Abuse of Stock Options
Alex Zakson
June 07, 2006
A Stock Option is a commitment by a company to sell a fixed number of shares over a fixed number of years at a fixed price. Since the price is set at the time of the grant the stock option has value only if the stock price is higher at the time of exercise than grant. The intent is for those who directly affect the stock price through their actions to share in the success of the company.
But, if executives and managers, through their ineptitude cause the stock price to drop precipitously, and the stock options become worthless, instead of firing the crew, companies have come up with devices to ensure that the in-crowd makes money anyway. One device is to grant additional options and the now lower market price. Another is to convert the higher priced options to options at a lower price, albeit with fewer shares. At maturity, the recipients will exercise only options that show a gain, and let those without value elapse, ensuring that they make money.
For example a four-year 1,000-share option at $50 a share allows the recipient to pay $50 per share to acquire up to 1,000 shares in a period of no less than 4 years, regardless of the then current price of the stock. If the market price is higher, say $100, the recipient will realize a well-earned gain of $50,000. If during the grant period the stock price drops to, say $20, the option becomes worthless. So the company grants a new option of 1,000 shares at $20 per share. Now if during the next 4 years the stock price reaches $40, the recipient will exercise the second option, gaining $20,000, and let the original option lapse. If the company had chosen to exchange the original 1,000-share $50 option for an 800 share $20 option, the gain would have been $16,000. Thus instead of punishment for ineptitude: stock price dropped from $50 to $40, the grantee is rewarded with a gain of $16,000 to $36,000, depending on the scenario. Imagine the rewards if the shares number in the tens or hundreds of thousands.
To stop this abuse and ensure fairness, I believe that the SEC must pass two rules: Prohibit conversion of one stock option for another at a lower price.
Forbid anyone from exercising a more recent option, if an earlier option is still outstanding. Thus key employees would have to participate in both benefits and risks. Consequently, those who caused an overall drop in stock price would not benefit from a partial recovery.
But, if executives and managers, through their ineptitude cause the stock price to drop precipitously, and the stock options become worthless, instead of firing the crew, companies have come up with devices to ensure that the in-crowd makes money anyway. One device is to grant additional options and the now lower market price. Another is to convert the higher priced options to options at a lower price, albeit with fewer shares. At maturity, the recipients will exercise only options that show a gain, and let those without value elapse, ensuring that they make money.
For example a four-year 1,000-share option at $50 a share allows the recipient to pay $50 per share to acquire up to 1,000 shares in a period of no less than 4 years, regardless of the then current price of the stock. If the market price is higher, say $100, the recipient will realize a well-earned gain of $50,000. If during the grant period the stock price drops to, say $20, the option becomes worthless. So the company grants a new option of 1,000 shares at $20 per share. Now if during the next 4 years the stock price reaches $40, the recipient will exercise the second option, gaining $20,000, and let the original option lapse. If the company had chosen to exchange the original 1,000-share $50 option for an 800 share $20 option, the gain would have been $16,000. Thus instead of punishment for ineptitude: stock price dropped from $50 to $40, the grantee is rewarded with a gain of $16,000 to $36,000, depending on the scenario. Imagine the rewards if the shares number in the tens or hundreds of thousands.
To stop this abuse and ensure fairness, I believe that the SEC must pass two rules: Prohibit conversion of one stock option for another at a lower price.
Forbid anyone from exercising a more recent option, if an earlier option is still outstanding. Thus key employees would have to participate in both benefits and risks. Consequently, those who caused an overall drop in stock price would not benefit from a partial recovery.
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