Study affirms peril of stock optionsRight-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
By
Al Lewis, Denver Post Business ColumnistRight-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Tuesday, March 22, 2005

Stock options are an economic incentive to commit fraud.

Anyone aware of the allegations at Qwest - which restated billions in revenues after its top executives cashed millions in stock options - already knows this.

"Why would you commit a fraud unless you were going to benefit from the fraud?" says Purdue University finance professor David Denis.

It sounds obvious.  But in the world of academia, even the obvious must be statistically verified.

So Denis - along with Santa Clara University finance professor Atulya Sarin and Purdue graduate student Paul Hanouna - studied 358 companies that were accused of fraud in shareholders' lawsuits between 1993 and 2002.

Their not-so-surprising conclusion:  The more stock options companies give their executives, the more likely they are to be accused of fraud.

The study, which has yet to be published, included scores of companies, from America Online to Qwest and Xerox.  Many of the alleged frauds have been long forgotten:  Woolworth Corp., Fruit of the Loom Inc. and American Cyanamid Co. to name a few.

History's two biggest frauds - WorldCom and Enron - came to the courts too late to be included in the study.  But these disasters would have only bolstered the study's conclusion.

Most of the frauds covered by the study fell squarely into two categories:  Misstated financial reports or misrepresented prospects.

It's the old pump-and-dump:  Hype your company's potential or just inflate the books while you unload your stock on an unsuspecting public.  This scheme is as old as stock itself.  But the notion that corporate executives should have millions of stock options is not.

In 1984, stock-based compensation made up less than 1 percent of CEO pay for the median company.  By 2001, that figure had climbed to 66 percent, according to research cited in Denis' study.

Ironically, this was the result of reforms in executive compensation.  Shareholders in the 1980s were upset when CEOs got raises as their stocks crashed.  So they pushed for stock options to align management's interests with their own.

Under this plan, executives would receive options to buy stock at a certain "strike price."  If executives managed their companies well, the stocks would climb above the strike price and the executives would get rich for a job well done.  Study after study has demonstrated that stock options are indeed a powerful tool for aligning the interests of management with the interests of shareholders.  But Denis' study underscores that stock options have a dark side as well.

After an unprecedented spate of corporate fraud, the use of stock options is now in decline.  They were once a way for companies to print money - issuing paper to key executives and employees instead of cash.  But beginning June 15, large publicly traded companies will be required to report stock options as expenses.  Once they become expenses, they will have to be doled out sensibly.

Denis wouldn't do away with stock options, despite their dark side.

"This is more of an indictment of boards of directors than the use of options," Denis said of his study.  "When you have options in place, you've got to be more careful, and boards of directors have not been careful."

Bruce Brumberg, editor of Mystockoptions.com, an online educational resource, concurs.  But he adds these people to the list of folks who should have been more careful:  cheerleading media and analysts, lax regulators and a generation of investors with a gold-rush mentality.

"Americans believe executives should be well-paid," Brumberg said.  "We also believe they should be paid for their performance."

Indeed.  Few batted an eye at reports of enormous stock-option profits until after the market crashed.

"If it weren't stock options, it would be something else," Brumberg said.

"What we have to do is make sure that when (corporate executives) claim a touchdown, that they really did score a touchdown."

Al Lewis' column appears Sundays, Tuesdays and Fridays. Reach him at 303-820-1967 or
alewis@denverpost.com.

By Al Lewis, Denver Post Business ColumnistRight-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Tuesday, March 22, 2005

Stock options are an economic incentive to commit fraud.

Anyone aware of the allegations at Qwest - which restated billions in revenues after its top executives cashed millions in stock options - already knows this.

"Why would you commit a fraud unless you were going to benefit from the fraud?" says Purdue University finance professor David Denis.

It sounds obvious.  But in the world of academia, even the obvious must be statistically verified.

So Denis - along with Santa Clara University finance professor Atulya Sarin and Purdue graduate student Paul Hanouna - studied 358 companies that were accused of fraud in shareholders' lawsuits between 1993 and 2002.

Their not-so-surprising conclusion:  The more stock options companies give their executives, the more likely they are to be accused of fraud.

The study, which has yet to be published, included scores of companies, from America Online to Qwest and Xerox.  Many of the alleged frauds have been long forgotten:  Woolworth Corp., Fruit of the Loom Inc. and American Cyanamid Co. to name a few.

History's two biggest frauds - WorldCom and Enron - came to the courts too late to be included in the study.  But these disasters would have only bolstered the study's conclusion.

Most of the frauds covered by the study fell squarely into two categories:  Misstated financial reports or misrepresented prospects.

It's the old pump-and-dump:  Hype your company's potential or just inflate the books while you unload your stock on an unsuspecting public.  This scheme is as old as stock itself.  But the notion that corporate executives should have millions of stock options is not.

In 1984, stock-based compensation made up less than 1 percent of CEO pay for the median company.  By 2001, that figure had climbed to 66 percent, according to research cited in Denis' study.

Ironically, this was the result of reforms in executive compensation.  Shareholders in the 1980s were upset when CEOs got raises as their stocks crashed.  So they pushed for stock options to align management's interests with their own.

Under this plan, executives would receive options to buy stock at a certain "strike price."  If executives managed their companies well, the stocks would climb above the strike price and the executives would get rich for a job well done.  Study after study has demonstrated that stock options are indeed a powerful tool for aligning the interests of management with the interests of shareholders.  But Denis' study underscores that stock options have a dark side as well.

After an unprecedented spate of corporate fraud, the use of stock options is now in decline.  They were once a way for companies to print money - issuing paper to key executives and employees instead of cash.  But beginning June 15, large publicly traded companies will be required to report stock options as expenses.  Once they become expenses, they will have to be doled out sensibly.

Denis wouldn't do away with stock options, despite their dark side.

"This is more of an indictment of boards of directors than the use of options," Denis said of his study.  "When you have options in place, you've got to be more careful, and boards of directors have not been careful."

Bruce Brumberg, editor of Mystockoptions.com, an online educational resource, concurs.  But he adds these people to the list of folks who should have been more careful:  cheerleading media and analysts, lax regulators and a generation of investors with a gold-rush mentality.

"Americans believe executives should be well-paid," Brumberg said.  "We also believe they should be paid for their performance."

Indeed.  Few batted an eye at reports of enormous stock-option profits until after the market crashed.

"If it weren't stock options, it would be something else," Brumberg said.

"What we have to do is make sure that when (corporate executives) claim a touchdown, that they really did score a touchdown."

Al Lewis' column appears Sundays, Tuesdays and Fridays. Reach him at 303-820-1967 or alewis@denverpost.com.