Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [19]
In his 1985 letter to Berkshire Hathaway shareholders, Buffett challenged the CEOs of corporate America. He offered to pay a substantial cash sum to any executive granted a restricted stock option in exchange for the right to any future gain the executive might realize. Stock options are a real cost of doing business.You say you cannot value them? Great! I’ll pay cash for them. Now try to explain to your shareholders how this cash didn’t just come out of their pocket and move into yours. Warren’s challenge, which he continually reissues, remains unanswered.
Many corporate executives resist expensing the value of employee stock options, complaining there is ambiguity in how one values them. But accounting practices are rife with ambiguities. As long as the rules are understood, accounting helps paint a picture of corporate value with a semblance of consistency. For example, corporations depreciate expensive factory equipment according to accounting rules. While depreciation does not precisely capture the exact cost and timing of equipment replacements, it highlights the fact that there is a significant cost to stay in business. The rules of depreciation create some ambiguities; but one cannot use this as an excuse to ignore a real cost of doing business.Treating all employee stock options as an expense clarifies whether the hit to reported earnings is justified by the projected increase in shareholder wealth needed to compensate shareholders for the cost. No wonder some CEOs did not want to expense them.
The intent of stock options is benign, but the execution is flawed. In a rational world, options have a realistic strike price reflecting the true business value after building in carrying costs and retained earnings. If employees increase the value of the company beyond that, they can exercise the options, buy the stock at a reduced price to the future higher price due to employee value creation, and participate in the gain. It is theoretically possible to come up with a fair and rational strike price, but it is rarely attempted.
Stock options, which are call options, are a moral hazard inviting unnecessary risk taking because corporate officers get leveraged rewards for any success—and suffer no consequences if they fail. Officers of corporations can leverage up corporate balance sheets, make poor acquisitions to pump up revenues, and be rewarded for stock price pumping mischief. Out-of-control—albeit legal—management behavior has no penalty, and often brings rich rewards.
When Merrill Lynch parted ways with CEO Stan O’Neal in October of 2007, he received no bonus or severance, but he kept $161.5 million in accumulated compensation and retirement benefits, more than an entire neighborhood of lower middle class Americans will make in a lifetime.Yet, he left Merrill after it took an $8.4 billion writedown in the third quarter of 2007.3 Shortly thereafter, he took a seat on the board of Alcoa.
Derivatives like stock options can be used to leverage a bet.They can also be used to cover a scoundrel’s tracks. The Wall Street Journal exposed a scandal of broad-reaching implications. By August 2006, over 100 corporations—with more to follow—were under investigation for backdating stock options after Assistant Professor Eric Lie of the University of Iowa identified anomalies in the strike prices of employee stock options. The research suggested the prices were intentionally manipulated to give greater value to the recipients. The corporate officers involved are not founders of these corporations; they are merely stewards. These officers consciously betrayed the trust of stockholders, misstated financial reports, and diverted millions of dollars of shareholder wealth for their personal gain.
If the corporation marks stock options to market, it may record large fluctuations in value, even if very little money has changed hands. Employee