Congress has options on options

Heads we win; tails you lose.

That's the situation for investors who own shares of corporations that give executives lush stock-option grants, critics say.

If the stock goes up, top executives stand to get rich when they convert their options to stock and sell it. Moreover, the company gets a tax break.

Enron, for example, reduced its income-tax liability by claiming deductions on nearly $600 million in options payouts from 1996 to 2000.

But the investor loses. He sees his ownership in the company diluted by the new shares.

"It's a shell game," charges Graef Crystal, a veteran expert on executive compensation.

Some lawmakers want to require corporations to list options as an expense against revenues in their regular earnings statements, as they already do for salaries, bonuses, and some other compensation. But Mr. Crystal doesn't want that. He'd rather have firms make the change voluntarily.

The options issue is relevant to debate last week in the Senate over a massive accounting reform bill by Banking Committee chairman Paul Sarbanes (D) of Maryland. Sen. Carl Levin (D) of Michigan considered introducing an amendment requiring any firm that treated options as an expense for tax purposes do the same in financial statements. But an options-expensing amendment of Sen. John McCain of Arizona was clobbered by parliamentary maneuvers Thursday.

So Mr. Levin proposed that the Financial Accounting Standards Board (FASB) – the body which sets accounting rules – review within a year the options issue. It is expected to come up today.

Whether public disgust with corporate corruption eventually forces Congress to act on options remains unknown. The relatively tough Sarbanes bill could be diluted in conference with the House, which has passed a less ambitious accounting reform bill.

Opposition from Silicon Valley corporate executives, famed for making political donations, especially to Democrats, has so far blocked legislative action.

"These guys still have a lot of clout," says Crystal.

TechNet, a high-tech trade group, sent a group of its CEOs to talk to members of Congress. "An expense approach would be misleading to investors," the group contends. "Because options cannot be measured accurately, an expense will lead, by definition, to inaccurate financial statements." And it amounts to "a corporate tax increase" and will "severely limit the ability of companies to recruit and retain talented employees."

In the mid-1990s, high-tech firms succeeded in getting Congress to kill an effort by the FASB to require options expensing. Sen. Joseph Lieberman (D) of Connecticut helped clobber the plan. The FASB did, though, insist that companies put a footnote in their more obscure but comprehensive 10-K forms telling what earnings would be if options were included as an expense.

Crystal tells of one company, Sable Systems International in Henderson, Nev., which declared 50 cents per share profit in its 2001 annual report and a $1.02 loss in its 10-K report footnote, taking account of options.

Proponents of expensing admit that techniques to measure the cost of options are not precise. But expensing would still improve the accuracy.

Barry Ehrlich, a London-based analyst with the investment banking firm Dresdner Kleinwort Wasserstein, suspects two factors will force many US companies to expense options, regardless of what Congress does.

One is that the European Union appears likely to adopt options-expensing reform soon. Firms listed on European exchanges would then be required to expense options by no later than 2005.

This would be easier for European high-tech firms than for American companies. Ehrlich estimates 2001 published earnings would take a 25 percent hit. In the US, it would be 75 percent.

Companies issuing many options are "still overvalued," he reckons. Even Blue Chips would be affected. Expensing options would have lowered reported net income for companies in the Standard & Poor's 500 index by 30 percent in 2001 and an average of 10 percent in the prior three years.

If Europe acts, it could be embarrassing for those Americans who insist that the US has the best corporate disclosure system in the world for stock-market investors.

Another reason why options expensing may spread in the US, regardless of the law, is the growing pressure from the investment community, especially pension funds. (A notable exception is the California Public Employees' Retirement System, located in a state where many Internet and other high-tech firms employ options compensation heavily.)

In addition, such notables as Federal Reserve Chairman Alan Greenspan and famed investor Warren Buffett support accounting reform for options.

Moreover, 67 percent of North American institutional investors and 98 percent of those in Europe support option expensing, according to a survey by the management consulting firm, McKinsey & Co.

Last week, the nation's second-biggest owner of warehouses, AMB Property, announced it would henceforth list options as an operating expense. With the desire to remove blemishes from their books, more firms are expected to follow.

An analysis cited by Ehrlich finds that companies which issue a lot of options have, on average, underperformed the market. He figures that reform in options accounting should not only improve the transparency and reporting consistency of high-tech companies, but ultimately help lower their cost of capital.

"We also expect a greater degree of restraint on what has clearly been the wanton use of options by some," he maintains.

In Milan last week, a subcommittee of the International Corporate Governance Network recommended that the "true cost" of options be expensed. Their report started with a quote from Lewis Carroll's Alice's Adventures in Wonderland about the "Caucus-race," with runners in a sort of circle, going all over the place.

"Who won?" asks the crowd.

"All," replies the Dodo after a great deal of thought. "All must have prizes."

Wall Street, however, likes clear-cut races between companies with accurate books. It wants to give its prizes to only those firms that actually won.

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