TCS Daily

An Expensive Proposition

By James K. Glassman - October 16, 2003 12:00 AM

Editor's note: TCS Founder and Host James K. Glassman recently interviewed former SEC commissioner Laura Unger about stock options and technology companies.

TCS: You're a former SEC Commissioner and in fact a former acting Chair of the SEC. The Financial Accounting Standards Board (FASB) and SEC Chairman Donaldson believe that expensing stock options is absolutely necessary to address new corporate governance concerns. Do you think mandatory expensing of stock options is necessary to bring clarity and integrity into corporate financial statements?

Laura Unger: No, I don't.

TCS: Why not?

Unger: The goal of Sarbanes/Oxley legislation passed by Congress last year was to bring corporate reform -- provide integrity, transparency, and, really, credibility back to the markets, and to restore investor trust in corporate America.

So now all eyes are on what kind of transparency we need to accomplish this. What do investors need to make an informed investment decision?

Because conventional wisdom is that stock options played a prominent role last year's corporate scandals, regulators are examining whether that means that we should now expense stock options. The real question though is whether or not this will actually get useful information into the hands of investors.

Talking through the issue of expensing stock options raises two different questions. One involves corporate governance reform and whether stock option expensing provides transparency essential to good corporate governance. The second is the whole notion, separate and apart from that, which asks whether or not we need to expense stock options.

We also need to distinguish between the public's visceral reaction to options for company officers -- especially at the CEO level where there seems to be a disincentive for CEOs to focus on long-term growth at the company in favor of focusing on short-term growth, short-term returns, and getting rich quick -- and for other employees. The fact of the matter is that broad-based stock options plans benefit all employees, not just executives, and that for many companies, especially in Silicon Valley, stock options are necessary to lure highly-trained, highly-talented individuals who would go elsewhere were it not for the incentive created by stock options. Companies like Intel, Cisco and even Microsoft wouldn't be what they are today without stock options.

Eliminating broad-based plans for employees -- which would be the net result of mandatory expensing -- would curtail job growth and will make it harder for U.S. companies to compete in the global marketplace.

TCS: It seems to me that someone who reads these company reports knows that under the current rules, you have a choice: You can either expense stock options coming up with some sort of a formula and add an expense to your income statement, or you can describe the extent of the stock options in great detail in the notes. And when I say notes, you know better than anyone, its not little tiny things in small type, its actually really the most important part of any financial statement.

Most companies extensively disclose -- they tell when the options are due and what the exercise price is and how many are out. Some people would say that is a good deal more transparency than sticking a number in the income statement. Do you agree with that?

Unger: I do agree with that because I think the average investor doesn't really understand financial statements. But most investors do understand a narrative that describes what compensation plan for a particular company and whether it includes stock options.

TCS: In your experience at the SEC and the business world in general, do you think analysts simply look at the bottom-line earnings number or do they examine the statement with more care and make their own judgments, adding and subtracting from that earnings number?

Unger: I think it varies from analyst to analyst. But certainly, no analyst just focuses on the bottom-line. They look at the business management, and a whole host of other issues. No one looks at just the bottom-line financial number. They generally drill down past the bottom line and take it apart and analyze it.

TCS: Do you think a company that chooses, as most of them do today, to take the alternate route -- very broad disclosure in the foot-notes, as opposed to a single number in the expenses -- is acting with integrity or is trying to hide something?

Unger: Well, if it was trying to hide something, there would be no disclosure (laughs). So, I would presume they were acting with integrity. But the problem with expensing options is that the bottom line number doesn't necessarily reflect the actual impact on the company of expensing the options. What I think is important to the analyst community or to the analyst generally, is the dilutive effect of options that are exercised.

TCS: Could you just explain that?

Unger: By dilution I mean the impact on the number of shares that are outstanding and the impact on existing shareholders that an exercise of options resulting in more shares outstanding has on holdings and the market in general. I can speak from first-hand experience on this because I'm on the board of a software company that issues broad-based stock option plans. The majority of shareholders, the institutional shareholders, care about the dilutive affect of the option grants, not the impact on the bottom-line financials.

TCS: One of the problems with expensing, it seems, is coming up with a formula that works. Black-Scholes has pretty much been rejected because it would reduce earnings by as much as 65% for some companies. Are you aware of any expensing method that has been agreed upon and that seems promising?

Unger: No, not to my knowledge.

TCS: Do you think that the administration should view stock options as part of its jobs focus?

Unger: Definitely. Stock options are a powerful tool for start up entrepreneurial and existing technology firms to attract talent, particularly in Silicon Valley. Broad based options benefit everyone in the company when that company becomes successful.

I can't tell you the number of times I've heard, especially when I worked on Capitol Hill, that small-business is the engine of economic growth. And with our engine of economic growth sort of in the sputtering stage, I think this is the worst time to roll the dice and gamble that expensing stock options won't negatively affect the economy.

TCS: Some people say that stock options will continue to be distributed to a broad base of employees, even if expensing goes through. Do you agree?

Unger: No I don't agree with that. Again going back to the board of the software company that I sit on, we've had the conversation about expensing options, and would be extremely negative or deleterious to the bottom-line of the company. I think that every company that would have to take that hit, would think long and hard about whether to continue granting stock options.

TCS: Let me ask you semi-political question. Howard Dean, the leading Democratic candidate for president and almost all of the other Democrats oppose the mandatory expensing of stock options. President Bush is also on the record opposed to the expensing of stock options, but members of his own Administration, most notably SEC Commissioner Donaldson, are leading the charge to expense. Do you think the Republicans will be hurt in 2004 if expensing goes forward?

Unger: If the impact of expensing is a bottom-line hit to earnings, and the price of the stock of these companies went down and you could actually see a correlation in the timing from the expensing of stock options to laying off people, or decline in their business or decreased revenues, then yes, I could say you would have a very strong case that it was caused by expensing stock options. That result would negatively impact the party or the group of individuals who pushed for expensing stock options.

TCS: Thanks for taking time to talk with us.

Unger: Thank you.


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