The Association of U S West Retirees



Pushing Fast-Forward on Options
By Ben White
Washington Post
Monday, December 19, 2005

At least 22 Washington area companies are among hundreds nationwide that have transformed millions of stock options, many of which would not have been available for executives to use until 2009, into fully vested shares.

According to Wall Street estimates, the fast-forwarding could wipe away more than $4 billion in expenses that would otherwise have shown up on income statements starting in 2006 under a new accounting rule that goes into effect Jan. 1.

None of this is illegal. But some financial analysts and corporate-governance experts say it is a dubious exercise nonetheless because it undermines the intent of the much-debated new rule. The critics also say that speeding up options hands an extra treat to already-well-fed executives, hurts a company's shareholders and misleads prospective investors.

Many of the companies that have pushed forward options vesting dates to beat the Dec. 31 deadline come from the high-technology and health care sectors, industries that have been heavy users of stock options in recent years.

Linthicum, Md.-based network specialist Ciena Corp., for example, announced in late October that it would accelerate the vesting dates for 14.1 million shares awarded to employees, officers and directors. Ciena said the accelerated vesting would help the firm erase $21.5 million in expenses.

While that is just a small fraction of the $436 million the company lost in the past year, executives nevertheless said they thought it made little sense for the company to record a cost based on options that are "out of the money," meaning the current market price of the stock had fallen below the fixed price at which the options were awarded. In such cases, employees typically delay exercising the options until the stock price rises. At that point, they are "in the money" and can be resold at a profit.

"Ciena's board of directors considered the expense savings that will occur under new accounting regulation and the lack of employee retention value associated with out-of-the-money options and firmly believes that accelerating these options is in the best interest of the Company and its shareholders," Ciena Executive Chairman Patrick H. Nettles said in a news release.

Nonsense, say the critics.

"This is simply a tactic by companies to lower their expenses and artificially inflate their earnings," said Bear Stearns analyst Chris Senyek. "It's smoke and mirrors." In a recent report, Senyek identified 439 companies that had sped up stock-option vesting as of late last month.

Senyek said moves such as Ciena's make it harder to compare companies because some have accelerated options vesting while others have not. He also said it makes it tough to gauge, at least in the short term, a company's earnings potential, a key measure for prospective investors. That's because while a company may recognize little or no option expense in 2006, it could still issue new options that would drive up expenses by an unknown amount in future years.

Paul Hodgson, senior analyst the Corporate Library, a research firm, put it more simply. "It's lying," he said. "It may be legitimate lying, but it is nevertheless lying to shareholders about the cost of options."

In addition to Ciena, companies with major operations in the Washington area that avoided the most expenses by accelerating options include Applera Corp., parent of Rockville biotechnology firm Celera Genomics. Applera said it wiped away $108.1 million in potential expenses over the next three fiscal years -- a significant savings for a company whose two units reported combined profit of about $40 million in the quarter ended Sept. 30.

McLean-based newspaper publisher Gannett Co., parent of USA Today, said it avoided $52 million in future expenses by accelerating options -- equivalent to about one-sixth of its earnings for the third quarter.

But it is hard to know if these are in fact the biggest option-expense avoiders.

Some companies disclosed the total number of options accelerated but did not attach a value to them. For example, McLean consulting firm BearingPoint Inc., which has been struggling with accounting problems, last week said it would accelerate the vesting of 3.2 million shares, or about 23 percent of the company's outstanding unvested options. The firm did not say how much it expected to save in potential future options expense.

BearingPoint said most of the accelerated shares would have vested in 2006 and 2007. Some companies have not disclosed when accelerated options would normally have vested. Among those that have, many said they accelerated option vesting periods by one to four years.

Disclosure is spotty in other areas, as well. For example, Chantilly-based GTSI Corp., which sells technology services and products to the federal government, said on Nov. 21 that it would accelerate the vesting of 75,000 options held by chief executive M. Dendy Young and 57,500 options held by Chief Financial Officer Thomas A. Mutyrn. But many other firms have not disclosed the names of executives receiving accelerated options. That information is expected to appear in executive compensation disclosure forms next year.

Stock options give the holder the right to buy a company's stock at a set price within a specific period of time. Typically, option grants "vest," or become available for the holder to use, in individual blocks over a period of several years. The original idea behind options was to give top employees a reason to stay and work hard over the long term to make a company successful and boost its stock price. The higher the stock, the more valuable the options.

Stock options have been a hot compensation tool for years, especially among fledgling companies with limited cash but with prospects for rapid growth. Until now, companies did not have to count options as an expense in their income statements. Instead, they could simply include an estimate for options value in a footnote in their financial statements.

But after a wrenching 10-year debate, the Financial Accounting Standards Board late last year approved a new rule requiring that companies deduct an amount from their earnings that reflects the estimated value of stock options. Adoption of the new rule came over the objections of corporate lobbyists, especially from the technology industry, and was a major victory for shareholders' rights groups.

The shareholder groups had argued for years that options represent a real cost to a company and its investors. When employees exercise options, the number of a company's outstanding shares rises, making all existing shares less valuable. In addition, the shares could have been sold to the public and the money added to the firm's capital, instead of being awarded to executives.

Many companies responded to those arguments by saying that any move to require options expensing would badly dent earnings and that no reliable model existed to value options.

The Financial Accounting Standards Board last year rejected those arguments, at least in part because of investor outrage over recent corporate scandals, many of which occurred at companies that were heavy stock-option users. The SEC earlier this year said companies could use one of several approved methods to value their options.

Several big companies, including Microsoft Corp., decided to record the cost of options in advance of the new rule. But for many others, the new regime will begin Jan. 1, leaving corporate executives and directors looking for a way to avoid the earnings hit.

Executives at several companies that accelerated options vesting said they knew they would be criticized but decided to proceed anyway rather than see earnings suffer. Many said they accelerated options because their competitors had already done so. Others said they feared that competitors would accelerate options before year-end.

"If we had a half-a-million-dollar compensation hit, that would really lower our earnings. And how would we have been perceived against people who didn't have that expense?" said Steven R. Delmar, chief financial officer at Gaithersburg network management software maker Ace-Comm Corp. "We probably spent a good six months, between myself, legal counsel, accounting and the board, sort of researching and analyzing this and taking a look at what other companies were going to do. . . . It was not an easy decision. And I'm not sure there is one right, easy decision on this."

Richard I. Linhart, chief operating officer of James Monroe Bancorp Inc., said regulators essentially changed the rules in the middle of the game. He said that if companies had been operating under the new accounting rule when they awarded options, they might never have handed them out.

"It's a little hard to point the finger," he said. Options awards "were made based on the accounting rules that existed at the time."

But by far the most popular argument among executives is that they accelerated only out-of-the money options. Michael P. Donovan, chief financial officer of Rockville pharmacy benefit management firm HealthExtras Inc., said the company decided not to accelerate the vesting of options that were significantly "in the money," or below the company's current stock price.

"Where there was a golden handcuff value, we kept it there," Donovan said of the firm's approach, using a common term for management-retention incentives.

Shareholder advocate Nell Minow, co-founder of the Corporate Library, dismissed that rationale, saying out-of-the-money options (also known as underwater options) should still be considered an expense. "You might hear people say that underwater options aren't worth anything, but ask them to give them to you and see if they agree," she said.

Other firms, including BearingPoint, noted in SEC filings that they were accelerating options vesting for only rank-and-file employees, not for senior executives and directors. "We didn't think it was right for the people who were making this decision to benefit from it," said BearingPoint spokesman John Schneidawind.

Senyek of Bear Stearns said his list has become a hot item among corporate executives who want to see if their competitors are on it. He said he expects many more firms to hit the fast-forward button before the new year dawns.

"Everyone wants to jump on the bandwagon," he said.