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FYI - a discussion on effects of stock options (may be the same points the other guy was trying to make from last year's post but better written). Nancy
- To: "'firstname.lastname@example.org'" <email@example.com>
- Subject: FYI - a discussion on effects of stock options (may be the same points the other guy was trying to make from last year's post but better written). Nancy
- From: "Montague, Nancy" <Nancy.Montague@nreca.org>
- Date: Wed, 28 Jun 2000 11:52:58 -0400
June 13, 2000
The Consequences of Corporate America's Growing Addiction to
By GRETCHEN MORGENSON
Microsoft and Cisco Systems, two of the nation's most
profitable companies, are well on their way to owing nothing in federal
income taxes on the money they have made so far this year.
How can powerful companies like these, reporting billions in
income to shareholders, owe nothing in taxes? It is all thanks to the wonder
of employee stock options.
Stock options have made many Americans wealthy beyond their
wildest dreams over the last decade. Less understood is how much stock
options have benefited the companies that offer them. But when stock prices
stop rising, some economists and investors warn, companies and their
shareholders will find themselves paying a heavy price for something they
thought was a free lunch.
Consider how options help eliminate a company's income tax
bill. Under I.R.S. rules, employees pay ordinary income taxes on the gain
they receive when they exercise their options, even if the gain is only on
paper. When they exercise their options, their company receives a tax
deduction equal to the gain.
With the stock markets soaring and many employees cashing
in, the taxes the employees pay on their gains have meant deductions that
greatly reduce and in some cases even wipe out some companies' current tax
bills. This does not mean the federal government is reaping less in taxes.
It simply means that the tax burden has shifted from corporations to
individuals, most of whom willingly pay because the taxes are so much less
than the gains.
Microsoft's options-related tax deduction of roughly $11.4
billion in the first nine months of this fiscal year, for example, saves the
company $4 billion in taxes. The size of that deduction, which shows up only
on the company's tax returns, exceeds the $10.6 billion in pretax income
that the company reported to shareholders. So while Microsoft may escape
taxes this year, its employees will presumably pay tax on that $11.4 billion
at ordinary rates.
Tax breaks are not the only benefit to corporations. Options
can also significantly cut companies' labor costs as employees, eager to get
rich off their options, demand less in cash compensation. Lower labor costs.
What more could a company ask?
"Stock options have become as American as motherhood and
apple pie," said Patrick S. McGurn, a vice president at Institutional
Shareholder Services, an investment advisory firm in Rockville, Md. "It has
all been fueled by this notion that options have no cost and that there is
an unlimited supply of them. It's like the government and its printing
press. But ultimately the market is going to suffer. The day of reckoning
When that day comes is, of course, unclear. But when stocks
stop soaring -- and many have done so this year -- the equation upon which
option mania is based changes. Employees exercise fewer options and
companies' tax bills will rise. And as worried employees begin to demand
more of their compensation in cash, companies' labor costs rise.
Desperate to appease employees, many companies will issue
even more options. After Microsoft's stock tumbled on the prospect of a
breakup by the government, the company issued $1.9 billion in new options in
April to supplement those issued last year that are worthless. This comes on
top of the $69 billion in outstanding Microsoft stock options as of last
Trouble is, the more options there are, the less valuable
the stock becomes.
Options carry significant costs. One is that companies must
buy back millions of their own shares to offset the stock they have
dispensed to employees at much lower prices in option programs. If they do
not repurchase stock, there will be so many shares on the market that the
company's earnings, on a per-share basis, will plunge. This is known as
In the last three years, for example, Dell Computer has
bought back $3.6 billion worth of stock to reduce share dilution. In the
period, Dell's net income totaled a little over $4 billion. The money Dell
put into buybacks might have gone into research and development.
Dell is not alone in stock repurchases. A 1999 study by J.
Nellie Liang and Steven A. Sharpe, researchers at the Federal Reserve Board,
found that in 1998 the 140 largest nonfinancial companies in the United
States expended 40 percent of their earnings to buy back shares, up from 17
percent of earnings used to do so in 1994. The study noted that large
companies have borrowed money or run down financial assets to finance
The upside of stock options has been well-chronicled in
recent years. They allow cash-poor start-up companies to attract talented
employees and help established companies keep the workers they have.
And options reward hard-working employees and give them the
benefit of ownership in their enterprise.
All to the good. But corporate America has played down the
costs associated with options. As a result, what began as a dalliance
threatens to become an addiction.
The number of employees receiving stock options in the
United States has grown to as many as 10 million from about one million in
the early 1990's, according to the National Center for Employee Ownership.
About one-third of companies have programs offering options to lower-level
workers as well as executives, according to Pearl Meyer & Partners, an
executive compensation consulting firm in New York. Last year, 200 of the
nation's largest companies granted equity incentives -- mostly options -- to
employees that represented 2 percent of the companies' shares outstanding,
on average, the firm said. Ten years earlier, the so-called grant rate was
about half that.
Now that many share prices are falling, options will harm
the value of a company's shares even more than they did when stocks were
higher, Mr. McGurn of Institutional Shareholder Services said. That is
because executives' option grants are typically based on a dollar figure,
say $2 million, rather than on a number of shares. A falling stock price
means more shares dispensed to the executive in an option grant.
As managers' compensation has depended more on stock
options, keeping the share price rising -- and options in the money -- has
Walter P. Schuetze, former chief accountant for the
enforcement division of the Securities and Exchange Commission, says the
prevalence of accounting gimmickry at many American companies is in part a
result of the increasing popularity of options.
"The amount of management compensation tied to the stock
price is huge," Mr. Schuetze said. "And it is driving corporate managers to
make their numbers so the compensation gets even larger."
An academic study by David Aboody, assistant professor of
accounting at the University of California at Los Angeles, and Ron Kasznik,
associate professor at Stanford University's business school, found that
executives manage the disclosures of corporate news to increase the value of
their options. The study will be published in the Journal of Accounting and
Studying option grants made between 1992 and 1996 at 1,264
public companies that make awards on fixed schedules, Professors Aboody and
Kasznik found that companies had significantly lower returns in the period
before the award than in the period immediately after it. This confirmed to
the professors that executives delayed announcing good news until after the
award dates and rushed out with bad news before the options were awarded.
"Such a disclosure strategy," the professors wrote, "ensures
that decreases in the firm's stock price related to the arrival of bad news
occur before, rather than after, the award date, while stock price increases
related to the arrival of good news occur after, rather than before, the
Indeed, stock options have become so crucial to executives
today that some economists say if stock prices tumble, managements
interested in maximizing the value of their compensation plans would have an
even greater interest in driving down their stocks' prices to guarantee
future gains on options issued at rock-bottom levels.
Andrew Smithers, founder and economist at Smithers &
Company, an investment advisory firm in London and the co-author with
Stephen Wright of "Valuing Wall Street: Protecting Wealth in Turbulent
Markets," said: "If the market were to fall, the interests of management
would cease to be driving up the stock price. It would be driving it down so
the next round of options are at a lower price."
Even now, some companies' option grants are at odds with
shareholder interests. A 1999 study of 900 companies by Ira Kay, a practice
partner at the Watson Wyatt Worldwide consulting firm, found that companies
with the greatest percentage of shares outstanding represented by
unexercised options produced lower returns to shareholders than those with a
smaller percentage of option grants hanging over them.
Graphic * Behind the Scenes at Microsoft
</library/tech/00/06/biztech/articles/13option.2.GIF.html> Microsoft is a
heavy issue of stock issuer of stock options which can be exchanged, or
exercised, at a preset price for common shares, to employees.
While Mr. Kay said that many companies produce good returns
for shareholders in spite of the so-called option overhang, he added, "It's
a scarce and very valuable resource that needs to be optimally allocated by
the board of directors."
If the use of options were limited to a handful of
companies, the overall market impact would not be great. But many companies
have joined the option game recognizing that they are at a disadvantage to
companies spreading the option wealth.
Laurence A. Tisch, co-chairman of the Loews Corporation, has
for years refused to make options a part of its executive compensation plan
because of their future costs to shareholders. Last year, however, he
succumbed to the pressure and now hands out a tiny portion of options to
managers. "I'm against options and we haven't had options at Loews in 25 or
30 years," Mr. Tisch said. "But it was a problem with some executives.
Whether we needed it or didn't need it, we thought we needed it."
One of the biggest arguments for options is that they help
companies retain good workers and provide an incentive for employees to
increase their productivity. John Connors, chief financial officer at
Microsoft, said: "We very much continue to believe strongly in the direct
linkage to our employees being shareholders and creating long-term
shareholder value. Both shareholders and employees would look at this
program as being an integral part of the success of our company."
Microsoft said it was impossible to predict what its tax
bill would be in 2000 since the year is not yet over. The company confirmed
that its options-related tax deduction exceeded its taxable income as
reported to shareholders so far this year, but said that there were many
different elements that go into figuring the company's taxes that are not
available to the public. Microsoft declined to make its tax returns
Mr. Connors acknowledged that his company's happy experience
with stock options had come in a bull market. It remains to be seen, he
said, whether options will keep employees happy if their company's stock
For the moment, options maintain their allure. Even
Washington is convinced that they are good for all. Rather than fretting
about the decline in corporate tax receipts, some lawmakers want to give
employees a tax break as well.
John Boehner, the Ohio Republican who is chairman of the
House subcommittee on employer-employee relations, has written legislation
that would create a new "superstock option." It would allow employees to pay
taxes on the options at capital gains rates rather than higher ordinary
The new options would still provide a tax deduction for the
companies issuing them. This would almost certainly reduce Treasury
Mr. Boehner said the legislation would help workers "share
in the tremendous growth of today's economy in a way that benefits them,
their employers and the entire economy." To qualify for the tax treatment,
companies would have to offer options to at least half of their employees.
Democrats on the subcommittee are hardly objecting -- they are just
insisting that companies make them available to 90 percent or more of
employees to qualify.
But the cost of making options more attractive than they
already are is high. "If you believe in the free market system you have to
have a scorecard that works," said Bill Parish, a former accountant and
auditor who is an independent investment adviser in Portland, Ore. "The
scorecard has been completely corrupted and the biggest way it has been
corrupted is through the issuance of watered stock. And the average person
doesn't know about it."
Copyright 2000 The New York Times Company