Title: LEGAL, ECONOMIC AND PSYCHOLOGICAL ISSUES OF ACCOUNTING FOR EMPLOYEE STOCK OPTIONS. AUTHOR: MICHAEL NWOGUGU, Certified Public Accountant (Maryland, USA), Certified Management Accountant (IMA). B.Arch. (City College Of New York). MBA (Columbia University). Business Consultant based in New York City. Address: P. O. Box 170002, Brooklyn, NY 11217, USA. Phone/Fax: 1-718-638-6270. Email:
[email protected],
[email protected]. Practical Applications The issues discussed in this article are relevant in ESO accounting, regulation of ESOs, incentive compensation, human resources analysis, tax policy, corporate governance, fraud, valuation of companies, derivatives regulation, behavioral analysis of law/rules, portfolio management and management strategy. Abstract This paper analyzes economic, legal, behavioral and public policy issues pertaining to the accounting for employee stock options. The paper explains: a) why employee stock options (ESOs) are superior to other forms of incentive compensation, b) why ESOs in their present form, are inefficient, c) why particular accounting, legal and tax treatments will provide the optimal results for the economy, the government, management/employees and shareholders. Keywords: Employee Stock Options, accounting, complexity, psychology, corporations law, economics of governance. 1. Introduction The main issues are: a) regulation of employee stock options (‘ESOs’), b) economic and psychological effects of incentives, c) whether and when to expense ESOs costs, d) disclose of ESOs, e) efficiency of ESOs as incentives. The government, shareholders, employees and the corporate entity are all partners in the quest to create wealth and jobs, and each party’s interests is relevant in formulating policy for ESOs. This will subsequently be referred to as Mutual Interest Theory. ESO accounting creates a ‘Realization Risk’ which can be borne by the government, shareholders, employees or the company. Realization Risk refers to the risk that ESO gains will not be achieved. ‘ESO costs’ are defined as the cost of ESOs to the company, which consists of: a) the difference between the strike price and the exercise price and b) the
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time value of the ESO. Arkes et al. [], Ittner et. al. [], Lipe []; Meulbroek []; Weinstein [], Wiseman & Gomez-Mejia []. Mitchell []. Bogus []; Pages []. 2. Accounting & Tax Issues. A. The Current Status Of ESO Accounting. The current rules in ESO accounting are explained in: Financial Accounting Standards Board, 1995 - Accounting For Stock-Based Compensation; US SFAS #123; Harter & Harikumar [], Ittner at al. [], Leuz & Verrechia []. Clement & Cohen []; Utsunomiya []; Fehr et al []. Ali & Stapledon []; Core et al []; Dybvig & Loewenstein []. Bell [ ]. Merchant et al []. Most existing methods of accounting for ESOs are very inaccurate. Methods that require recognition at the date that the ESO is issued typically: a) do not record the true cost of the option grant at exercise in the future, b) do not create any balance sheet reserves for changes in the cost of the options, c) have not addressed the issue of amortization periods to be used, d) typically do not include the timevalue of the option, but record only intrinsic value on the date of issuance (which is often zero). Methods that require recognition at the date of exercise of the ESOs typically don’t address: a) balance sheet reserves for changes in the cost of the options, b) amortization periods to be used, c) other economic issues raised in this article. Both the Intrinsic Value method and the Fair Value methods contravene the matching principle in accounting. Furthermore, expensing ESOs simply reduces stockholders’ equity (after dilution), whereas the same accounting transaction may have the opposite effect of adding capital to shareholders’ equity from payment of the strike price. Harter & Harikumar [] developed the ‘Economic Cost’ method, as an alternative to the ‘Intrinsic Value’ and ‘Fair Value’ methods. The Economic Cost method: a) does not recognize that the ESO ‘cost’ is a non-cash expense, b) is not accurate in situations where the option was in-the-money at grant and became out-of-the-money at exercise, c) does not resolve the issue of the appropriate amortization period (for capitalized ESO costs)..
B. The Case For Expensing ESOs The case for expensing ESOs are summarized in Bodie, Kaplan & Merton []. Contrary to Bodie et al [], ESOs are very different from stock-for-stock mergers and stock payments for
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goods/services because:a) unlike ESOs, the prices of shares (used for payment) are easily approximable, b) share prices are more stable than options prices and c) unlike ESO compensation, such payments are for measurable services already performed, d) ESOs have different values to employees, employers and investors, because ESOs are not transferable, are contingent rights and require vesting - such divergence in valuation obfuscates financial reporting. ESOs lack the characteristics of expenses – if ESOs expire worthless then they are technically not expenses because no value has been transferred. Any transfer of value inherent in ESOs is: a) fully accounted for by equity dilution, 2) variable, not measurable and contingent on conditions that may not occur, 3) represents windfall gains, 4) is economically the same as value from ‘founder’s stock’. Thus, ESOs should not be expensed. There is no accurate model for valuing ESOs. Existing options valuation models contain an unacceptable level of approximation, and provides incentives for fraud. Finnerty [ ]. Nwogugu [ ]. Contrary to Bodie et. al.’s [ :69], expensing options will hurt young businesses. The startup company is typically cash-strapped and ESOs or common stock grants are the only practical way to pay and motivate employees (and in some cases, to pay for goods and services). Startup companies do not typically pay employees with common stock because there is uncertainty about employee performance (hence, vesting) and future dilution. See Board Of Trade Of City Of Chicago, 677 F2d at 1156-7 (1982). The startup company still needs several rounds of funding, and confirm market acceptance of its products/services, before underwriters get involved. Underwriters typically do not underwrite ESOs/warrants of young companies. In mature companies, ESOs provide incentives, and cash incentive compensation may trigger shareholder revolts. ESOs can enable companies to align the interests of shareholders and employees, without giving away equity unnecessarily. Expensing ESOs will reduce earnings and affect startup companys’ prospects of obtaining much needed expansion/development capital. The use of ESOs has spread to low-level employees as illustrated in Table 1. Table 1. Percentage Of Annual Option Grants Awarded To Executives And Employees below The top Five, 1992-2000.
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Fiscal Year 1992 1993 1994 1995 1996 1997 1998 1999 2000
S&P 500 Industrials 77.6% 75.7% 74.2% 76.4% 76.1% 76.1% 77.4% 77.2% 78.9%
S&P 500 Financials 75.2% 77.6% 71.8% 77.5% 72.6% 73.1% 76.8% 76.9% 77.0%
Smaller Firms 63.9% 62.0% 62.2% 63.5% 62.9% 63.0% 65.6% 64.7% 67.0%
New Economy 78.0% 78.1% 76.1% 77.7% 76.8% 77.5% 79.4% 77.1% 79.6%
Source: (Murphy, 2002); S&P's Execucomp database). Data Includes only firms where at least one of the top five executives Received options during the year. S&P 500 excludes financial Services (SIC Codes 6000-6999) and utilities (4900-4999). Smaller firms are those in the S&P's Midcap 400 and SmallCap 600. New Economy firms are companies with primary SIC Codes 3570, 3571, 3572, 3576,3661, 3674,5045,5961,7370,7371, 7372, and 7373. Contrary to Bodie et. al. [ :64], issuing ESOs and common stock conserves cash for the small company, and there is no ‘opportunity cost’ because there is typically very few buyers and no liquid markets for their equity. Investors factor in the dilutive effect of ESOs, and can use various methods to calculate the common stock equivalents of in-the-money ESOs. Contrary to Bodie et al. [ :67], if a company compensates its suppliers with ESOs rather than cash, its profitability measures will not be distorted if the company discloses: a) the fair market value of the goods and services supplied, b) the fully diluted shares outstanding, c) the common-stock equivalents of in-the-money ESOs and their dilutive effects. Thus, the key issue is disclosure of transaction details, and not the form of business.
C. Other Accounting Issues
Recognizing or expensing ESOs at issuance or exercise will cause employees to misstate ESO
values, and attempt to synchronize earnings performance with the issuance/exercise of ESOs, and hence, fraud. ESOs can be construed as ‘intangibles’. In certain cases, salaries for staff are included in inventory, intangibles and Fixed Asset accounts, and this complicates accounting for ESOs. ESOs typically cover compensation for work not yet performed and for profits/gains not yet realized. It is
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difficult to assign ESOs to employee performance for any given period. Expensing ESOs contradicts the ‘matching’ principle of accounting. A case could be made for companies to capitalize and amortize ESO costs. Ittner et al [ ]; Weinstein [ ]. By requiring ‘vesting’, the issuance of ESOs represent the acquisition of a set of unique intangibles (defined as employee commitment to increase shareholder value) which prevents competitors from hiring employees. The magnitude of this intangible is becoming clearer with the transition to a ‘knowledge-based’ economy. Bell et al. [] found that investors perceive ESOs as intangibles. There is no standard method for valuing ESOs, and there are no standard forms of ESOs. Finnerty [ ]. Companies are not required to disclose inputs for ESO valuation (volatility, interest rate, etc.). ESOs have different values to the grantor company, the grantee employee and regulators. Various studies have shown that ESO valuation affects the propensity for fraud and investors’ beliefs about the accuracy of financial reporting. Thus, ESO valuation results in agency, moral hazard, and information asymmetry problems. Arkes []; Hiler []. Bell []; Nwogugu []. There is some difficulty in assigning option gains to employee performance in specific periods. There is a case for promulgating rules in which accounting for ESOs will be based on the purpose of issuing the ESOs. Such rules will be very complicated because each ‘purpose’ has different economic, pyschological and tax impacts on various parties. Compliance costs are likely to be substantial and the propensity for fraud higher. Company size partly determines the economic and psychological effects of ESOs. Small and large companies are valued differently, issue ESOs for different reasons, and their employees react to ESOs differently due to a) perceived employee job security, b) proportion of total compensation that consists of incentive compensation, c) differences in job design and scope of responsibility, and d) differences in organization processes. Bodie et al [ ]; Wiseman & Gomez-Mejia [ ]. D. Taxation and Capital Structure In many countries, there is no prevalent theory of ESO taxation. Progressive tax theories will tend to apply different taxes depending on income. Re-distributive tax theories will attempt to funnel tax revenues towards social services and pension obligations. ‘Capital maximization’ theories will tend to
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maximize the government’s revenues, and may involve multiple taxation at grant, at exercise and at sale of the common stock. ‘Growth enhancement’ theories will encourage entrepreneurship and growth, and will typically impose taxes only at sale of the underlying common stock. The choice of theory will depend on political conditions, and the legal environment. The regulation of ESOs should be partly based on capital structure effects, timing and the optimal taxation.
The key issues pertaining to corporate taxation are: a) ESOs are not measurable operating expenses or economic costs to the company, b) ESOs are better accounted for in other ways other than expensing them, c) ESOs are not debt or equity, e) the impact of expensing ESOs on corporate-tax revenues depends on the tax theory applied in the jurisdiction, f) ESO tax shields are much more valuable than interest tax shields and depreciation tax shields. As of Summer 2003, the US Senate was reviewing a bill to compel uniform treatment of ESOs costs for tax and financial reporting purposes. (US Senate Bill #1940 – the Levin & McCain Bill).
For purposes of individual taxation, some of the major economic and legal considerations are: a) are ESOs base compensation or incentive compensation, b) should ESOs gains be taxed as capital gains, and should taxation depend on the holding period of both the option and the common stock, c) ESOs are the economic equivalent of ‘founder’s stock, d) The differences in taxation of ESOs, SARs and performance-based compensation is not justified – in the case of SARs and performance-based pay, the government and shareholders bears almost none of the ‘realization risk’, e) employees’ ESO losses have not been accorded the same tax treatment as employees’ ESO gains - in most cases, such losses are not deductible in tax returns, and the ‘realization risk’ is shifted to the option holder only. The taxation and accounting treatment of ESOs affects the firm’s capital structure. ESOs gains can be taxed via individual income taxes, or individual capital gains taxes, or as individual income taxes on dividends (shareholders), or ac corporate taxes (depending on whether the options are compensatory or incentive options). Taxing large-company ESO gains or ESO awards at
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issuance provides more certain tax revenues, while shifting the risk of ‘realization’ to the companies. Small companies usually have operating losses in their first few years, and thus, the optimal timing for the government is to tax the options at sale of the underlying common stock. Imposing taxes on ESOs gains before the sale of the stock negates the purpose of ESOs, and imposes undue hardships on ESO grantees, and will increase fraud, and discourage companies from using ESOs. There are two broad classes of ESOs with different tax effects – non-qualified options plans (NQOs) and incentive ESO plans (ISOs). Hanlon & Shevlin [] and Harter & Harikumar [] explains the two general classes of ESOs. ESOs are not operating expenses, and should be disclosed differently. Expenses are typically costs that affect one accounting period. Unlike depreciation, ESOs are not measurable, are contingent, and are not standardized, and this complicates taxation, because management can falsify taxable income. The ‘profit profile’ of expenses is roughly ‘symmetrical’, in that expenses can produce gains or losses, but ESO holders are insulated from any detrimental consequences of risk-taking. ESOs typically does not involve cash payments by the firm (except for stock repurchases). Labor expenses are directly related to the actual value of measurable effort contributed by employees, but ESO gains are determined by stock market fluctuations. The only economic impact of ESOs is equity dilution, and expensing ESOs amounts to double-counting a transaction. A distinction has to be made between: a) wealth distribution mechanisms, b) equity grants to employees to motivate them, and c) operating expenses. By their nature, ESOs are incentive mechanisms. ESOs are essentially ‘delayed’ issuance of founder’s shares in the company (which are not taxed). ESOs are a contingent wealth distribution mechanism, and not a property distribution that affects the company’s financial stability. The taxation and accounting treatment of ESOs affects the firm’s capital structure. Wiseman & Gomez-Mejia []. Desai [ ]; Kahle & Shastri [ ]; Forker [ ]; Rajgopal & Shevlin. Employees can reap the benefits of ESOs even if the firm becomes financially distressed. ESOs that are expensed for tax purposes also provide tax shields that are more valuable than interest tax shields (from debt), because: a) ESO tax shields do not involve any payment of cash, b) ESOs are not typically classified as liabilities, c) unlike interest payments, expensing ESOs does not affect the firm’s probability of bankruptcy. These
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factors provide an incentive to finance the firm with debt and expensed ESOs instead of equity. Expensing ESOs will only complicate the principal-agent problems implicit in the combined use of interest-bearing debt and ESOs, and will change the financing of companies and obfuscate the measurement of risk, insolvency and profitability. ESO tax shields are more susceptible to manipulation because there is no accurate way of valuing ESOs. Under current US rules, companies can use at least four different methods to expense ESO costs, and this affects the company’s tax burden – See Table 2. Table 2. Microsoft Corporation Pretax Income And Option Expense (In $ Millions)
Fiscal Year June 1995 1996 1997 1998 1999 2000 2001 Cumulative % Of Cumulative Pretax Income
Reported Options Expense Pre-tax SFAS 123 Tax Exercise Income Method Method Method 2,167 314 511 870 3,379 451 1,006 1,520 5,314 615 2,263 3,308 7,117 852 4,437 5,844 11,891 1,041 8,877 10,935 14,275 1,443 15,814 16,003 11,525 3,377 5,903 6,466 55,668 8,093 38,811 44,946 15%
70%
81%
Risk Method 4,393 3,290 15,812 19,512 26,391 (7,518) (4,538) 57,342 103%
Source: Trend Macrolytics Research; Company filings. 3. Legal And Regulatory Issues ESO accounting presents several legal and regulatory issues that affect investor reactions and company operations. Langevoort []; Hiler []; Ribstein []; Mitchell & Netter []; Merchant et al []; Leuz & Verecchia []; Guinn & Harvey []. These include: 1) Disclosure will be more problematic if ESOs are expensed before the sale of the underlying stock. ESOs should be disclosed only in footnotes. The minimum disclosure should include: a) number of ESOs, b) number of in the money ESOs, c) common stock equivalents of in-the-money ESOs, fully diluted EPS, cash flow, d) Forecasted Eso grants for the next five years, and resulting dilution.
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2) What should be the government’s policy on taxation of awarded ESOs and gains from ESOs ?. In most tax jurisdictions, expensing ESOs costs will reduce corporate tax revenues and result in budget deficits. The tax issues were discussed in earlier sections of this article. 3) Expensing ESOs will incur substantially more compliance costs, will be much more difficult to enforce, and will create more opportunities for fraudulent misconduct. 4) At the present, there is no standard method of determining the fair value of services for which small company employees are awarded ESOs. Thus, management can arbitrarily award ESOs based on arbitrary values of services/goods. 5) Existing legal systems cannot handle the consequences of financial fraud and do not minimize enforcement costs– such as litigation costs, sentencing and penalties, adverse publicity, declining stock prices, reduces sales, problems with suppliers, investigation costs, labor problems, and financial losses. The cost of these laws/processes to shareholders/employees sometimes far outweigh the benefits of enforcement. The extent and amount of these costs often affects: a) prosecutors’ willingness to investigate fraud cases, and b) insiders’ willingness to report fraudulent activity. Legal systems should be changed to: reduce the litigation time and costs, Lewin & Trumbull [];; clarify and simplify standards of proof and evidence, Lando []; minimize information leaks to the public; establish better discovery processes; reduce judicial discretion; Kessler & Piehl []; Lewin & Trumbull []; Polinsky & Shavell []; Grasmick & Green []; better define situations in which the corporation is held lianle as opposed to specific employees (Chapman[ ]); develop and utilize more effective criminal sanctions that reduce transaction costs and compliance costs. Vicarious corporate liability regimes have been ineffective primarily due to too little personal liability against employee. Given that most employees are relatively judgment-proof, its better to assign liability to both the company and the employee, and assign nonmonetary sanctions to specific employees. The use of ESOs can result in fraud, whether or not they are expensed; and such fraud arises from a) the managerial power doctrine, b) negotiation and execution of ESO agreements; award and implementation of ESO plans, c) repricing, d) disclosure of ESOs. Ehrlich []; Kessler & Levitt []; Kyung & In-Gyu []; Polinsky & Shavell []. Garoupa []. Grasmick & Green [].
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Lewin & Trumbull []; Corporate crime has been hard to and expensive to investigate because perpetrators can afford advisors, corporate crimes are easy to cover-up, and there is a tendency to treat corporate crime as civil matters. The recent corporate crimes at Enron, Tyco, and Arthur Andersen (and the enactment of laws – Sarbanes-Oxley Act, etc.) show that there is over-reliance on companys’ internal governance mechanisms for prevention of corporate crime. The number of white-collar criminals imprisoned in the US during 1987-2000 declined, while the incidence of white-collar crime increased during the same period. Tomasic [ :191, paragraph 2]. With regard to effectiveness of sanctions for fraud: a) the effect of monetary fines is limited, and depends on the perpetrator’s wealth and access to legal advisors, b) sanctioning only the corporate entity reduces the effectiveness of sanctions, c) most anti-fraud criminal and civil laws do not require post-indictment or post-adjudication monitoring of corporate offenders (similar to a bankruptcy trustee); d) chosen sanctions must minimize enforcement costs; e) jail sentences for employees increase enforcement costs and reluctance to prosecute due to adverse publicity; f) cease-and-desist orders also have limited deterrence effects because penalties have statutory fines and remedies that may be less than potential gains from violation. Thus, there is a need for: a) new laws to criminalize misconduct that was previously regulated by corporate governance mechanisms, b) new types of criminal sanctions that minimize transaction costs, compliance costs and enforcement costs - such sanctions include: 1) increased fines and provisions for treble and quadruple damages, 2) proportional or ‘progressive’ fines, in which the magnitude of the fine partly depends on the perpetrator’s wealth; 3) restitution to direct victims of such corporate crime, 4) monitoring by special overseers, 5) filing of additional post-adjudication compliance reports for a specified period, 6) cash contributions to special funds used for investigations and enforcement, 7) mandatory employee training. 6) In large companies, ESOs can result in over-compensation, and the opportunity costs of such over-compensation is substantial – in terms of lost R&D, hiring more workers, capital expenditures, quality initiatives, lost tax revenues (personal income tax reduction strategies), etc.. Bogus [ ] erroneously advocates a judicial solution to the over-compensation problem instead of a market, or taxation or corporate governance solution. Judicial solutions are impractical due to high transaction
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costs, potentially large volume of litigation, litigation costs, few statutory remedies except shareholder derivate actions, and difficulty in ascertaining proper compensation without a shareholder vote. The business judgement rule cannot eliminate over-compensation because of difficulty in determining and applying the reasonableness standard. 7) Repricing and ‘ESO Exchange Programs’: Repricing ESOs for the same performance period, without shareholder approval, and before their expiration is unfair to existing shareholders and constitutes unenforceable contracting because: a) it changes employees’ risk appetite (more risk taking), b) it over-compensates employees for poor performance, c) it dilutes equity, d) its often done without shareholder voting and is heaviliy influenced by management to the detriment of shareholders, e) its a change in contract terms, for which there is typically no or inadequate consideration. Some jurisdictions (eg. Delaware, and New York state) do not require shareholder approval of ESO repricing. Chidambaran & Nagpournanand []; Archaya et al []; Johnson & Tian []; Langevoort []; Core et al []; Utsunomiya []; Carter & Lynch []. Anticipation of repricing reduces employee motivation, and there are other alternatives such as increased monitoring, hiring new staff or changing the structure of ESOs. Some companies have ESO ‘exchange programs’ in which existing ESO are exchanged for new ESO after a statutory time period (six months). Lau []. The key issues are whether such exchange programs are unfair and whether they constitute ‘issuer tender offers’. Under US rules, any company that reprices its ESO must expense any appreciation in the repriced ESOs until the ESOs are fixed, exercised or expired, and such treatment differs from accounting treatment for ESOs. Lau []. An ESO exchange program will be deemed unfair where: a) it is not approved by shareholders, b) the strike price of the new ESO is substantially less than that of the old ESO, c) the exchange program applies only to a group of employees, d) the exchange program contravenes the company’s bylaws. US issuer tenders offer are governed by the Securites Exchange Act of 1934 (Rule 13(e)(4)), and applies to companies that registered pursuant Section 12 of the 1934 Act or are required to file periodic reports pursuant to Section 15(d) of the 1934 act for tender offers of its own registered or unregistered securities. Some factors that determine whether ESO exchange program is a tender offer are: a) whether there is active and
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widespread solicitation of public shareholders, b) whether a substantial percentage of the issuer’s securities are being solicited, c) whether the offer is contingent on certain conditions, d) whether the offer is for a limited time period, d) the price of the offer, e) whether different terms are being offered to different ‘classes’ or groups of shareholders, f) whether the offerree is pressured to sell his/her securities, g) mode of acceptance of the offer, h) whether the ESO holders must make ‘individual investment decisions’ in accepting or rejecting such offers, i) the nature of the offer and the information disclosed in the offer. Lau []. However, Rule 13(e)(4) has exemptions from Rules 13(e)(4)(f)(8)(i) and (ii) – the allholders and the –best-price rules – if: a) the issuer can use Form S-8, and the securities exchanged in the tender offer will be issued pursuant to an Employee benefit Plan as defined in Rule 405 of the 1934 Exchange Act; b) the exchange offer is done for compensatory purposes, c) the issuers discloses the essential features of the exchange offer and the risks involved, d) the issuer otherwise complies with Rule 13(e)(4). The key issues pertaining to ESO exchanges are that: a) ESOs are not securities that are governed by standard securities laws, b) ESOs exist in a compensation framework and are not the type of securities that were contemplated by securities laws such as the 1933 and 1934 Acts (USA), c) ESO holders are a small percentage of claimholders of any type, d) ESOs are not equity interests or debt obligations in the corporate entity, and ESO holders do not have the same rights as shareholder and debtors, e) tender offers and associated laws are typically intended for equity, debt or hybrid securities. 7) Terminated employees that own vested options are typically required to exercise such options shortly after termination – typically ninety days after termination. This requirement constitutes undue influence and duress, is unconscionable and renders such ESO agreements subject to reinterpretation by courts. The ESO holder may not have the resources to exercise the options immediately. Given that the performance is completed, such employee has earned rights to the ESO gains. 8). The differences in the accounting treatment of ‘variable’ ESOs and ‘fixed’ ESOs are unjustified and constitute discriminatory treatment for ESOs that are functionally the same.
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9) Expensing ESOs creates several sources of mis-statements in disclosure for ESOs, and thus, liability under securities laws – options valuation, allocation of ESOs costs over several periods, basis for grant of options, impact on EPS, improper use of accruals to manage earnings, etc.. 10) ESOs are not equity interests because ESOs are defined by ESO Agreements which are executory contingent agreements that require future bilateral performance and the satisfaction of future conditions, before performance. ESOs are un-matured contract rights (different from property rights) because: a) conditions must be fulfilled before the right converts to common stock which is a property right (Hansman & Kraakman [
:378-380]; Allen []), b) the option right cannot be transferred, c) the
option right does not bestow any special rights such as voting rights, dividends, interest payments, security interests, etc.. ‘Un-matured contract rights’ are contingent rights that are created by executory contracts, for which the pre-requisite conditions have not occurred – even when such pre-requisite conditions have occurred, ESOs are still contract rights. A distinction is made between matured contract rights and incomplete property rights. Allen []. ESOs are not debt obligations, and ESOs do not create any obligations for the firm except to issue common stock when certain future conditions occur. The option right does not exist until after the ‘vesting period’ and all other associated conditions, if any. The standard ESO is a ‘compound option’ where the ‘barrier’ is vesting and in some cases, other condition. Thus, most pre-vesting ‘monetization’ of ESOs are void. Guinn & Harvey []; Kreitner []; Schizer []. There is technically no exchange of consideration at inception and during the life of the contract because: a) the options are typically granted to the employees for free, and b) the grantor company is not obligated to provide employment to the option grantee (at-will employment doctrine), and working for the firm is typically not the sole condition for the option right to arise, c) the ESO grantee is typically not obligated to work for the firm, and can leave at any time, and the employee’s promise to work for the firm in the future, in exchange for the ESO, is not valid consideration for the ESO agreement to be valid – absence of consideration and failure of consideration, e) typically, there is no bargained-for exchange that requires an affirmative decision by the employee to give up specific consideration (apart from future employment) in exchange for a financial expectations interest in the company. Hough & Spowart-Taylor
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[]. Kremer []. Gompers & Lerner []. Thus, most ESO contracts are void and unenforceable. (See the following cases: Wyatt v. Cendant Corporation, 81 FSupp2d. 550 (DNJ, 2000); Compass Group PLC, SEC No-Action Letter 1999 WL 311797 (May 13, 1999); Childers v. Northwest Airlines Inc, 688 FSupp 1357, 1363 (D.Minn, 1988). ESO agreements can be rendered void due to: a) capacity to contract – preclusion by the company’s bylaws, government regulations, and any past, present or future conditions, b) mis-representation by the company (its condition and relevant information), c) unconsionability – suitability and appropriateness of such contracts, and major deviations from the norm, d) undue influence by either party, Edwards [ :17-19]; e) failure of consideration. Hough & Spowart-Taylor []. Kremer []. Bernstein []. Furthermore, ESO agreements can be construed as ‘contracts of necesssity’ because: a) the employer typically has much more bargaining power, b) ESO agreements tend to be standardized in each company, c) the ‘fair price rule’ applies to contracts of employment and particularly to small companies. Esposto []. ESO agreements exceed the normal bounds of ‘incompleteness’, and are highly speculative contracts - in some instances, none of the terms are fixed, eg. indexed reload options. Edwards []; Maskin []; Fehr & Schmidt []; Fehr & Falk []. Bell et al [ ] founds that investors percieve ESOP as intangibles. Given that ESOs are not debt, hybrid securities or equity, they should not be reported in the financial statements but should be disclosed in the notes to the financial statements. The foregoing discussion has implications for swaps which are erroneously considered off-balance sheet items. A swap is an executory agreement (in which two parties typically net payment obligations) and is a matured contract right which evolves into a property right or obligation once these conditions exist: a) future payments are measurable, b) there are no pre-requisite conditions other than the passage of time, c) the agreement produces a future interest or obligation, d) the rights implict in the agreement, ‘run’ with the agreement. Ciro []. Bernstein []. In this instance, classification as a property right should not be conditioned on transferability because the property right or obligation that arises from the swap agreement is defined adequately regardless of the transfer or the characteristics of the transferee - an acquiree company has different values to different acquirors, but the acquiree’s common stock is a well defined property right. Thus, the present values of the swap can be calculated using forecasted spot rates,
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forward rates and index prices (ie. the present value of future netted payments which can either be an asset or a liability and should be reported in financial statements). 11) The use of ESOs as collateral for transactions raises the issues of : a) whether ESOs are ‘securities’ under federal securities laws and commercial law codes (the UCC), b) whether the issuance of ESOs constitutes a ‘sale’ or ‘purchase’ of securities that requires registration. Hoeffner & Greensfelder [] focused only on the ‘no-sale’ doctrine and the application of the US Securities Act of 1933 and the US Securities Exchange Act of 1934 to ESOs. In the US, this issue is not directly addressed by the 1933 Act and the Securities Exchange Act Of 1934, but the issue has been interpreted by International Board Of Teamsters, et al v. Daniel, 439 US 551 (1979) – where the US Supreme Court held that the receipt of securities in a ‘non-contributory’ pension plan does not constitute a sale of securities. The US SEC’s position is that involuntary contributory employee benefit plans involve a purchase of securities by employees, that is governed by federal securities laws. Many lower courts have issued conflicting rulings. See: Yoder v. Orthomolecular Nutrition Institute, 751 F2d 555 (2nd Cir., 1985); Krim v. BancTexas Group, 989 F2d 1435 (5th Cir., 1993); Wyatt v. Cendant Corporation, 81 FSupp2d. 550 (DNJ, 2000) quoting McLaucghlin v. Cendant, 76 Fsupp2d 539 (DNJ, 1999); Compass Group PLC, SEC No-Action Letter 1999 WL 311797 (May 13, 1999); Childers v. Northwest Airlines Inc, 688 FSupp 1357, 1363 (DMinn, 1988). The issuance of ESOs occurs in an employment context and is a relatively rarer occurrence than typical transactions intended to be regulated by securities laws – thus ESO issuance is not a sale/purchase. In Cohn, Ivers & Co v. Gross (289 NYS2d 301), the court held that a call option was not a security, but was a general intangible. See: Board Of Trade of City of Chicago v. SEC, 677 F2d 1137 (1982) cert den. 459 US 1026 (GNMA options are not securities). Cohn,Ivers & Co. (289 NYS2d at 304-5) describes four conditions, all of which must be satisfied in order to classify an option as a security. Colt v. Fradkin (281 NE2d 213, 217 - paragraph 2) declined to follow Cohn Ivers, and sought to distinguish situations where: a) the holder of an option makes a contract to sell the option, and b) the owner or prospective owner of a security makes a contract to sell it at the option of a buyer. However, both situations are the same - if the option in the former is a general intangible, then the process of
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formation of the option (described in the latter) will also result in the same general intangible. In both situations, the underlying instrument represents a right created by contract. Note that the call options discussed in Cohn Ivers and in Colt were exchange-traded options (typically issued by exchanges), were not used to finance companies, did not represent title or equity, and were not instruments for the payment of money (because they were executory agreements that were contingent on conditions) and thus, are very different from ESOs, in that ESOs are used to finance companies, aren’t used for risk-management and aren’t traded on exchanges. ESOs are issued for compensatory and incentive purposes, and are not intended to be a form of investment. ‘Contract performance’ in ESO agreements differs from performance in exchange-traded call option agreements. In publicly-traded options, the option right exists immediately the contract is formed, and the performance consist of the option exercise and compliance with trading rules, and both parties to the contract are not required to do anything that directly affects each other economically. In the case of ESO agreements, the option right exists only after certain conditions are achieved (vesting, etc.); and performance includes bilateral conduct that directly affects the other party economically – ie. vesting, employment. ESOs and public options differ from ordinary options for sale (option to purchase land). The rulings in Cohn Ivers and Colt were partially erroneous with regard to the nature and purposes of stock options. ESOs do not meet the tests described in Board Of Trade Of City Of Chicago, 677 F2d 1137 (1982) - ESOs are not investments per say, but are incentive mechanisms in an employment context, b) profits comes from others efforts, c) the ESO grantee does not assume risk of bankruptcy of the grantor company, d) there is no ‘common enterprise’ at creation of the ESO agreement because existence of the ESO depends on vesting and other conditions, e) even after vesting, ESO gains received by each ESO grantee is not proportional to his/her contribution to the company (gains depend on market fluctuations and vesting). Thus, from a securities law perspective, ESOs are not securities. From a commercial law perspective, Guinn & Harvey [42:1140-1141] states that there has not been any cases decided under the old or revised Article Nine of the UCC as to the proper classification of OTC derivatives. Ciro []. Hazen []. Bernstein []. Hains []. Section 8-103 of the revised UCC describes rules for determining whether obligations/interests are
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securities or financial assets – and states that ‘….a share or similar equity interest issued by a corporation or business entity is a security..’. Thus, ESOs and exchange-traded options do not meet the requirements for classification as a security under Article Eight of the UCC (Sections 8-103, 8-102(a)(15), and 8102(9)), or UCC Article Nine, because of the reasons mentioned in this paragraph. The ‘economic substance’ test in Ciro [] is invalid, because derivatives are used to raise funds, and serve price discovery and risk management purposes, and in some instances, involve a transfer of the underlying asset (eg. convertibles) or the functional equivalent of a transfer of economic benefits and obligations pertaining to the underlying asset. Swaps are also not securities because they do not meet the ‘commonality test. Bloomenthal [ : 2-2: 50]. For there to be liability under US federal securities laws, there needs to be: a) an acquisition/sale of securities, b) a misleading or improper prospectus, c) omission of material facts. Thus, ESO-related fraud is not covered by securities laws. 12) The disclosure of ESOs in financial statements constitutes a projection of future economic performance (hence, a ‘forward-looking statement’) about which any two parties can disagree, primarily because there is no standard method for valuing ESOs. Thus, disclosure of ESOs is actionable under securities laws (eg. Rule 10(b)(5) of the US Securities And Exchange Act of 1934, and provisions of the US Securities Act of 1933). Expensing ESOs will simply create more lawsuits. See: Blue Chip Stamps, 421 US 823 (
)(options holder were purchaser/seller of securities). Hiler []. Roussel []; Mitchell &
Netter []; Schizer [] Langevoort []. Defendants in securities lawsuits that are based on misstatements and omissions have typically relied on two defenses – a) under the ‘Bespeaks Caution’ doctrine, forwardlooking statements are deemed immaterial if accompanied by meaningful cautionary statements, and specific risk disclosure (Roussel []); b) under the ‘Corporate Puffery’ defense, the forward-looking statements are deemed so vague that they do not affect stock prices. Expensing ESOs will make it much harder for firms to use either of such defenses in securities fraud lawsuits, primarily because: a) there is no standard method of valuing ESOs, b) expensing ESOs will provide incentives for management to falsify financial statements. 13). Expensing ESOs will increase compliance costs – which include costs of ESO valuation, or
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lower earnings, and monitoring costs. Kyung & In-Gyu []; Langevoort []; Ribstein []; Maskin [ ]; Ehrlich []; Lewin & Trumbull [ ]. ESOs are a major cause of volatility, subjectivity and fraud in equity markets, and the impact of ESOs on stock markets is partly determined by ESO disclosure, and ESO ‘over-hang’ (outstanding ESOs). 14) Employee use derivatives (equity swaps, etc.) to hedge their equity compensation, (and can also use derivatives for insider trading in the process) and this reduces their exposure to firm-specific risk and changes their risk appetite. Schizer []; Ciro []. In most jurisdictions, there are no laws that directly regulate such misconduct, which can be a major source of fraud. Securities laws may be applicable to such misconduct if the employee: a) possessed material non-public information about the company’s prospects, b) traded on such information prior to its public release, c) had the intent to profit from such derivatives trades, d) made derivatives trades that were the functional and economic equivalent of purchases or sales of the company’s common stock, e) traded the derivatives within a relatively short time before the public release of material information – ie within nine months, f) made derivatives trades (and their functional/economic equivalents in the company’s common stock) that would not have been made if existing circumstances did not exist. In the US, the use of derivatives to hedge equity compensation meets two requirements necessary for causes of action: a) the ‘engage in any act, practice or course of business which would operate as fraud or deceit upon any person in connection with the purchase or sale of any security..’ clause, and b) the ‘…use of fraudulent schemes and devises in connection with the purchase or sale of securities…’ clause. Ribstein []. In most jurisdictions whether derivatives (such as equity swaps and collars) are securities, is decided on a case by case basis. Schizer [ ]; Ciro [ ]. Under existing US regulations: a) zero-cost collars are not considered to be ‘constructive sales’ of the underlying equity securities, b) executives can defer capital gains taxes on any capital appreciation of the trade, through the life of the collar, c) equity swaps are considered to be ‘constructive sales’, d) companies and executives are not required to disclose the type size and frequency of such derivative transactions. Thus, there is a need for disclosure of such derivatives transactions, and
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implementation of limits on such use of derivatives by employees to reduce their exposure or to trade on inside information. 15) Under the ‘managerial power’ theory, managers and boards of directors can be held liable for fraud, breach of trust and breach of fiduciary duties, for their participation in the design and implementation of executive compensation and ESOs plans if it can be shown that: a) managers exerted substantial influence on the process to the detriment of shareholders, b) the terms of ESO awarded to management were more favorable to those at similar companies, c) the business judgment rule was violated, d) the award process was arbitrary. The ESO award process is unregulated and disclosure of ESO valuation is not mandatory. Langevoort []. Garoupa []. Bebchuk et al []. Securities law and tort liability applies because shareholders are entitled to protection from conflicts of interest, intent to defraud, and conduct that may detrimentally affect their future interests in the company. Many ‘accredited’ and knowledgeable investors cannot fully comprehend the dilutive and wealth-transfer effects of ESOs and the conditions for ESO award and vesting – the ESO process is opaque. In some instances, ESOs plans are developed and implemented without shareholder votes. The managerial power theory does not differ much from the ‘optimal contracting’ theory because managerial power is the primary determinant of the nature and extent of agency costs in executive compensation. Bebchuk et. al. []. The extent of liability under the managerial power theory depends on board composition and managerial power (measured in terms of managements’ equity ownership, policies and procedures, company bylaws, etc.. Liability under the managerial power theory is easier to establish in large and middle-market companies which are more structured. New laws are required to protect shareholders of small companies. Hall []. 16) In many companies, ESO plans are the only retirement-type benefits provided, and many companies cannot afford traditional retirement programs. In many jurisdictions, ESO plans are not regulated by federal pension, social security and retirement laws. In the US, ESOs plans are not governed by ERISA. New laws are required to regulate ESOs better, and where feasible to bring them under the retirement-plan regulatory regimes. Gordon [].
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17) The issue of whether boards of directors and managers owe a fiduciary duty to ESO grantees has been decided differently in various jurisdictions. In the US, there is no such fiduciary duty. Starkman v. Warner Communications, 671 FSupp 297 (SDNY, 1987)); Glinert v. Wickes, 1990 WL 34703 (199) aff’d 586 A2d 1201 (1990); Simons v. Cogen, 549 A2d 300 (De., 1988); Bill v. Emhart Corp, 1996 WL 636451 (Conn. Super., October 1996)). Blue Chip Stamps v. Manor Drug Stores, 421 US 723. Generally, there must be an existing property right or an equitable interest upon which any fiduciary duty is based – ESOs satisfy both conditions. (see the ‘constructive insider’ theory in Dirks v. SEC, 463 US 646 (1983)). Nygaard & Myrtveit []. De Geest et al []. Hopt & Wymeersch []. An ESO represents an ‘expectations interest’ in the company which is neither debt nor equity but is a contract right which creates a fiduciary duty, because: a) managers’ and board of directors’ actions will affect the values of such ‘expectations interest’, and b) ESO grantees are controlled by the board of directors. Furthermore, in equity, ESOs represent a future equitable interest in the company. 18) Many jurisdictions treat ordinary ESOs differently from cash-settled ESOs. Ordinary ESOs are classified as ‘securities’ in many jurisdictions. The election to settle in cash can be made by either the grantor employer or the grantee employee, and economically, the three types of ESOs (ordinary, cashsettled and stock-settled) are very different, because: a) cash-settled ESOs do not dilute equity and there is no continuing interest in the company, but the cash payment may have very high opportunity costs, and the settlement option is valuable because the future value of the common stock may be greater or less than the cash-settlement value, b) the ordinary ESOs dilute equity, but conserves cash, c) there may be mis-pricing of stock used in stock-settled ESOs, d) the opportunity costs of cash is much higher than that of common stock, because more business transactions can be done with cash payments. The issue is whether the right to cash settlement constitutes a right to purchase a security in the future. When the ESO contains a right (by employee or employer) to settle with cash, the ESO is not a security, because of the differences in the future economic values of cash and common stock. 19) The existing ESO regulations can result in over-compliance – expensing ESOs will only increase such compliance costs. Chapman []. Dow & Raposo []. Polinsky & Shavell []. Garoupa [];
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Grasmick & Green []; Lewin & Trumbull []. Ehrlich []. Over-compliance can severely limit a firm’s strategic alternatives and employee motivation, and may result in the abandonment of ESOs. Overcompliance arises from: a) monitoring, b) review of, and limitations on employee exercise of ESOs, c) conditions for vesting and differential tax treatment of classes of ESOs, c) rationale for award and valuation of ESOs, d) anticipated costs associated with government investigations and prosecution. 20) Most ESOs are void because they are ‘wager contracts’ that are disconnected from the economics of the underlying employer-employee relationship: a) ESO gains/losses are dependent on stock market fluctuations and have almost no relation to the market value of labor services provided, Kreitner [ :1097]. b) ESOs allocate risk improperly and don’t include any penalties for sub-par employee performance. Kreitner [ :1134]. ESO grantees have no downside risk. ESOs encourage excessive risk taking by employees. c) ‘Volatility’ is presently a major determinant of ESO values. Less than 50% of volatility is attributable to earnings news. Liang []; Carpenter et al []. According to Samuels, Brayshaw & Craner [ :64], 55% of share-price volatility is attributable to stock market fluctuations, 15% of volatility is attributable to sector fluctuations, and 30% to company-specific factors (and its probably impossible to determine what percentage of this 30% is attributable to any employee). Blasi & Kruse [] found that most employees who were granted ESOs were also paid market-rate wages irrespective of the ESOs they were granted. Its reasonably inferable that shareholders did not intend to pay ESO recipients all the substantial value that are typically transferred by ESOs. d) The exercise of ESOs is fortuitous event because the ESO grantee may not have the funds to pay the strike price, the ESO may be out-of-the-money or in-the-money, the ESO grantee may not have vested, and the grantor company may not have intended to perform the ESO contract, Kreitner [ :1105]. Hazen []. g) In Counselman v. Reichart, (72 N.W. 490 (1897)), the court determined that for a contract to be void as a wager, there must be mutual but not necessarily communicated intent to gamble, and there
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need not be direct evidence of intent to gamble. The parties to typical ESO agreements are effectively gambling on future stock prices, without any real reference to the value of labor provided (Kreitner []). Thus, most ESOs are unenforceable (but not illegal) contracts. Bernhardt []. Bernstein []. h) ESO grantees often receive unearned wealth; Campbell & Wasley []; Bebchuk et al []. Holmstrom & Milgrom []: 1) ESOs value depend on stock prices which are deteremined by external factors. Most ESOs do not reflect performance within specific periods. 2) Management influences ESO repricing, and can transfer wealth by synchronizing unfair repricing. 3) ESOs should be based on trailing average daily stock prices, to increase efficiency and reduce fraud. 4) The difficulties in valuing ESOs obfuscates the determination of the extent of wealth transfer. The process of awarding and valuing ESOs are sometimes arbitrary. There are different decision processes for awarding ESOs to executives and employees. Stock options awarded to entities in exchange for services typically have more favorable terms than ESOs. 5) Wealth transfer via ESOs is more significant in non-dividend paying companies, because ESO returns are typically unlimited. The use of SARs and ESOs in their present form causes agency problems. 4. Behavioral And Economic Issues Corporate taxes account for a substantial portion of government tax revenues in many countries, but in the US, the opposite if the case - individual taxes account for more than 60% of government tax revenues. Economic issues pertaining to ESOs are as follows: 1. ESOs are anti-competitive as illustrated by the Microsoft anti-trust case – Microsoft was built with ESOs. ESOs cause employees to behave in ways that reduce competition in industries, since they would not do so without ESOs. Wiseman & Gomez-Mejia []; Weinstein []. ESOs elicit more motivation, because cash compensation does not have the same ‘psychological growth potential’, and
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ESOs have less forecasted dilution and ‘psychological dilution’ than common stock. The rise of conglomerates has also resulted in intra-company anti-trust violations such as: a) Informal price collusion. b) ‘Bundling’ (ie. the Microsoft case). c) Exclusive contracts with suppliers and customers. d) Market dominance through strategic alliances, joint ventures, complementary products, etc.. e) Control of marketing channels through promotions, etc.. e) Labor agreements that will be detrimental to competitors; control of trade union officers. f) Customer financing with tie-ins and restrictions. g) Product/service price announcements – press releases, etc. – that temporarily increase stock prices. h) Information exchanges with competitors, with intent to collude. i) Anti-competitive transfer pricing. j) A subsidiary may be in a regulated industry with price controls while the parent is not. The parent can subsidize the subsidiary, and exert illegal market influence through bundling, informal control of customers, etc.. 2) Fixed ESO strike prices affects employee motivation as the stock price changes. ESO incentive effects are most pronounced when the ESO is out-of-the-money and until its slightly in-themoney. Once the ESO is deep-in the money, its incentive effect declines faster as the stock price rises further. When the ESO gains become substantial, ESOs have negative psychological effects, because the employee shifts into a wealth ‘preservation mode’, becomes much more risk averse, is less likely to accept positive NPV projects. This termed the ‘Strike-price Effect’, which is the primary causation of ESO-related fraud. However, ‘incompleteness’ of ESO contracts decreases with time, and this dampens the incentive effects of ESOs, and enlarges the Strike-price effect. Capped are unlikely to produce the same effect because employees. 3) Expensing ESOs at issuance or exercise creates tax deductions and accounting losses, reduces corporate taxes (without any guarantee of capital gains taxes because the stock price may decline) and
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reduces investor valuations without necessarily creating any shareholder value. Expensing ESOs is akin to a tax break for large profitable companies. 4) ESOs are not cash operating expenses, and do not affect solvency. Operating expenses do not affect future accounting periods. Unlike depreciation, ESOs are not measurable, are contingent, and are not standardized, and thus management can falsify taxable income. Langevoort []. The down-side risk of ESOs is insulated from any detrimental consequences of risk-taking. Wiseman & Gomez-Mejia []. Labor expenses are directly related to the actual value of measurable effort contributed by employees, but ESO gains are determined by stock market fluctuations. By their nature, ESOs are incentive mechanisms. If ‘founders stock’ of new companies are not taxed, then ESO grants should not be taxed because both they serve the same economic purposes. Exercise of ESOs may improve the solvency, because cash is paid as strike price. ESOs are a contingent wealth distribution mechanism, and not economic payments which affect solvency. The wealth being distributed is not assured, and cannot be measured accurately at any time (current ESO formats). Core et al []; Hall []; Carter & Lynch []; Utsunomiya []; Bogus []. The economic impact of ESOs is limited to dilution of equity of existing shareholders. If options costs are expensed at exercise: a) reported net income will be lower, and thus reduce shareholder’s equity, b) but payment of the strike price will increase shareholders’ equity and will improve the company’s cash position – these two effects may offset each other and distort economic reality, c) there will be dilution of equity. This negates all accounting principles. 5) ESOs, performance-based plans and Stock Appreciation Rights (SARs) serve the same purpose and thus there should be uniformity in their disclosure. 6) In their present form, ESOs are flawed, but without such incentives, competition will decline and employees will probably divert shareholder wealth through other means, without significant returns to shareholders. Contingent performance-based cash payments and issuance of common stock will probably cause employees to falsify company records, cause shareholder revolt and may be difficult to implement. ESOs provide more incentives than most other forms of compensation, because the right is awarded in the present for future performance. Motivation via ESOs arises from the immediacy of the
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award, and implicit contingency, and grantees have the opportunity to actively influence the outcome. De Geest et al []. Cragg & Dyck []. Feltham & Wu []; Kraisberg et al []. Psychologically, restricted stock is ‘money-in-the-bank’ which does not provide optimal motivation. Restricted stock raises the issue of voting rights. Management influences the establishment and implementation of Restricted Stock programs. Employees can use derivatives to hedge and monetize Restricted Stock, and thus, change their exposure to firm-specific risk. There is sometimes inadequate disclosure of restricted stock in financial statements, making it more difficult to value companies. Restricted Stock programs are less standardized than ESO programs. Restricted stock doesnt enhance comparability. Hall []. Armour et al []. Feltham & Wu []. Hall [] described six problems with ESOs: a) mismatched time horizons; b) gaming; c) the valuecost wedge; d) the leverage-fragility tradeoff; e) aligning risk-taking incentives; and f) avoiding excessive compensation. Mismatch of timing horizons can be solved by issuing stock options that are exercisable if performance targets are achieved during specific time periods. ESOs will not be characterized as gambling contracts if they are capped and are directly related to employee and firm performance. The differences in the value of an ESO to the company and the employee can be resolved by using employeeand department specific performance benchmarks, by capping the ESO, and by adjusting for illiquidity (issuing more ESOs). The leverage-fragility tradeoff problem can be solved by: a) capping the ESO, b) using the right combination of employee specific and department-specific performance targets (built into the ESO) and Strike Price, and c) valuing the company accurately. Establishing minimum ESO gains after vesting can solve the repricing problem. The issue of aligning risk-taking incentives can be solved by: a) capping ESO returns, b) ensuring that employees cannot hedge or monetize their equity compensation with derivatives. The over-compensation problem can be solved by capping the ESO, not using stock market indices, and directly linking ESO returns to achievement of performance targets. Current academic literature suggest that the optimal compensation structure is debt. However, debt produces substantial moral hazard issues, results in cash payout without any guarantee of value creation, and can only be used for a small percentage of senior executives. 5) ESOs increases managerial risk appetite because of the payoff profile of options, and the tax
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shields provided by expensing ESOs, the absence of cash commitment by the risk-taker. ESO holders have limited downside risk, and are less psychologically sensitive to losses. Wiseman & Gomez-Mejia []; Bogus []. Aggarwal & Samwick []. Bebchuk et al []. Carter & Lynch []. A special case occurs when base pay is restructured into incentive pay (typical in small companies) – managerial risk taking declines substantially because more of their recurring income becomes more speculative. Thus, expensing ESOs will increase managerial risk taking. 7) Expensing ESOs will result in: a) More government intervention in securities markets and incentive compensation issues. c) Increased stock market volatility and skepticism about financial statementgs. d) Changes to the tax system due to lower corporate taxes and or individual taxes. e) Increased shareholder activism. f) Reduced use of, or elimination of ESOs, particularly in industries with volatile stock prices and substantial entrepreneurial activity. Companies will tend to shift to ‘performance-based’ plans which are typically not disclosed until compensation is paid. 8) Incentive compensation is a ‘windfall’ and should not be considered as compensation – thus, the ESOs should not be treated as operating expenses. Employees typically use regular pay for recurrent consumption, they use incentive pay for non-essential expenses (vacations, luxury goods, etc.) and savings, and they do not attach any security to variable and incentive compensation. Wiseman & GomezMejia []; Arkes et. al []. Blasi & Kruse [] found that ESO grantees were typically paid market-rate cash wages in addition to ESOs. 9) ESOs create information asymmetry, which causes fraud, because ‘insiders’ typically have more information than ‘outsiders’ and shareholders about the company’s prospects, and insiders can manipulate financial statements and time ESO exercise to benefit from superior information. Some firms have responded to this problem by establishing ESO ‘exercise windows’. Chapman []. Mitchell & Netter []. Assume the following:
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C = value of ESO at time t = (S – K). V = value of information possessed by insider = Vinsider – Voutsider; where Vinsider is equal to the value of the call option if exercised by the insider at any time between t0 and t1; and Voutsider is equal to the value of the ESO if exercised by an ‘outsider’ at any time. P = Penalties imposed for insider trading violations – present value of fines, lost salary, attorney fees, litigation costs, etc.. T = Transaction costs for exercising options. The insider will always exercise the ESO when: V+C>P+T+C
10) In their present form, ESOs create agency and moral hazard problems by providing the wrong incentives – which result in earnings manipulation, inefficient capital budgeting decisions, etc.. Rajgopal & Shevlin []; Wiseman & Gomez-Mejia []; Campbell & Wasley []; Core et al []. However, standard principal-agency theory is not always applicable in the ESO context because: a) The board of directors is typically influenced by management. b) ESOs give management ‘shadow’ ownership which makes them behave more like shareholder. c) Managements’ actions are increasingly being limited and controlled by boards of director, employees, shareholders and new laws (such as the Sarbanes-Oxley Act in the US). d) The contracts between managers and shareholders are typically incomplete, and the principals’ property interests are incomplete, and thus principal-agency theory is inapplicable. e) The nature of decision-making in the firm and the structure of the firm may change the principal-agent relationship. Many key decisions are increasingly being shifted to shareholders and there is increasing shareholder activisim worldwide. f) Employees’ use of derivatives to hedge and monetize their equity compensation effectively renders principal-agent theories inapplicable, by changing the risk profiles, tax consequences, economic benefits and incentive effects of ESOs. Ali & Stapledon []; Bettis et al [].
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g) The restrictions on common stock compensation makes it a less effective corporate governance and incentive tool. h) The lack of employee portfolio diversification implicit in ESO awards creates substantial incentives for options grantee to commit fraud, and changes the principal-agent relationship. i) Psychological and non-monetary motives can affect the structuring of, and the employee reaction to incentive compensation, and thus render principal-agent theory inapplicable. Fehr & Falk []. Such motives include: 1) the desire to gain specialized experience or work on interesting projects, 2) desire to avoid social rejection, 3) reciprocity, 4) commitment to public service, 5) personal experiences, 6) employee’s socio-economic background may limit his/her ability to negotiate for adequate compensation, 7) fear of uncertainty which may cause employees to prefer combinations of certain and uncertain compensation. The employer may be influenced by other motives such as: 1) job preservation, 2) cross-training employees for assignment to other divisions, 3) labor union concessions, 4) prevention of unionization. j) Most principal-agent models erroneously assumes that all types of risk are costly to managers and that such risk have the same value to both principal and agent. In this instance, ESOs have different value to managers, company and investors. Meulbroek []. 12) Dividend payouts reduce the values of ESOs, and may create principal-agent problems because managers then have choose between positive NPV projects or paying dividends. Such managers are less likely to pay dividends if a substantial portion of their compensation consists of ESOs. This problem can be ameliorated by adjusting ESOs for dividend payouts. The manager’s choice between dividend payouts and reinvestment depends on: a) the cost of equity capital, b) whether the estimated project returns exceeds the cost of capital, c) the proportion of the managers’ wealth that is ESOs, d) the distribution of the project’s net cash flows over time, e) historical and projected stock market reactions to the company’s earnings announcements, dividend payments and operating cash flow, f) conditions for vesting, g) the degree to which the ESO is in-the-money, h) internal controls, the propensity to commit fraud, and organizational cohesiveness (predominance of groups and the existence of cross-functional
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teams), i) the nature of the budgeting and strategic planning process, and how projects are originated, j) the nature of the costing system – which determines how project costs (including opportunity costs) and benefits are allocated, k) the approval processes for projects (whether it varies by dollar amount, scope, location or duration), l) the performance measurement system. 13). The structure of the US and the world economies have changed substantially during the last twenty years. Iintangible assets account for at least 61% of assets of US companies. Since human capital is so much more relevant, employees are underpaid with the present form of ESOs. Vested employees can loose substantial wealth if the stock price declines permanently. , 14) “Reload” ESOs illustrate why expensing ESOs and the present accounting models do not reflect economic reality. The actual cost of adding the reload feature is low, but its economic impact (on tax revenues, capital gains and market volatility) is substantial because: a) the reload feature facilitates tax deferral which could be detrimental if stock prices decline after a rise, b) reload options cannot be accurately valued by existing options pricing models, c) the reload feature implies indefinite and unlimited compensation for labor that has a finite value, d) the reload feature increases ESO ‘overhang’ which in turn creates divergences in equity valuation by different investors, and thus increases volatility, e) the reload feature results in over-compensation - employees do not have to be employed by the option grantor company while the reload feature is being used. Meulbroek []; Bebchuk et al []. 17) In their present forms, ESOs agreements are ‘incomplete contracts’ because many of the terms, implicit contingencies and future performance are uncertain. Maskin []; Fehr & Schmidt []. Robinson []. Gompers & Lerner []. Hudson []. Not all aspects of ESO agreements are contractible: a) there cannot be any significant limits on ESO exercise, b) limits on hedging or monetizing ESOs may be deemed illegal, c) verification of performance may not be accurate, d) most existing ESOs do not directly establish minimum standards of employee performance and do not eliminate the ‘free-rider’ problem. Such contract-incompleteness may create agency and moral hazard problems, and the results include: a) distractions from other performance measures, b) negative inferences from such incompleteness, c) incentives to manipulate financial statements, d) fraud, e) motivation and de-motivation of employees.
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The effect of such ‘incompleteness’ depends primarily on transaction costs and ‘penalties’ for subpar performance. The transaction costs include costs of monitoring, termination costs, costs of hiring or retraining another employee, administrative costs, and costs of finding a new job. ESO agreements do not contain any penalties (reduced bonus, delayed payment, etc.) for sub-par employee performance, and this encourages excessive risk taking and other misconduct. The ‘implicit’ terms of ESO agreements perform better than the ‘explicit’ terms, because the explicit terms are highly speculative, and provide opportunities for manipulation. The explicit terms include term, strike price, vesting, settlement, etc.. The implicit terms include performance, continued employment, vesting, and firm growth. The optimal level of ‘incompleteness’ of ESO contract.is maximum completeness of how much value the employee will get, and limits on hedging/monetizing ESO contracts. 18) Research has shown that Indexed ESOs are not efficient and do not eliminate ‘market’ and ‘industry’ effects on stock prices. Meulbroek []. ‘Indexed’ ESOs including those developed in Meulbrook [] are not efficient because: a) Even when ‘indexing’ is used in ESOs, there can be substantial divergences between the stock price performance and traditional employee performance measures (eg. quality, customer satisfaction, operating cash flow per employee, employee morale, etc.). Given the vagaries of stock markets, some shareholders may value improvements in such employee performance measures more than temporary increases in share prices. b) The ‘indexed’ price used in pricing the ESO may reflect investor perceptions of future events, misunderstood issues and matters that are beyond the control of managers/employees in the current accounting period and even over the life of the ESOs – these may cause divergences of beliefs, and thus increased volatility. c) The chosen index may not be proper. There may be problems in the construction of the index in terms of correlation, etc..
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d) In Meulbrook [], the hedging of the ‘portfolio’ against industry/market movements is subject to adverse correlation effects, imperfection of hedges, and external shocks that are not reflected in estimated variables used in developing the hedges. e) Isolating company-specific risk from equity indices is sometimes not feasible because such indices do not fully reflect industry conditions, the correlation between the index and company operations may be weak, and the extensive use of derivatives (particularly index options and futures) adds substantial volatility that distorts the correlation between the indices and industry performance (or company-specific performance). f) Attempting to isolate company-specific risk from custom baskets of stocks of companies in the same industry is sometimes not feasible or accurate because such indices will still be subject to economywide fluctuations, such indices do not account for differences in size, capital structure, operations, human capital. g) Indexing ESOs does not solve the ‘incompleteness’ of ESOs contracts. Maskin []. Fehr & Schmidt []. h) The measures used in defining risk (standard deviation, variance, etc.) are improper. i) Under current US rules, indexed ESOs are treated as ‘variable’ options and their expense is included in (marked to market) in the income statement. Under US rules, incentive ESOs cannot be indexed, because of tax constraints. Schizer []. j) Indexing ESOs does not solve principal-agent and moral hazard problems that are inherent in ESOs because: 1) the existing methods of indexing ESOs does not prevent over-compensation of ESOs grantees, 2) indexing in its present form does not capture the effects of differences in capital structure, labor union activity, etc., 3) indexing ESOs does not capture the impact of, or solve the problem of managerial risk-taking and the free-rider problem, iv) the existing methods for indexing ESOs can be used only by publicly-traded companies. j) Indexing is difficult because of diversification by conglomerates – many industry indices include conglomerates.
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From the foregoing discussion, it appears that the better indices are measures of activity such as industry sales (units or dollar values), industry capacity utilization, industry corporate profits, industry cash flow, etc.. 19) Traditional ESOs have different values to the employer, the grantee employee, investors and regulators, and this reduces the incentive effect of ESOs. Meulbrook []. This is also complicated by the fact that substantial portions of many executives’ wealth is in the form of ESOs and common stock of their company. Differences in value can be resolved by capping ESOs, awarding more ESOs and adjusting the ESO for the cost of capital. 20) The economics and structure of the US healthcare sector depends on incentives provided to healthcare professionals, to reduce costs while providing adequate care. Robinson []. Rodwin & Okamoto []. Danzis []. Nygaard & Myrtveit []. Armour et al []. Bresnen & Marshall []. Loke []. Hall []. Johnson & Tian []. Physicians and other healthcare professional are paid via reimbursements from insurance companies and government insurance-type plans, which influence the type, scope and cost of treatment. Physicians and physician groups should be statutorily banned from owning pharmacies and medical labs. There should be state-level statutory limitations on physician referals and referral fees. The major problems are that: 1) there is excessive physician discretion (inadequate peer review of physician decision-making before and after implementation), 2) the cost of errors/misdiagnosis are high, 3) there are substantial compliance costs and transaction costs (professional liability insurance, staff salaries, etc.), 4) physicians do not face meaningful monetary and non-monetary penalties for inefficiency (such inefficiencies are difficult to manage and are typically not severe enough for disciplinary action, or lawsuits, but increase costs), and 5) the current reimbursement methods provides strong incentives to professionals to deliver sub-optimal healthcare services and inflate costs. There should be a ‘mixed’ capped reimbursement system for physicians’ treatment of any diagnosed medical condition – reimbursement will be paid on a per-visit basis up to a stated maximum reimbursement per condition, and another physician will provide any additional services. Similarly, reimbursements for diagnostic lab services, pharmaceuticals and hospital stays for any condition should be capped. This
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compensation structure provides similar incentives as capped ESOs. Properly designed ESOs can provide incentives and help reduce provider conflicts of interests, moral hazard and agency costs, and treatment costs: a) In group practices: 1) professionals that meet pre-specified performance benchmarks can be rewarded with incentive redeemable performance-based capped ‘barrier’ ESOs, 2) professionals can be awarded compensatory performance-based and capped ‘barrier’ ESOs in lieu of a portion of their base salaries. Such ESOs will facilitate use of physician-specific and nurse-specific performance benchmarks (eg. customer satisfaction, insurance company claim disputes, efficiency, volume of patients, etc.). b) Insurance companies can conceivably: 1) award capped incentive stock options to group practices, physicians, pharmacies, and pharmacists that achieve stated goals, 2) award capped compensatory stock options to physicians, pharmacies/pharmacists and group practices – a portion of the reimbursement will be capped stock options, 3) provide special incentives to physicians to reduce pharmacy expenses. c) Physicians can be rewarded with redeemable Minimax Stock Options which have minimum and maximum values at exercise (applicable to only publicly traded shares of healthcare companies and insurers). The option right comes into existence only if pre-determined performance benchmarks are achieved (ie. ROI, sales growth, cost reduction, quality, customer service, productivity, cash flow growth, etc.) – thus, the option is an up-and-in option. At exercise, the strike price automatically resets to a strike price that will result in a maximum pre-determined gain to the option holder. The strike price is adjusted for the effect of dividend payments, if any. Assume that X is the original strike price which is calculated as the twenty-four month daily average stock price, and S is the stock price at exercise, and B is the ‘floating automatic-reset strike price’ that will result in a ‘capped return’, Z is the ‘capped maximum return’ in currency units and Y is the minimum option payoff in currency units. B is binary, and B = S – Z, if S>X, and B= S – Y if X> S. R is the ‘Growth strike Price’ which is equal to the normal strike price multiplied by an annual or quarterly factor to reflect a) the investor’s minimum return, and the form’s cost of capital, such that Rt = R(t-1)(1 + r); and R0 = X *(1 + r); where r is the percentage return. Thus, R
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increases periodically, and the ESO grantee earns profits only if investors make a specified return. D is the present value of expected future dividends, D is non-negative, and D > 0 only for dividend-paying companies. Then at exercise, the option payoff = Max{[max(0, max(0, [S – (max(X, R, B)-D)]))], [max(0, max(0, [S – (min(X, R, B)-D)]))]}. d) As a condition for reimbursement, insurers should be: 1) granted the option to terminate reimbursement to a particular physician, or to reduce reimbursement to that physician, or 2) granted the option to receive stated ‘penalty fees’ from the physician/practice, if that physician repeatedly fails to meet pre-specified performance and quality targets. e) Insurance companies in specific markets can pool an ‘incentive fund’ for rewarding physicians, pharmacists and nurses in such markets. The incentive fund will award cash-settled stock options to care providers (Incentive Points Options System ). The ‘underlying’ for the Incentive Points Options will be a point system in which providers gain/loose points determined by stated performance benchmarks (quality, customer satisfaction, cost reduction, patient volume, errors, etc.). Each point will have a dollar value. The ‘strike price’ for each provider (physician, nurse, pharmacist, etc.) will depend on various factors such as qualifications, experience, job functions, past performance, etc.. The ‘points’ systems will enable the healthcare industry to: a) value and trade inefficiency, efficiency and customer satisfaction, and b) to provide a penalty system for misconduct/inefficiency. Physician group practices, hospitals, pharmacy chains and healthcare companies could buy and sell ‘points’. ‘Points’ could be included in physicians’, nurses’ and pharmacists’ pay packages – ie. instead of a base salary of $120,000, a physician could be paid a base salary of $90,000, X number of points and an incentive option with a higher strike price (X + Y points) – the professional will then gain or loose points depending on his/her performance, measured with industry standards, and any in-the-money ‘points’ will be redeemed with cash at the end of each performance period. f) The patient-physician interaction (patient records, diagnoses, treatment plans, prescriptions, lab tests, referrals, reimbursement, claims, etc.) should be automated and online to facilitate: 1) improved efficiency and quality – patients could fill forms online, and professionals could review cases before the
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appointment, 2) peer review of physicians’ decisions and treatment plans – such reviews could eventually be automated using fuzzy scores, databases and decision rules, 3) performance measurement and dispute resolution. It is assumed that R&D will be encouraged and the best diagnostic methods will be used at the early stages of treatment. 21) The global Telecommunications industry has been hampered by inefficient industrial organization and inadequate incentives. Farquhar & Fitzgerald [ ]; Hazlett [ ]; Binmore & Klemperer [ ]; Banks et al [ ]; Davidson [ ]; Patterson [ ]. Dreazen [ ]. The two main areas are: a) Telecomm companies sometimes inefficiently route data/voice traffic through other company’s networks/lines, thus, increasing costs to customers. An incentive ‘points’ system could be established, and carriers could gain/loose ‘Points’ for efficient/inefficient routing of voice/data traffic loose points to the originating carrier (the Telecommunications Incentive Points System ). Every quarter, carriers that earn above a stated amount of points will redeem their points with cash or federal tax credits. The points system could be developed and maintained by a federal agency and an industry consortium. b) The future of the telecomm sector depends on adequate transmission rights (3G and spectrum rights, etc., are typically auctioned off by governments), but the present method of allocating these rights is grossly sub-optimal and appropriate incentives can vastly improve the sector. The NextWave (US Supreme Court) case illustrates the inefficiencies of rights/spectrum auctions – 1) licenses typically involve huge upfront payments which small innovative companies cannot afford, 2) government revenues are capped, 3) licensees may not be the most profitable users of the spectrum, 4) the bankruptcy process delays sale of licenses, 5) licensees do not have enough incentives to use assets optimally as long as they cover their fixed costs; and 5) given crucial public policy issues (allocation of limited rights among critical military, commercial and individual uses), in the event of licensee’s bankruptcy, the government should have automatic control over the license. Leasing spectrum from licensees is not efficient: 1) leasing does not provide adequate incentives, 2) the license may restrict activities in the spectrum and limit lease terms; 3) lessors/licensees can inflate rental costs; 4) the efficient-allocation problem remains
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unsolved and is pushed to licensees; 5) the government looses control over a key resource; 6) in the US, leasing will have minimal impact because there is little spectrum surplus. Davidson [ ]. Auction values do not reflect the true value of licenses to society, because auction values are largely a function of the bidder’s access to capital (ie. NextWave purchased its licenses for $4.8 billion at auction, and were subsequently auctioned to bigger carriers for $15.8 billion within two years). Salmon [ ]. The most innovative and profitable companies should get the licenses: i) Instead of a one-time license payment at auction, the government: 1) should establish minimum quarterly revenues for each spectrum available for sale, and a periodic ‘participation’ payable to the government (which shall be a fixed percentage of licensees revenues from activities in the spectrum); 2) award the license for an initial 10-15 year term (renewable), based on pre-established criteria such as technological capabilities, projected cash-flow, etc., - for nominal one dollar fee, 3) simultaneously obtain a call option from the license winner to buy back the license for one dollar if the minimum revenues and ‘participation’ payments are not achieved in any three consecutive quarters, or in the alternative, obtain a forward contract in which the license automatically reverts to the government if said targets are not achieved. ii) Instead of a one-time license payment at auction, the government: 1) should establish minimum quarterly licensee revenues for each spectrum available for sale, and a periodic ‘participation’ payable to the government (a fixed percentage of licensees’s revenues from the spectrum); 2) award the license for an initial terms of 10-15 years (renewable), based on several criteria (including technology, usefulness, projected cash-flow, etc.) applied to the three companies that make the highest bids for minimum quarterly revenues (above the government-established minimum) - for a nominal fee of one dollar fee, 3) simultaneously auction three call options to three companies, and each call option will entitle the holder to bid for the license (ie. bid for highest minimum quarterly revenues and ‘participation’) if the initial licensee does not achieve stated performance benchmarks, d) obtain a call option from the winner to buy back the license for one dollar if the minimum revenues and ‘participation’ payments are not achieved in any two consecutive periods at any time after five years from the award of
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the license, or in the alternative, obtain a forward contract in which the license automatically reverts to the government if benchmarks are not achieved after five years. 22) In the construction sector, and in government contracting, incentive options can reduce costs while maintining quality. The construction contract could be in the form of a cash-settled range option awarded to the contractor – such that if the total construction cost falls within a given range, the contractor gets pre-specified gains or penalties. Such incentive options in government contracts could be settled with tax credits. ie. the total construction cost (including the contractor’s profit) is estimated at $7-10, and if its between $5-7, the contractor get a $1.5 payment; $0.8 if its between $7-8, and $0.6 if between $8-9; and a penalty of $0.2 if between $9-10. $10 is the absolute maximum that the customer will pay. 23) In their present form, ESOs contracts involve substantial ‘switching costs’ because employees typically forfeit all ESOs if they leave the firm or are fired before vesting. Burguet, Caminal & Matutes [119]. Fehr & Schmidt [41]. This arrangement is unfair to employees. ESO’s should have ‘phased vesting’ in which portions of ESO awards vest over time as employees complete service. Switching costs include job search costs, lost salary, value of lost ESOs, and litigation/arbitration costs. 24) An alternative to the present form of ESOs is increased monitoring of employees which has a cost. Monitoring does not provide the same psychological and incentive effects as ESOs. Monitoring reduces employee risk taking and affects managerial selection of projects. The extent of monitoring depends on the agent’s liability, limits and monitoring costs (which decrease as with more advances in technology). Thus, the optimal ESO contract will include both monitoring and incentive effects. Fehr & Schmidt [41]. Demougin & Fluet [120]. 25) Social security is typically financed by payroll taxes. In many companies, ESOs are the only form of retirement-type benefits. Governments should impose social security taxes on gains from ESOs, other equity compensation and founder’s stock. This is because: a) many pension plans are grossly underfunded, b) projected government budget deficits, c) inflation, d) outstanding government debt in many countries is substantial, e) many companies do not have any pension plans, f) current employee
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contributions to social security are grossly inadequate, g) the savings rate in many countries is very low – typically 2-8%, h) many employees treat ESO gains as windfall gains. Furthermore, governments could create new classes of pension plans funded by ESOs and other performance-based equity compensation – such plans will be accorded the same tax and regulatory benefits (including portability) as existing pension plans. Under such pension plans: a) employees will have the options of contributing their ESOs to the plans, b) companies will have the options of funding pension plans partly with ESOs and common stock, with the requirement that the company must diversify such plans once the company becomes publicly traded, and that only the employers cash contributions be tax-deductible. 5. Optimal Compensation Structure The foregoing discussion raises the issue of the nature of the optimal compensation structure. Optimal contracting is the foundation of business transactions and can boost efficiency - in many sectors such as healthcare, government contracting, construction, real estate, technology and retailing. ‘Optimal’ in this context means: a) maximization of shareholder value, b) alignment of the interests of shareholders, investors, government and employees (Mutual Interest Theory), c) minimization of compliance costs and operating expenses, d) minimization of external monitoring costs, e) minimization of internal monitoring costs, f) motivation of employees, g) adequate mix of base compensation and incentive compensation. As discussed, although ESOs are somewhat problematic, are superior to most other forms of incentive compensation. The challenge is to develop more efficient ESOs. Brickley [121]. Core [122]. Demougin [120]; Fen & Liang [123]; Forker [124]; Garvey [125]; Hanlon & Shevlin [126]; Desai [127]; Kahle & Shastri [128]; Leuz, Nanda & Wysocki [129]; Nwogugu [130]; Matthewson & Winter [131]; O’Hanlon & Peasnell [132]; Perfect et al [133]; Phillips [134]. Bodie et al [135]. Matsunaga [136]. Disclosure Criteria: The accounting treatment that is chosen for ESOs should be one that should make investors and companies to focus on cash flow and quality of assets. Expensing ESOs simply reinforces the erroneous reliance on the income statement when analyzing and valuing companies. The chosen accounting treatment and disclosure requirements for ESOs should minimize the costs of compliance with accounting standards and disclosure rules. Expensing ESOs either at issuance or at exercise is the most
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expensive, least accurate and most complicated alternative for disclosure. ESOs should be disclosed in the notes to the financial statements. Disclosed data should include: ESOs outstanding, number of in-themoney and out-of-the-money ESOs, the fully diluted effect of in-the-money ESOs, ESO strike prices, hedging of ESOs and equity compensation by executives and employees using derivatives, ESO’s granted and exercised during the period and YTD, dollar value of in-the-money ESOs, the number of ESO’s granted and exercised by employees and executives YTD and during the period, etc.. Hanlon & Shevlin [126]. Finnerty [137]; Forker [124]; Hodder et al [138]; Clearly, ESOs as they are presently structured and used, are flawed. Some options structures can cap returns from options, and match ESO benefits with specific periods of performance – such solutions will drastically reduce agency, moral hazard, valuation and information asymmetry problems associated with the use of ESOs. Conditions for Optimal Incentive Structure 1. Eliminate moral-hazard/agency, free-rider, information asymmetry and over-compensation problems. 2. Ensure that shareholders earn returns and the company has tangible improvements in operations before managers earn incentive compensation. 3. Minimize cash payments by the company; and minimize dilution of shareholder equity. 4. Minimize compliance costs and financial reporting costs. 5. Minimize the propensity to commit fraud while providing strong targeted incentives coupled with performance objectives. 6. Eliminate the possibility of using derivatives to monetize (or change the reward profiles of) equity incentive compensation. 7. Match compensation to performance within specific periods. Alternatives The following are some examples of alternative structures for incentive compensation: a) The Capped Option with averaged-strike and performance-based barriers. The option right exists only if the pre-specified performance targets are achieved – the option is an up-and-in barrier
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option. The ordinary Strike Price is calculated as either 1) a fixed amount or 2) the daily average stock price for the immediately preceding twelve months. There is a ‘minimum reset strike price’ mechanism. This will help ensure that options-holders gain profits only if the company has consistently been profitable. The strike price is adjusted for the effect of dividend payments. A is the original strike price which is calculated as the twenty-four month daily average stock price, and S is the stock price at exercise, and B is the ‘floating automatic-reset strike price’ that will result in a ‘capped return’, Z is the ‘capped return’ in currency units (thus, B = S – Z). R is the ‘Growth strike Price’ which is equal to the normal strike price multiplied by an annual or quarterly factor to reflect investors’ minimum return, and the company’s cost of capital, such that Rt = R(t-1)(1 + r); and R0 = A *(1 + r); where r is the percentage return. Thus, R increases periodically, and the ESO grantee earns profits only if investors make a specified return. D is the present value of expected future dividends, D is non-negative, and D > 0 only for dividend-paying companies. Then at exercise the option payoff = max(0, [S – (max(A, R, B)-D)]). Alternatively, in the case of the reset exercise price, if Sc is the Reset Exercise Price, and S0 is the stock price at exercise time (calculated as the average daily stock price for the immediately preceding twentyfour months), and A is the original fixed strike price, and Z is the capped return, then: Sc = Min[S0, (A + Z)], and the ESO payoff is: C = Max [0, (Sc – (max(A, R) – D))]. This alternative can be used only when publicly-traded or measurable common stock is issued for the difference between the strike price and the exercise price. b) The Range Option with performance-based barriers: the option comes into existence only if certain pre-specified performance targets are achieved – the option is an up-and-in option. The value of the option is directly determined by the range in which the stock price falls at the time of exercise. Consider a call option on a common stock whose current stock price S, is $10.00. The stock can close within six ‘ranges’ - R1 (below $10.00); R2 ($10.01 – 15.00); R3 ($15.01 – 20.00); R4 ($20.01 – 25.00); R5 ($25.01 – 30.00) and R6 (any price greater than $35.00). If at exercise, the stock price is within R1, or R2, or R3, or R4 or R5 or R6 at exercise, then the option payoffs are the amounts A, B, C, D, E, and F respectively. Each ‘Range’ is increased periodically to factor in the investors’ minimum returns, and the
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firm’s cost of capital such that R1t = R1(t-1)(1 + r); and r is the pre-specified percentage rate of return. The option is adjusted for dividends. If the present value of future dividends is Y, then the ESO payoff is: C = Max(0, Max[(A-Y), (B-Y), (C-Y), (D-Y), (E-Y), (F-Y)]), where A, B, C, D, E and F are each equal to zero, unless the stock price closes within their range. c) ‘Average-strike capped and indexed’ ESO with performance-based targets and exercise ‘windows’. Strike prices of ESOs is calculated as the average daily stock price for the immediately preceding twelve months. The stock price S is indexed to an industry activity index such as industry cash flow or industry sales. The strike price is adjusted for the effect of dividend payments if any. X is the original strike price which is calculated as either a fixed amount (private company) or the twelve-month daily average stock price (public company). B is the ‘floating automatic-reset strike price’ that will result in a ‘capped return’, Z is the ‘capped return’ in currency units (thus, B = S – Z). R is the ‘Growth strike Price’ which is equal to the normal strike price multiplied by an annual or quarterly factor to reflect the investor’s minimum return, and the company’s cost of capital, such that Rt = R(t-1)(1 + r); and R0 = X *(1 + r); where r is the percentage return. Thus, R increases periodically, and the ESO grantee earns profits only if investors make a specified return. D is the present value of expected future dividends, D is nonnegative, and D > 0 only for dividend-paying companies. At exercise, the option payoff = max(0, [S – (max(X, R, B)-D)]). Alternatively, in the case of the Reset Exercise Price, if Sc is the Reset Indexed Exercise Price, and S0 is the Indexed stock price at exercise time, and Z is the capped return, then Sc = Min[S0, (A + Z)], and the ESO payoff is: C = (Max [0, (Sc – max(A, R) - D)]). This second alternative can be used only when publicly-traded or measurable common stock is issued for the difference between the strike price and the exercise price. d) The Combination Stock Option , which will be settled with common stock or cash at the company’s option, and which combines a barrier put and a barrier call and is applicable to only publicly traded companies. The option right comes into existence only if pre-determined performance benchmarks are achieved (ie. ROI, cash flow growth, cost reduction, quality, etc.). At exercise, the strike price automatically resets to a strike price that will result in a put-return or a call return to the option
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holder. The strike price is adjusted for the effect of dividend payments, if any. Assume that X is the original strike price which is calculated as either: 1) a fixed amount or 2) the rolling twelve-month daily average stock price; and S is the stock price at exercise, and B is the ‘floating automatic-reset strike price’ that will result in a ‘capped return’, Z is the ‘capped maximum return’ on the call side in currency units; and Y is the capped maximum option payoff on the put side, in currency units. B is binary: B = Bc = S – Z, only if S>X, and B = Bp = S + Y only if X> S. R is the ‘Growth strike Price’ which is equal to the normal strike price multiplied by an annual or quarterly factor to reflect the investor’s minimum return, and the company’s cost of capital, such that Rt = R(t-1)(1 + r); and R0 = X *(1 + r); where r is the percentage return. D is the present value of expected future dividends, D is non-negative, and D > 0 only for dividend-paying companies. Then at exercise, the option payoff = Max{0,[max(0, max(0, [S – (max(X, R, Bc) - D)]))], [max(0, max(0, [(min(X, Bp) + D) - S]))]}. e) Capped Barrier Stock Appreciation Rights – 1) the option right comes into existence only if pre-determined performance benchmarks are achieved (ie. cost reduction, quality, cash flow growth) – the option is an up-and-in option. At exercise, the strike price automatically resets to a strike price that will result in a maximum pre-determined gain to the option holder. The SARs will be settled in common stock or cash. The ordinary Strike Price X, is calculated as either a fixed amount (private companies), or as the daily average stock price for the preceding twelve months (publicly-traded companies). The strike price is adjusted for the effect of dividends. S is the stock price at exercise, and B is the ‘floating automatic-reset strike price’ that will result in a ‘capped return’, Z is the ‘capped return’ in currency units (thus, B = S – Z). R is the ‘Growth strike Price’ which is equal to the normal strike price multiplied by a periodic factor to reflect the investor’s minimum return, and the company’s cost of capital, such that Rt = R(t-1)(1 + r); and R0 = X *(1 + r); where r is the percentage return. R increases periodically, and the ESO grantee earns profits only if investors make a specified return. D is the present value of expected future dividends, D is non-negative, and D > 0 only for dividend-paying companies. Then at exercise, the option payoff, C = max(0, max(0, [S – (max(X, R, B)-D)])). Alternatively, in the case of the Reset Exercise Price, if Sc is the Reset Exercise Price, and S0 is the stock price at exercise time, and Z is the
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capped return, then Sc = Min[S0, (X + Z)], and the ESO payoff is: C = Max[0, (Max [0, (Sc – max(X, R) D)])]. 6. Conclusion ESOs in their present form (including indexed ESOs) are not an efficient method of compensating or motivating employees. The use of ESOs (in their present form) and the expensing of ESO costs by companies will increase the incidence of fraud. ESOs should not be expensed at any time, for various economic, legal and behavioral reasons, but primarily because dilution fully accounts for the impact of ESOs. There are unjustifiable differences in the tax treatment of ESOs, incentive stock grants and Stock Appreciation Rights. ESOs should be taxed only upon sale of the underlying common stock. In most jurisdictions, the existing accounting framework for ESOs is inaccurate. There should be more detailed ESO disclosure in financial statement notes. ESOs are not operating expenses or economic costs, and have minimal or no impact on the company’s solvency. The impact of ESOs is fully accounted for by dilution. In the current forms, ESOs create agency, moral hazard, over-compensation, free-rider, information asymmetry and valuation problems. Repricing ESOs is unfair, even after the statutory (sixmonth) waiting period. In their present form, ESOs have negative psychological impact on investors and provides employees with substantial incentives to commit fraud. ESOs in their present form are an inefficient method of compensation and motivation. ESOs are not debt or equity or hybrid interests. ESOs in their present form, are essentially incomplete contracts and wagering contracts. ESOs can be applied to improve efficiency and reduce costs in the healthcare and technology sectors. Re-designed ESOs can be more efficient than other forms of incentive compensation. There should be limits on employees’ use of derivatives to hedge and monetize their equity compensation. Bibliography 1. Arkes H., Joyner C. & Stone E. (1994). ‘The Psychology Of Windfall Gains’. Organizational Behavior And Human Decision Processes, Vol. 59, pp. 331-347. 2. Ittner C. & Larcker D. (1998). ‘Innovations In Performance Measurement: Trends And Research Implications’. Journal Of Management Accounting Research, Vol. 10, pp. 205-239. 3. Lipe M. (1998). ‘Individual Investor’s Risk Judgments And Investment Decisions: The Impact Of Accounting And Market Data’. Accounting, Organizations And Society, Vol. 23, pp. 625-640.
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