The Wall Street Journal Wednesday strongly endorsed a paper by Kip Hagopian in the California Management Review denouncing the expensing of stock options, and demanding a return to the previous system whereby stock option costs were as far as possible ignored. The paper was co-signed by 26 eminent figures, including astoundingly Milton Friedman. I will defend staunchly the proposition that Friedman is the greatest economist of the last half century, but if the Royal Swedish Academy of Sciences reads the paper and is doing its job it will seriously consider revoking his Nobel.
The Hagopian paper claims that expensing stock options is improper accounting because stock options represent a contract between shareholders and employees, that is outside rather than within the company itself; thus their cost should not be reflected in the company’s accounts.
This claim looks plausible (albeit far fetched, since I know of no other cost item that gets treated this way) until you consider the question of where the stock option expense should be reflected. Contrary to tech sector management’s belief, it’s not magic money from nowhere, so if it produces a gain for the recipients of stock options (and it certainly does) it must produce an equal and opposite cost for someone else. If it’s a “gain sharing instrument” between shareholders and management, as Hagopian claims, the cost of the gain must be attributed to shareholders.
For individual shareholders, this would not matter; most of them would attempt to claim the loss from the IRS, then grind their teeth when the deduction was disallowed. However, in the case of mutual funds, the grant of stock options clearly increases the management costs and expenses of the funds, and so should be added to such costs. This would be highly salutary, but not very helpful for the tech sector, as tech sector mutual funds would all report management and operating costs of perhaps 8-9 percent of assets per annum. Since mutual fund shareholders, unlike hedge fund shareholders, are not stupid, nobody would invest in tech sector mutual funds on such a basis, and the tech sector would be unable to raise money from the mutual fund pool. Pension funds, also, would have a fiduciary duty not to invest in securities that imposed such exorbitant costs.
Not only is the accounting treatment recommended by Hagopian bizarre, therefore, it would also if carried through logically render the tech sector a highly unattractive investment unless stock options were eliminated altogether — presumably not the result he had in mind. In reality, stock options are executive compensation just like any other executive compensation; they are a cost of running the business which would presumably fall apart without a CEO (in some large companies, a Dilbertian view that top management is the chief obstacle to progress may be appropriate, but surely not in all of them.) Thus they need to be expensed on the income statement; the only question is how they should be valued.
The principal objection to “free” stock options for management is not accounting but economics – it provides management with incentives that are highly detrimental to the interests of shareholders.
In the early 1990s, when stock options were becoming fashionable after the Revenue Reconciliations Act of 1993, in an economically illiterate move, had disallowed management compensation above $1 million as a deduction from corporate income tax, the principal justification for stock options was that they aligned management’s interests with those of the shareholders. Nothing could be further from the truth.
The principal difficulty in making shareholder capitalism work is the agency problem between management and the shareholders. In the Anglo-American system (the German system is different, and in some respects better) management is appointed by the Board of Directors, who are elected by the shareholders at the Annual General Meeting. In a family company, as were most enterprises in the early years of industrialization, this works fine – any nonsense from management and the family gets together to put pressure on the directors to remove them.
In a company with a broad public shareholder base, it’s not so easy. Obviously, one difficulty is that it may be very difficult to assemble a coalition to do anything, so that shareholders’ rights may not be properly asserted. More important, many of the shareholders are institutional, therefore having owners who themselves have an agency problem with the managers of the money. This immediately provides a temptation for institutional managers to collude with company management against the interests of shareholders. If that happens, individual shareholders might as well give up immediately; they have neither the voting power nor the organizational capability to resist.
There are many ways in which collusion between institutional money managers and company management can manifest itself. One is political: as fashionable nostrums such as environmentalism, divestment from un-favored countries and “corporate social responsibility” appear, money managers and corporate management can and do collude to fritter away shareholders’ money on them. Another is excessive freebies – what could be more natural than management taking favored institutional shareholders to the company box at the World Series? A third is charitable contributions – nothing warms the heart of the major charitable donor more than the knowledge that it is somebody else’s money he has given.
In the case of stock options, it would at first sight appear that management and institutional shareholders have a traditional win/lose relationship: as value is extracted by company management through stock option grants, stock performance should suffer and the institutional money managers be correspondingly penalized. However, in the case of stock options, two factors mitigate this. First, if the options are not expensed and exercise of the options is delayed several years, their granting has no impact on the financial statements of the granting company, and hence money managers have no incentive to prevent the options being granted – in five years time, when a massive transfer of wealth from shareholders to management occurs, they will be managing other money and their role will be forgotten.
Even with expensing of options, they may not be properly expensed. The current FASB Statement 123R allows a wide choice of methods for options expensing, and it is safe to assume that the majority of companies in the tech sector will choose the method that is least damaging to the income statement, hence generally least adequate as a statement of reality. Google, for example, opted to amortize granted stock options over the 5 years of their life; since at the time of its Initial Public Offering it had only been issuing options in substantial numbers for a year, this effectively divided its option expense by 5 in the financial statements used for its IPO document.
However, there is a greater and more generally important conflict in the stock options issue, which is that both company management and institutional money managers mostly belong to the MBA-educated affluent management class. Without buying excessively into Karl Marx’s vision of inevitable class conflict, it has to be admitted that if a particular class of persons together control the economic system (which between them, corporate management and institutional money managers do) they may be able to rig it in their favor.
Judging from the Census Bureau’s 2005 “Income, Poverty and Health Insurance Coverage in the United States” that is precisely what has happened. Real median household income in 2005 was lower than in 2000, on the other hand, the top 5% of income earners have seen a significant increase, even though their income from investments has sharply declined from 2000’s bubble high. The household Gini coefficient of inequality has risen to 46.9, well towards Latin American levels (mostly in the 50-60 range) and far above its early 1970s level of around 40. The top 1% of earners have seen their average remuneration rise from 8 times the national average in 1980 to 16 times in 2004. Fortune 500 CEOs received around 240 times the compensation of the average worker in 2005, up from a ratio of 20 to 1 in 1980. The compensation of institutional money managers has increased commensurately, with the fee and compensation structures in the hedge fund sector exerting a particularly sharp upward pressure in recent years.
In the long run, competition from foreign companies with less exorbitant management pay scales will prick this bubble, and a good tight-money recession will precipitate reform. However, the mechanism by which the bubble was inflated is pretty clear, and un-expensed executive stock options, whereby management gets money but shareholders are apparently unaffected for several years, have been a key element in that mechanism. Their economic damage, as well as their accounting fallaciousness, really isn’t seriously debatable.
As far as shareholders themselves, rather than the wider economy, are concerned, stock options incentivize management to pump up short term earnings and engage in other activities that inflate the stock price in the short term at the expense of the long term health of the company. Accounting chicanery in particular is attractive to option-compensated executives, as shown by data on the prevalence of “extraordinary items” in corporate income statements, which averaged 5% of earnings of companies in the Standard and Poors 500 Index in the 1980s, reached an alarming 60% of corporate earnings in the recession year of 2002 and are now running around 15-20% of Index earnings.
There’s a case for banning incentive stock options altogether in publicly held companies; they are un-transparent, prone to fraud (as in the options backdating scandal), incentivize management poorly and encourage management and institutional money managers to pump stock prices at the expense of long term shareholders. There is no justifiable case for losing the hard-won gains of 2004 by removing options costs from the income statement. The “free money” un-expensed stock options zombie needs to stay dead.
Professor Friedman, there’s a runaway U.S. monetary policy that needs your attention!
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)