April 15, 2004, 8:39 a.m.
Options to Sue
The danger of “reforming” executive pay.

I have not been able to figure out what all the fuss is about when it comes to stock options for business executives. The people who want to require that the estimated cost of these options be subtracted from companies' bottom lines argue that it will do a lot to prevent corporate corruption. Opponents of this requirement make it sound as though it would put an end to America's high-tech sector. It's been hard to see how either claim could be true.

For supporters of "expensing" options — i.e., deducting their estimated cost from corporate profit reports — the issue is simple honesty. Stock options for executives are a form of compensation and should be reported as such. Moreover, we should not encourage stock options over other forms of executive compensation by making it possible to hide their impact on shareholders.

Opponents say that nothing is hidden. Corporations already disclose all the information that the reformers want, albeit not as prominently as they want. Moreover, the impact of the options on price-per-share is revealed the moment the options are exercised — which is to say, the moment a cost is actually incurred. Opponents also say that there is no reliable method of estimating what options will cost years before they are exercised.

As far as I can tell, the opponents are right about these points. But I still have not been able to see what's so terrible about expensing. If the stock market is rational, how can a requirement that meaningless information be reported affect anything? If the information is meaningful, on the other hand, why can't markets factor it in now, since it is already publicly disclosed? (I take it that this is the position taken by Holman Jenkins, the terrific business columnist for the Wall Street Journal's editorial page.)

I could see the point of blocking a proposal such as the one offered by Senators John McCain and Carl Levin, which would have limited the corporate deduction on stock-option compensation to the original estimate. That would have led to some double taxation. If the estimate was too low, the value of the option would have been taxed at both the individual and the corporate level. And since the value is impossible to estimate reliably, the amount of double taxation would have been unpredictable. That would have been a powerful disincentive to the issuance of stock options to employees, and the high-tech industry's hostility to the measure was fully justified.

Now that I have read a new paper by Kevin Hassett and Peter Wallison of the American Enterprise Institute, I can see why expensing is a problem, too. They note that the Financial Accounting Standards Board is leaning toward requiring expensing without specifying the method for determining the value of the options — an implicit admission that it is difficult to come up with a good one. (Most of the paper is dedicated to explaining the technical reasons that is so.) Leaving the choice up to companies and their auditors, write Hassett and Wallison, "creates a serious legal risk for both companies and auditors to which the Board seems oblivious."

They continue: "In the absence of a designated and approved method for valuing employee stock options, companies will have to make choices, not only about the model to be used but the various inputs that the model requires. These choices can have a substantial impact on the reported earnings of a company, and that in turn can leave companies open to class-action lawsuits by disgruntled shareholders."

Fear of legal exposure may well operate the same way a double tax would have: as a powerful disincentive to issue stock options. The journalists on the pro-expensing side have been awfully smug. They have criticized the congressmen who want to stop FASB from acting on the ground that they should leave regulatory issues to the experts. (The constitutional principle here would seem to be the separation of Congress from legislation.) But the congressmen — notably the House Republican and Democratic leaders, Denny Hastert and Nancy Pelosi — are right.

A case can be made that the use of options has gotten out of hand. The tax code favors options over salaries (there are limits on the deductibility of high salaries) and stock gifts. But the answer is to fix the tax code, not to unleash the tort bar on high-tech companies.

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