Never mind the conventional wisdom that Republican control of the White House and the House of Representatives should augur an era of business-friendly government. The time may be riper than you think for a little pendulum swinging when it comes to stock options.
Between the collapses of the stock market, tech sector and economy and, now, the Enron Corp. scandal, the public is becoming somewhat disenchanted with the so-called entrepreneurial wealth creators that it worshipped for much of the past decade. And savvy politicos haven't missed the turning tides. Recently, stock options attracted the withering glare of Federal Reserve Chairman Alan Greenspan, who took the occasion of testifying before the House to wag a finger at the Financial Accounting Standards Board for its "unfortunate" 1994 ruling allowing firms to account for stock options with mere footnotes to financial statements, rather than take a direct hit to earnings. The practice not only caused management to focus almost exclusively on short-term earnings growth, he sighed, but also further pumped up an already inflated equities market. "We estimate that over the period 1995 to 2000, almost three full percentage points of the average annual gain in earnings resulted from the fact that stock options, rather than cash, was used as compensation amongst our major corporations," he told the House Financial Services Committee on Feb. 27. "This undoubtedly had an effect on accelerating earnings."
As far as Washington goes, there's hardly a person you could name worse than Greenspan to claim as a foe. So having the Fed chief decide that stock options are among the villains of the recent economic downturn probably means that executives should prepare themselves for some kind of change.
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But the story for stock options gets worse. Not only does Greenspan think the current accounting rules are too liberal, so does FASB, which promulgated the rule in the first place. The board is shifting the blame back to greedy politicians who wouldn't allow the appropriate reforms because of the lure of so much soft money connected with pro-business legislation. "In the mid-'90s, we had pushed for stock option reform," says FASB
spokeswoman Sheryl L. Thompson. "We wanted to have options expensed against earnings in the income statement." Thompson explains that the final FASB pronouncement, Financial Interpretation No. 44, requiring stock option costs to be footnoted rather than expensed, represented a less than desirable compromise that at least gave investors some notice of how much executives were taking home. "Prior to the work that we did, there was no information available," she argues. "Now the information is available. You just have to go look for it in the footnotes," adding that, in any case, "we have done our work, and we have no plans for taking [the issue] up again."
So, that's it? Not quite, since FASB will also be getting a new chairman in June, and there's nothing like a change at the top to give a group the rationale for a reassessment.
What's more, Congress is making noises as well–and in the Senate, the cries for change are coming from two respected mavericks, John McCain (R-Ariz.) and Carl Levin (D-Mich.). In February, the two introduced legislation entitled "Ending the Double Standard for Stock Options Act." The measure, if it becomes law, would deny a corporate tax deduction for option gains in the year of exercise unless the same amount was charged against earnings. In the floor statement he made to introduce the bill, Levin cited an analysis by Citizens for Tax Justice which claimed that one-third of the $1.8 billion in income reported by Enron in the five years ending in 2000 was the result of stock option inflation because companies were allowed to omit employee stock option compensation as a charge against earnings. "Enron could give its executives, directors and other employees $600 million in stock options and never show one penny of that pay on its books," Levin told his fellow senators. "It could dole out stock options like candy and never reduce by one penny its alleged income of $1.8 billion." At the same time, he said, Enron was able to avoid paying income tax by claiming the same $600 million as a write-off.
Pro-option forces believe Levin is being disingenuous about his bill. According to Frederick W. Cook, president of a New York consulting firm bearing his name, it "is ostensibly a tax bill," but posing as an accounting bill. Gains from stock options are already taxed at 39.6%, he says, and the option profit would cause companies to be taxed "at the marginal corporate tax rate of 35%," which means the government could pocket 74.6 cents on the dollar of option profit.
So what does all this mean for the world of compensation? You already have top executives using the relinquishing of stock options to demonstrate moral correctness. "We will not take cash compensation, restricted stock or option grants that would make our results superior to yours," wrote Berkshire Hathaway Chairman Warren E. Buffet, in a Feb. 28 letter to shareholders in part designed to explain how he lost them $3.77 billion in 2001.
But after the mea culpas subside, will executives actually see fewer stock options, particularly if some form of the Levin-McCain measure were to pass? Clearly, stock options become a less advantageous tool for companies to keep executives content if they suddenly must be charged against earnings and/or eliminated as a tax deduction. If FASB or Congress make a decision quickly–under the mounting Enron spilloff–without openly discussing the matter with the corporate community, the answer could be yes. Russell Boyle, an executive recruiter for search firm Egon Zehnder International, notes that it is important for shareholders, directors and executives to demonstrate how stock options can be awarded fairly to the benefit of everyone. "Stock options can be a tremendous incentive in aligning management's interests with the company's," he says. "It would be terribly unfortunate to see options so diminished as to remove what has been a benefit to executives, managers and employees."
IF LEVIN-MCCAIN BILL BECOMES LAW
- Companies would be limited on taking a tax deduction on stock options to the amount they claimed as an expense on their financial statement
- Companies could only take the deduction in the year in which the employee declares the stock option income
- Companies would be restricted on the research tax credit they claim for employee wages paid in stock options
Source: Sen. Carl Levin (D-Mich.)
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