick Swartz, associate professor of finance.

Swartz has performed extensive research on the salaries of CEOs and their compensation packages.

“Many companies complained,” he said, “that they would have to get rid of stock options for many of the other employees if this happened and [that it] could cause stock prices to go down.”

For some time, he added, the industry avoided the idea of stock options disclosure, but in the end decided to require companies to disclose how many options were out there so that shareholders could have a more accurate idea of how big a piece of the pie the top executives actually owned.

Swartz added that while this was a good concept, there really wasn’t a good method to use to find the value of an option.

He said FCC and FASB offered corporations three methods to compute the value, but he said none of those methods was very accurate.

Now that the hurdle had been jumped and companies had to report a general value of stock options, Swartz said there was still another catch: There was no requirement to include in the report of earnings the actual number of stock options.

“The disclosure was useful, but not enough,” Swartz said. “And all that companies had to do was include a little footnote saying ‘We estimate costs to be about this much.’

“But there was still a good chance you were getting an inaccurate number,” he said.

Swartz noted that fairly accurate models are available to determine the value of an option to buy for a short period of time — say nine months. But the longer the term of the option, he said, the harder it is to compute the option’s true value.

He said that calls for additional disclosure have arisen again as stockholders and regulators discovered the proliferation of stock options and began finding out that companies often were using more stock options than they were revealing.

One reason for this proliferation, Swartz said, is that the options awarded to program managers are set up to increase with their salaries.

He said that often executives making salaries of $1 million to $2 million actually may have as much as $19 million in stock options.

And depending on how those stocks perform over the year, he added, the executive ultimately could end up receiving $20 million to $25 million for a given year.

“Managers are rewarded on stock prices going up, not earnings,” explained Swartz.

“The two usually move in tandem, but not always.

“The import figure, though, lies in how much the stock price goes up. A manager may have a clause in his contract that states when the stock price goes above $15 a share, for every dollar earned, the manager receives a bonus. So if the price goes to $20 a share, they may receive $2 or $3 million.”

Swartz said that the positives and negatives, however, tend to even out.

He said in his research he found that, in the end, managers act in the interests of the shareholders.

He explained that his logic is that the managers are rewarded by making the stock price go higher and — by virtue of creating more value — they get a piece of that added value.

However, Swartz noted, managers alone are not solely responsible for the rise in value of a company or a stock.

The employees have a hand in it, too, he said, and often employees aren’t given any stock options. In addition, he pointed out that managers rarely are held accountable for stocks going down.

Often what will happen, Swartz said, is that when the price of a stock goes down, the manager is often given more stocks, at the new lower price. He said it’s a way of resuming the same incentives all over again, all in an effort to keep the manager with the company.

Of course, he said, sometimes the current manager just can’t seem to make the company work and a replacement is needed.

And looking for a highly reputable individual to take over a failing company is going to be an expensive investment, Swartz added.

“You want someone good to make the company viable again and that is going to cost money up front,” said Swartz. “However, in the end it is one of the smartest investments. And it is the most crucial decision you have to make.”

Swartz added that not many people want to run a failing business. But it’s when a business is failing that the best person is needed, he said, and that is going to cost the company.

The result, he noted, is going to be a return on investment that will be worthwhile. The $20 million a company may invest in a new leader may come back in the form of $20 billion in revenues.

“Many managers aren’t prepared to go through the good and the bad with a company and in many cases aren’t held responsible if the company does plummet,” said Swartz.

“If compensation were based on earnings it would be entirely different. However, then we get into big potential for fraud, as in the Enron case.”

Swartz said that in his opinion there is a 50-50 chance that full disclosure of stock options will go into effect as law.

“Just knowing varied figures and how much is really out there can really make a difference to shareholders,” said Swartz. “Knowing the value of those shares is very important.”

And while Swartz believes this is still a worthwhile way to compensate managers he does feel strongly about disclosing more information to shareholders.

“The more open you are with your shareholders, the more they are going to trust you,” he said.

“And the more they trust you, the more they may believe in your company and want to invest in it and drive up your stock price,” said Swartz.

“This really can turn out to be a good thing for companies and can in the end, be a big win for upper level management.”

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