Infectious Greed (38 page)

A spokesman for General Electric was smug about accusations of earnings manipulation, saying, “You have to have the earnings to be accused of smoothing them.”
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General Electric, in particular, received special treatment. Many of the SEC's cases had been prompted by financial journalists' exposés of wrongdoing. Ultimately, those reports led to the bankruptcy
of Enron and WorldCom, and prosecutions of officials at both firms. But, notwithstanding numerous reports since 1994 of careful timing of capital gains, and creative restructuring charges and reserves, at General Electric, the SEC did not bring a case against that firm or its officers.

 

 

I
n hindsight, it is obvious that stock options were a key factor in the major corporate fiascos of the mid-to-late 1990s. As noted in the previous chapter, the rise of stock options was due primarily to regulatory changes: a $1 million cap on tax deductions for executive salaries, with an exception for performance-based compensation (which included stock options), and an accounting rule that said stock options were essentially free.

Professor Kevin J. Murphy, one of the leading scholars studying executive compensation, has estimated that option grants in industrial companies more than doubled from 1992 to 1996.
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Compared to the average worker's pay, CEO compensation in 1996 was three times higher than it had been before 1990. Including stock options, the average CEO made 210 times more than the average worker.
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There were many arguments in favor of options, most notably that they aligned the incentives of managers and shareholders. However, options only aligned incentives in one direction. Managers who held options had a limited downside, whereas shareholders were not so protected. That meant that both managers and shareholders benefited when shares went up, but managers were more willing to gamble because of their limited downside. This was especially true when companies, such as Cendant, repriced executives' stock options when the stock went down, lowering the price at which they could buy stock, or when companies
reloaded
executives' stock options by issuing new options when an executive cashed in some options before their maturity.

In other words, executives who owned
stock
were aligned with shareholders—for good or for ill—but executives who owned
options
were less aligned with shareholders because their downside was limited. The difference between a CEO with stock and a CEO with options was like the difference between a captain who was prepared to go down with the ship, and a captain with the only lifeboat (or, better yet, a helicopter) set aside for times of danger. The best way to align the incentives of executives and shareholders was to put them in the same boat, which stock options did not do.

Some economists worried that CEOs were too risk-averse, and therefore favored stock options precisely because they encouraged CEOs to take on more risk. This argument was more speculative. Before the mid- 1990s, CEOs had taken on plenty of risk without the incentives of huge, 10-year stock-option grants—Walter Forbes, Dean Buntrock, Al Dunlap, and Martin Grass were all examples. Moreover, when the stock price declined, options could lead CEOs to take on too much risk.

Besides, if companies really wanted to “incentivize” their CEOs, they could do so in two ways that made much more economic sense. First, they could pay CEOs more in stock, based on their performance. For example, Jack Welch had received hundreds of millions of dollars of
restricted stock
—stock that could not be sold in the market for a period of several years. This stock carried many of the regulatory benefits of stock options, but forced executives to think more about downside risk.

Second, they could pay CEOs in stock options that were based on how well their company did relative to its competitors or an index, so that CEOs were rewarded for outperforming the market and not merely for being in office as the tide rose.

Many companies offered restricted stock, but the percentage of stock held by CEOs—ignoring stock options—actually declined throughout the mid-1990s.
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Only one in 1,000 firms offered
indexed
options—based on how well its stock did relative to other stocks. Why? The only plausible explanation was legal rules: these two alternatives were better economically, but they forced companies to record an expense. (Unlike standard stock options,
outperformance
options had to be disclosed as an expense, because the 1972 accounting rule had created exceptions only for options with a fixed-exercise price.)
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Stock options had other drawbacks. They diluted the value of shares, because if the price of a stock went up and executives exercised their right to buy shares, there would be more shares outstanding and each shareholder would own a smaller fraction of the company. Companies were required to disclose this dilution in their financial statements, although many companies tried to minimize dilution by repurchasing from shareholders enough stock to set aside for executives when they exercised their options. The problem with repurchases was that they required companies either to spend cash that could have been used in more valuable projects, or—if they wanted to repurchase shares and do the projects—to borrow money, thereby increasing their debt.

Options also were a very expensive form of compensation, because
the cost of the stock options granted to executives, in terms of how they were valued in the market, was much greater than the value to the executives themselves. An economically rational CEO would much rather have $1 million in a diversified portfolio (or in cash) than $1 million of stock options. In order to pay a CEO $1 million of value (to the CEO), it would cost the company either $1 million of cash or, say, $2 million of options. The reason was that CEOs had so much invested in their companies—reputation, other compensation, pensions, and so forth—that a concentrated position in stock options was just about the least valuable form of compensation they could receive. One of the central tenets of modern finance is that a diversified portfolio is worth more than a concentrated one, because it is less volatile. CEOs valued diversification, like anyone else. Some studies showed that, in rough terms, a typical CEO valued stock options at half their market value.
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In other words, it was twice as expensive for companies to pay their CEOs in stock options as it was to pay them cash.

Another odd consequence of stock options was that they advantaged CEOs who were already rich or who liked risk, because they placed a higher value on stock options than their middle-class, risk-averse counterparts. Again, the explanation was diversification. A rich CEO would have only a small part of her wealth in options, whereas a middle-class CEO would have a much more concentrated position. According to Professor Murphy, a CEO with 90 percent of her wealth in her company's stock options would value those options only
a fifth
as much as a wealthy CEO with the same options, if those options represented only half of her wealth. In other words, companies might prefer to hire rich CEOs because they didn't have to pay them as much.

The list of problems with stock options goes on and on. Because options do not receive dividends, CEOs who receive large stock-option grants have an incentive to reduce dividends. In fact, the dividends paid by public companies decreased dramatically during the 1990s. Before that, dividends—not capital gains—accounted for three-fourths of the returns from stocks, and companies signaled that they were doing well, not by increasing reported earnings to meet expectations, but by paying high cash dividends.
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(Another reason not to pay dividends is that they are taxed, but this feature did not change during the same period.)

But the biggest problem with options granted during the 1990s was that they were hard to value. Most options granted during the 1990s had long maturities, and restrictions that limited the use of option-pricing
models, such as the Black-Scholes model. For example, 83 percent of options had 10-year terms, and most executives could not cash in the options for several years. That meant the maturities of most executive stock options were more than twice as long as the options Bankers Trust and Salomon Brothers had been unable to value. Options models did not work well for long-maturity options, primarily because the variables—especially the key variable, volatility—change so much over time. Moreover, the restrictions on cashing in options were very difficult to incorporate into an options-pricing model. By one estimate, the true value of a typical executive stock option was only about half of the value estimated by the Black-Scholes model.
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In other words, the opponents to the FASB rule requiring companies to include stock options as an expense—particularly Senator Joseph Lieberman—had a valid point: these options were quite difficult to value. Consultants to corporate boards gave a wide range of valuations for options, and some directors used a rough rule of thumb that the value of a typical option was about one-third of the value of the stock. But given the uncertainty about value, was it really a responsible business decision to give executives options in the first place? Even with a rough rule of thumb, it was easy to see that the stock options were of very high value. By this measure, one million options on a stock with a price of $60 were worth about $20 million. Walter Forbes, Dean Buntrock, Al Dunlap, and Martin Grass had millions of stock options, each. And they were not alone: with the dramatic increase in stock-option grants to corporate executives in the mid-to-late 1990s came greater temptation for corporate executives to commit fraud.

The corporate frauds of the mid-to-late 1990s likely would not have occurred without the dramatic increase in stock-option grants to corporate executives. Three conclusions from this period are indisputable: first, legal changes in the early 1990s led companies to give unprecedented amounts of stock options to their CEOs; second, those stock options became much more valuable if companies inflated profits and hid losses for a few years; third, many companies, in fact, engaged in accounting fraud.

 

 

A
s stock options were on the rise, other new financial instruments were coming back to life after a brief post-1994 hibernation. The over-the-counter derivatives markets continued to grow, and with them the concern that corporate executives who wanted to manipulate earnings might
move beyond simple accounting tricks to use derivatives in schemes of unimaginable complexity.

One reason these new instruments hadn't appeared in a major accounting scandal yet was that top-level corporate executives—whose involvement typically was required—didn't understand them.
Risk
magazine, a leading financial-industry publication, harshly concluded, “Top management, whether corporate or otherwise, failed to understand the nature of the products being used in their treasuries or trading operations.”
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Whereas the derivatives scandals of the early 1990s had come from the bottom (salesmen and traders at Bankers Trust, First Boston, and Salomon; junior treasurers at Gibson Greetings and Procter & Gamble), where at least some of the people understood derivatives, the more recent accounting scandals had come from the top, where most CEOs did not.

Even several years later, corporate boards still had a lot to learn about financial engineering. According to partners at several major accounting firms, most board members had only a cursory grasp of their risk exposures in 1996.
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In response to the fiascos of 1994, most boards had approved policy statements dealing with derivatives, but not much more. A traditional audit was of little value in assessing financial risk, and members of corporate-audit committees often didn't even know the right questions to ask. Corporate directors attempted to insulate themselves from liability for any future problems by implementing corrective procedures and controls, but that didn't mean they actually understood any of the details themselves.

Corporate directors of many of the top companies in the world—from Aetna to Dow Chemical to General Electric—did not spend much time focusing on these new financial risks. Barbara Scott Preiskel, a member of the board of General Electric, told
Derivatives Strategy
magazine, in 1996, “At GE, we've never had a full board discussion about derivatives.”
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That was a shocking admission, given that General Electric had made (and lost) huge amounts of money on new financial instruments, and its financial subsidiary, GE Capital, had been involved in derivatives markets for many years. Clayton Yeutter, former chairman of the Chicago Mercantile Exchange and a member of half a dozen major boards, agreed that corporate directors rarely discussed or understood new financial techniques: “It's a rare occurrence where the board is in a position to dispute the presentation of a senior financial officer on risk management matters.”
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No wonder so many CEOs were walking away with $100 million of stock options.

Directors of companies felt—perhaps quite rationally—that their role was to put procedures in place, and then rely on others to do their jobs. But, as a result, the responsibility for ensuring that shareholders were not exposed to undue or undisclosed risks fell on senior executives and their accountants—precisely the same people who had just completed a round of unprecedented accounting fraud.

There were some signs, even in the early accounting scandals, of new financial instruments lurking in the background. To give one example, one of Cendant's first acts after the merger of CUC and HFS was to issue $1 billion of new financial instruments bizarrely called FELINE PRIDES. A few months later, owners of these FELINE PRIDES would become embroiled in litigation surrounding Cendant, as yet another victim of the company's fraud. But the Byzantine structure of these instruments—the very nature of the FELINE PRIDES—raised troubling questions about the state of U.S. financial markets.