Pay me- quickly

As is nearly always the case, people and companies will find ways to circumvent regulations to their own benefit. It should hardly be surprising that the same is being done in relation to the new stock option expensing rules, known as FAS123R, that come into effect for many companies this financial year.

Despite a recent six-month extension to the deadline for the effective date for the expensing of options, the rush to bring forward vesting dates continues to gather pace. The idea is simple: get rid of as many options as possible before the rules take effect, thus reducing what needs to appear as an expense on the balance sheet. 

The practice is receiving a great deal of attention and opinion on its ethical grounding. The espoused benefits vary widely depending on whether you are an investor, a corporate or a lawyer/adviser. 

The drive to force firms to expense all options paid to executives and employees has been building for some time, and many influential figures have come out in favor of the idea. This led the Financial Accounting Standards Board (Fasb) to develop rule FAS123R, but the introduction of this rule has attracted incredible opposition from many corporations – so much so that the SEC controversially stepped in to delay the rule’s effective date. 

An uneasy truce

This intervention has not been popular. Speaking at a recent ‘proxy talk’ hosted by Glass, Lewis & Co LLC, John Biggs, former chairman and CEO of TIAA-Cref, said: ‘Institutional investors should be screaming bloody murder about the fact that the SEC has now over-ridden Fasb on stock option expensing in terms of the time of the implementation. I think it is inexcusable for us not to run with it and get it started, but now we’re delaying it for most companies until 2006.’ 

Biggs also raised doubts about the long-term fate of the rule. ‘Who knows what’s going to happen between now and then in terms of the political efforts of the opponents of expensing?’ he asked. 

Albert Meyer, general partner at 2nd Opinion Research, feels the SEC’s intervention is even more serious. ‘The SEC over-ruling Fasb and offering an extension on expensing is further proof that the commission is not interested in protecting shareholders,’ he says. ‘It is far more interested in the rights and needs of the executive community.’ 

Elliott Schwartz of the Council of Institutional Investors (CII) is also concerned about the impact the SEC’s interference might have. ‘We have doubts whether expensing will actually take place,’ he notes. ‘There is still a possibility Congress will step in again. The CII strongly approves of options expensing and we hope the movement toward expensing will continue.’

Regulators are now allowing companies to escape much of the impact of the rule by accelerating option scheme vesting dates. A recent report from Bear Stearns finds that, by early April this year, 102 companies had already accelerated the vesting dates for employee stock option schemes. Up to mid-May around 40 more had followed suit. Of the 102 firms, twelve accelerated both in-the-money and out-of-the-money options. Bear Stearns estimates that, as a result of the accelerations, $1 bn of options expense has circumvented future income statement recognition. 

The need for a new rule forcing the expensing of options is underlined by a report from Credit Suisse First Boston (CSFB). The research finds few of America’s largest firms including any expense for option payments. The report says that ‘up to December 2004, 77 percent of S&P 500 firms recorded no stock option expense in the annual report and accounts.’ 

The SEC was aware many companies would respond to the new rule by modifying vesting dates – as was shown in a speech in December 2004 by Chad Kokenge from the SEC’s office of the chief accountant. Talking about out-of-the money options, he stated: ‘We understand the perceived accounting benefit for modifying the awards to accelerate the vesting before adopting the new standard is that it allows the company to accelerate the recognition of compensation cost such that it only impacts the fair value pro forma disclosures required under FAS12.’ 

There are two opposing schools of thought on whether the accelerating of options should be allowed. Broadly, there are those who feel it should not be permitted under any circumstances and those who believe it is acceptable provided an explanation of the change and the reasons for it are included in the annual report. And then there are those, mostly the corporations themselves, that are against any sort of expensing in the first place. 

‘It is very simple – stock options are an expense and should be recognized as such,’ says Schwartz. ‘Acceleration of vesting dates is bad practice and there should be a very solid reason for doing it.’ And that reason does not include merely trying to avoid FAS123R. 

Mike Lofing, senior research analyst at Glass Lewis, has a similar view. ‘We find that most investors are strongly in favor of complete options expensing,’ he comments. ‘Increased transparency regarding the valuation of stock options allows investors to get a clearer picture of the true position of a company’s expenses.’ 

‘Institutional investors know how to look for the expense and reconcile it with Gaap,’ notes Schwartz. ‘There is a transparency issue here. The true value of all options and other incentive schemes should be made more obvious.’

Meyer toes a harder line. ‘Vesting acceleration is an utter farce,’ he declares. ‘Put simply, the non-expensing of options – and now the rush to accelerate existing plans – is nothing less than institutional fraud.’ 

Meyer is concerned that the real economic value (and thus the true cost) of options is not being reflected under current accounting rules. ‘Companies would never issue stock options as compensation if they were forced to account for them the same way they do in a tax return,’ he explains. ‘The true economic value of options is not being shown. Even under the new expensing rules this will still be the case. There are many ways to value an option in terms of volatilities, maturities, vesting dates, and so on. The firms are aware of this and simply change the numbers to get the best possible result – that is, the lowest expense – they can.’ 

Clear and valid reasons

The idea that vesting should take place only if there is a good reason for it is, to Meyer, a ludicrous one. ‘The only reason to accelerate vesting is to avoid disclosing the true liability,’ he points out. 

Companies have been quite candid in their explanations when announcing accelerating vesting. In a statement in February from Fairchild Semiconductor, CEO Matt Towse said: ‘We believe the acceleration is in the best interest of stockholders as it will reduce the company’s reported compensation expense in future periods.’ 

One of the fundamental purposes espoused for the use of stock options as a form of executive payment is that of incentives. Accelerating options vesting has a huge impact on this argument as, by bringing the vesting dates forward, the long-term incentive is, in effect, removed. 

‘The important thing when looking at any reorganization [of options plans] is that the new scheme has the same fair value as the existing one,’ explains Lofing. ‘If not, there has been a fundamental change in the agreement with the employee. One of the main purposes of issuing employee option plans is to provide long-term incentive. In the case of accelerating the vesting dates there is a real possibility the incentive will be removed.’ 

The Fairchild Semiconductor statement addresses this issue, revealing that ‘because the accelerated options are underwater they may not be fully achieving their original objective of incentive compensation and employee retention. In order to prevent unintended personal benefits to executive officers, restrictions will be imposed on any shares received through the exercise of accelerated options held by those individuals. Those restrictions will prevent the sale of any shares received from the exercise of an accelerated option prior to the earlier of the original vesting date of the option or the individual’s termination of employment.’ 

An inappropriate instrument

The language used by Fairchild s strikingly similar to that of most other firms that are accelerating vesting dates. Meyer feels this type of explanation borders on the insulting. ‘What they are saying is that the investment community is not particularly sophisticated and can’t work out that this is a genuine expense,’ he complains. 

Some commentators do not believe that options offeranything more than a very basic level of incentive for employees. Schwartz suggests ‘there is a very real question as to whether options are an incentive beyond tenure.’

Paul Volker, former member of the Conference Board’s Commission on Public Trust and Private Enterprise and former Federal Reserve chief, advocates expensing of options and goes even further, calling for the use of restricted stock rather than options. n fact, he refers to stock options as ‘a creature of the devil.’

What effect will options expensing and accelerating vesting have in the long run? Former SEC chief Arthur Levitt explained at the Glass Lewis event that disclosure is the key. ‘The SEC’s disclosure proposals on compensation are extraordinarily inadequate,’ he said. ‘If you combine disclosure on various elements of compensation with a true accounting of what they are,the implications of repricing those options and other benefits would dampen the enthusiasm for those elements of compensation very quickly.’

‘If the market truly understood the reality of stock options and buybacks, stock prices would plummet,’ Meyer observes.

Levitt feels the current scandals relating to excessive option grants, together with the likely expensing of stock options, will diminishdiminish the use of non-restricted stock options. With companies accelerating vesting dates, we might see a greatly reduced use of options in the future.

‘Accelerated vesting means companies have bought some time, in many cases up to three years,’ says Meyer, ‘so FAS123R will have almost no impact.’