On July 6, 2006, SEC Commissioner Paul Atkins spoke at the 11th Annual Conference of the International Corporate Governance Network (see www.sec.gov/news/speech/2006/spch070606psa.htm).The ICGN is a U.K. nonprofit that aims to "develop and encourage adherence to corporate governance standards and guidelines, and to promote good corporate governance worldwide." What a great audience to come before to display how this most powerful regulatory agency is committed to protecting the capital markets!
Atkins stepped up to the podium with this statement: "The title of this conference, 'Creating Value - Building Trust' is refreshingly upbeat." He then uttered the standard disclaimer that the views he was about to express were his own and not the commission's, which is fortunate because he went on to tackle an issue that he does not understand and took a stance that represents the worst of the weak attitudes demonstrated by today's leaders in the financial markets.
Specifically, Atkins talked about stock options, delving into recently unveiled despicable actions designed to put more of the stockholders' money in employees' pockets. To his credit, he condemned deliberate back-dating, in which grants are assigned to the date in the past when the stock price was at its lowest.
But, much to the puzzlement of ourselves and others, he then clearly condoned the practice called "spring-loading." In this situation, directors agree to grant options, but must decide whether to grant them before or after releasing good news that will push the stock price higher. If the price rises, so also will the options' value.
For example, suppose 10 million options were to be granted before publishing the good news when they're worth $3 each, for a total nominal transfer of $30 million. Then, suppose the news drives up the stock value and the options appreciate to $10 each. At that point, the employees hold options worth $100 million.
If, instead, the grant is deferred until after the news drives up the stock price, the options will be written with a higher strike price and be worth, say, $4 each. To provide a comparable value of $100 million, the company has to grant 25 million options instead of only 10 million. In either case, the directors would have transferred $100 million of shareholders' wealth to the employees.
Amazingly, Atkins concluded that shareholders are better off with the spring-loaded tactic. He completely missed several points when he said: "In approving the grant, the directors may determine that they can grant fewer options to get the same economic effect because they anticipate that the share price will rise. Who are we to second-guess that decision? Why isn't that decision in the best interests of the shareholders?"
Mr. Atkins is pretty sophisticated, and was long involved with the SEC before becoming commissioner, so he knows he can call on some very smart people for advice. However, it appears he failed to ask.
In the above example, SFAS 123R would require the company to acknowledge that only $30 million of compensation was prepaid to the executives. This amount would then be allocated over the vesting period; if that were five years, the reported expense would be $6 million per year. Notice that the executives have pocketed $100 million of value, yet the shareholders are told that the compensation cost is only 6 percent of that amount.
On the other hand, if the directors wait and issue 25 million options at $4 each, GAAP would require $100 million of compensation to be spread over the next five years at $20 million each year. It would take an extreme optimist, nay, a totally naive person, to believe that the directors would spring-load the options without noticing that doing so minimizes the reported expense.
Note that the eventual sacrifice by the shareholders is the same whether the grant is dated before or after the good news is released. However, the reported cost in the financial statements is substantially lower if they're given away beforehand. We'd venture to say that earnings management is the primary, if not the only, motive behind spring-loading, and an ulterior one at that.
Who are we to second guess?
Next, consider this series of answers to Mr. Atkins's question, "Who are we to second-guess that decision?"
* You are a seated member of the SEC;
* The SEC is charged with producing fairness in the capital markets;
* The scope of the commission's authority includes establishing and enforcing accounting and reporting standards that promote fairness;
* The commission delegated the duty of developing those standards to the Financial Accounting Standards Board, while retaining oversight;
* The commission has the duty to supplant standards that don't produce useful information; and,
* It has the authority to prosecute miscreants (including managers and directors) who abuse those reporting standards with the goal of misleading the markets.
That's who you are, commissioner, and that's why we condemn your bizarre stance that nothing is wrong with spring-loading.
Read our lips, commissioner: Spring-loaded options are detrimental to shareholders in particular and the capital markets in general. In looking only at the letter of the law, you completely missed an opportunity to reinforce the SEC's longstanding policy goal of fair and full disclosure.
Instead, you have blessed a stock-option maneuver that deliberately, and severely, distorts the related financial statements and destroys investors' confidence and trust. Your blunder is even more ironic in light of the commission's July 26 release calling for substantially more information about executive compensation!
Wait, there's more!
Atkins wasn't done, because he then went on to assert that spring-loading is not insider trading. Surely he knows that this complicated issue can only be resolved after a lengthy and complex due process. And he must also know that he and the other commissioners will be called on to reach an official verdict on that issue after the evidence is mustered.
But what did he do in this speech? First of all, he took a stand that is not substantiated by precedent. Second, in a very conspicuous setting, he put into the public record proof that he has already made up his mind before the due process has even started!
Did he not anticipate that his statement would destroy his impartiality and credibility, while damaging the public's confidence in the commission's ability to protect the capital markets? Apparently these thoughts never crossed his mind.
The FASB angle
We couldn't come this far without making a couple of points about the Financial Accounting Standards Board's role in this situation.
First, the board's option standard not only produces bad accounting, but also provides an opportunity for management to play games with its financial statements. Although FASB's members knew that measuring the cost as of the grant date would lead to these results, they put it into effect anyway.
There's no doubt that better information flows when options are reported on the balance sheet as derivative liabilities and marked to market to reveal the effect of changes in their value. If such a standard were in place, there would be no incentive for managers to spring-load, and the capital markets would have direct access to the information they need.
Second, the spring-loading situation illustrates the untapped and immense power in the Rule 203 exception that FASB is poised to eliminate. (As a reminder, this exception exists to compel auditors to reject misleading GAAP numbers.) In our example, the SFAS 123R measure of $30 million compensation should be set aside as misleading, and replaced by the $100 million measure, because the latter more reliably describes the real value transferred to the employees.
Without the 203 exception, auditors have no choice but to countenance the smaller number, and thus become de facto co-conspirators with management in a plot to deceive shareholders. If they were to analyze their situation this way, we believe auditors would find this just as intolerable as we do.
Better thinking and more character is needed at the top. If Atkins' speech, managers' deception, FASB's compromises and auditors' acquiescence are the best the accounting and regulatory professions can offer, it's time for some serious housecleaning, maybe even a revolution.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at firstname.lastname@example.org.
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