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May 13, 2003
Investors Press Companies on Stock Options Expensing
    by William Baue

A shareowner resolution on options expensing is garnering support, and a California pension fund has released a study on how to best expense stock options.


Stock options may have been an arcane subject in the past, but it has become a hot topic for investors this proxy season, as the International Brotherhood of Teamsters has filed a shareowner resolution asking more than 100 companies to expense their stock options. The resolution has been getting strong support from shareowners. For example, the resolution received support from 65.3 percent of Georgia-Pacific (ticker: GP) shareowners last week, and last month it received majority votes at both Weyerhaeuser (WY--51 percent) and PPG Industries (PPG--52.4 percent).

What's more, the California State Teachers' Retirement System (CalSTRS) released a report last week entitled The Perfect Stock Option Plan, written by executive compensation expert Graef Crystal. CalSTRS, which manages the nation's third largest public pension fund with a $90 billion portfolio, commissioned the report to inform its proxy voting on executive compensation issues and its dialogue with companies on corporate governance best practice.

For readers unfamiliar with the arcana of stock options, a few words are in order. Unlike regular stocks, which must be purchased with money, stock options are granted to corporate employees, notably executives, as part of their compensation. They are meant to act as incentive to work hard, according to the logic that the stock price of a company rises as a result of efficient and effective work. Because stock options do not have a specific value until they are redeemed, many company do not report them as an expense in their financial statements, but rather include them as a footnote, as allowed by law.

The stock option expensing shareowner resolution quotes respected investor Warren Buffet, chair of Berkshire-Hathaway (BRKa), in making its case against the deceptive practice of omitting stock options from corporate financial statements.

"For many years, I've had little confidence in the earnings numbers reported by most corporations," wrote Mr. Buffett in a July 24, 2002 New York Times op-ed piece. "Without blushing, almost all CEOs have told their shareholders that options are cost-free. When a company gives something of value to its employees in return for their services, it is clearly a compensation expense."

"And if expenses don't belong in the earnings statement, where in the world do they belong?" Mr. Buffett asked.

As of January 1, 2003, many companies have voluntarily chosen to report their stock options as an expense, a trend that prompted the Financial Standards Accounting Board (FASB) to revise its guidelines for expensing stock options. Such companies include DuPont (DD), ConocoPhillips (COP), and Gabelli Asset Management (GBL), among others.

Other companies are sitting on the fence.

"A lot of companies--Gillette (G) being one--are saying, we're not opposed to the concept, but we don't want to do it until the formula is clear about how to expense them," said Tim Smith, president of the Social Investment Forum (SIF), the socially responsible investment (SRI) industry organization.

CalSTRS' report seeks to remedy this situation by offering a comprehensive and coherent solution to the abuse of stock options. Report author Graef Crystal demonstrates the growing abuse of stock options by comparing the value of stock options in the 1960s, when he served as compensation director for General Dynamics (GD), to now. In the mid-'60s, General Dynamics granted CEO Roger Lewis approximately $16,000 a year. Between 1999 and 2001, CEOs at 180 companies with revenues over $8 billion received stock options that averaged $9 million a year according to Mr. Crystal.

"That's 562 times the present value of Lewis' grant during the mid-1960s," Mr. Crystal wrote.

In addition to the skyrocketing value of stock option grants, Mr. Crystal also documents other stock option abuses, such as timing option grants when the stock price is low, and the repricing of options. Mr. Crystal likens the latter phenomenon to trading in a 1971 Cadillac directly for a 2003 model.

Mr. Crystal's recommendations follow the maxim passed along to him by former FASB board member Ray Lauver: "Never measured, never managed." Mr. Crystal also added the converse: "Measured, managed."

Consequently, Mr. Crystal recommends not only expensing stock options, but also requiring option grants at the same time annually, and discouraging option repricing by requiring economically equivalent exchanges.

"No more . . . trading in your 1971 Cadillac for a 2003 model in an even exchange," Mr. Crystal wrote.

 

 
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