Fixing the Flaw in Executive Options

I've penned a few RealMoney columns about the problems with stock options. Before I discuss possible solutions, here's a quick review of the key points in those pieces:

Options encourage wrongful insider trading: Insiders, privy to material inside information, are not supposed to trade on it. The very nature of stock options (e.g., if the stock price falls below the exercise price, they are worthless) creates an enormous incentive to sell stock acquired via options ahead of bad news. Usually, wrongful trading is impossible to prove. But sales in front of bad news occur nonetheless. In that column, I highlighted a few insider sales of stock (acquired by options) that happened before bad news, including a very profitable one by former Sen. Bob Kerrey.

Earnings at many companies are illusory: If you include the cost of options, then Cisco (CSCO - commentary - Cramer's Take), Amgen (AMGN - commentary - Cramer's Take), Qualcomm (QCOM - commentary - Cramer's Take) and eBay (EBAY - commentary - Cramer's Take) each lost money over the past five years. Calculated with options costs, these companies lost more than $4.5 billion combined instead of earning the $9.7 billion reported. The $14.2 billion difference represents the amount of cash required to keep shareholders in a static position -- no dilution, net of the tax benefit that the companies received.

Option liabilities are huge at many companies: Despite the fall in equity prices, option liabilities are still enormous -- and they're unstated on the balance sheet. In this column, I reviewed several companies whose option liability represented a material percentage of their assets. While many companies are loath to pay shareholders much in the way of dividends, they'll aggressively allocate a large percentage of resources to paying management via stock options.

An Insurmountable Flaw

One more overriding problem with options hasn't yet been discussed, but it merits throwing the entire option system overboard in lieu of something more sensible. Linking compensation to a short-term stock quote -- as opposed to long-term business value -- is a structural, insurmountable flaw of the system.

In recent years, business leaders like Larry Ellison of Oracle (ORCL - commentary - Cramer's Take), Michael Eisner of Disney (DIS - commentary - Cramer's Take), Michael Dell of Dell (DELL - commentary - Cramer's Take), Thomas Siebel of Siebel Systems (SEBL - commentary - Cramer's Take), John Chambers of Cisco, Jozef Straus of JDS Uniphase (JDSU - commentary - Cramer's Take) and many others have made $150 million or more in a single calendar year from stock options. In every case, the current stock value is substantially below the price it was when they cashed in the options. These executives profited from a short-term stock price, not from long-term value creation.

Here's the key: Stock options are valuable to a holder based on the stock's volatility. Long-term value creation isn't required to make lots of money holding options. In fact, the current market decline is like manna from heaven for participants in option plans. Some of their option grants are now under water, but they'll soon get new grants at very low exercise prices. And if the market continues to fall, that's fine, too, because they'll get another load of options next year at even lower prices. As long as stock prices are volatile, option holders can make lots of money, regardless of whether business value increases or decreases.

Fixing the Problem

How do we put an end to stock options, an experiment in compensation that's gone woefully wrong? First and foremost, boards of directors need to get a grasp of the problem. They aren't fulfilling their fiduciary duty to protect shareholders' property -- largely because many boards are ignorant of the harmful effects of stock options. They can't prevent the damage if they don't understand it. Here's a brief primer, then, for my director friends.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.