How Stock Options Became Part of the Problem
Once Seen as a Reform, They Grew Into Font of Riches And System
to Be Gamed Reload, Reprice, Backdate
By Mark Maremont and Charles Forelle
The Wall Street Journal
Wednesday, December 27, 2006
Eugene Isenberg is the little-known chief executive of a
modest-sized oil-services company in Houston. But he stands out
in one way: He is among the highest-paid corporate executives
in history. In the past 19 years, he has pocketed more than
The key to this wealth: stock options, in abundance. His
employer, Nabors Industries Ltd., has lavished more than 25
million options on him over the years.
They became lucrative partly because of Nabors's generally
rising stock price, but also because of some controversial moves
that gave the options more punch. When Nabors's stock fell
below the price at which the options could be exercised,
temporarily making them worthless, Nabors let him trade in some
of his options for new ones with lower exercise prices. And
when Mr. Isenberg cashed some options in, Nabors "reloaded" him,
replacing those he'd exercised with the same number of new ones.
Stock options were hailed two decades ago as a remedy for
runaway executive pay. Academics, politicians and investors,
tired of seeing CEOs pocket big money for a so-so job, pushed to
have stock options become a primary method of compensating
executives. Options -- granting the right to buy stock tomorrow
at today's price -- would pay off only if the company's stock
went up. To advocates they were the ideal carrot, an incentive
for good work that aligned executives' interests with those of
That happened -- sometimes. But at many companies, options
morphed into the biggest executive bonanza yet, pouring out cash
like a stuck ATM, and sorely disappointing those who thought
options would moderate executive pay.
Instead of replacing big bonuses, options became an additional
form of pay slathered on top of already-generous packages.
Employers doled out options in ever-growing numbers, in part
because, until recently, accounting rules meant companies didn't
have to treat this largess to executives as an expense. And
like Nabors, some used repricing, reloading and other tactics
that made it even easier for executives to score huge hauls.
This year, options practices exploded in one of the biggest
corporate-fraud scandals in decades. Some companies and
executives stole from shareholders, by pretending that options
had been issued earlier than they really were, at more favorable
prices. At least 130 U.S. corporations are under investigation
for possible backdating of option grants. Some have admitted to
it. More than 60 executives and directors of public companies
have lost their jobs so far, 17 of them chief executive
officers. After probable backdating was exposed at giant
insurer UnitedHealth Group Inc., the CEO had to resign and give
up about $200 million of stock-options value. The company said
it will have to restate past earnings by as much as $1.7
Nabors's Mr. Isenberg offers an example of the huge wealth CEOs
have gained through stock options. Now, some of his option
grants appear to raise questions about how they were dated. A
number came on days when the stock hit its lowest close for the
month or the quarter. At other companies, a series of low-price
grants has been a pattern that has suggested possible dating
problems. At the least, the favorable grant dates added to Mr.
Isenberg's mammoth options gains.
A spokesman for Nabors said its legal department did an internal
review and found "no irregularities in its grant practices."
Nabors showed internal documents to The Wall Street Journal that
the company said provide evidence the grants were properly
dated. Some of the documents bolster that assertion. The
spokesman, citing Mr. Isenberg's record in lifting Nabors from a
company in bankruptcy court to one with a market value of more
than $9 billion today, also said that "Nabors strongly believes
that Mr. Isenberg is appropriately compensated."
The backdating scandal at scores of companies shows one way
stock options, once seen as an executive-pay reform, have often
been distorted by corporate officials and their consultants.
Nell Minow, a longtime corporate-governance advocate, calls
backdating "just another in an endless and unstoppable series of
mechanisms to subvert the purpose of stock options." A vocal
proponent of options in the early 1990s, Ms. Minow now regrets
that stance. "Options became completely disconnected from
shareholder interests," she says. "I grossly underestimated the
capacity of corporate boards and corporate managers to
circumvent the principles we established."
From 1992 to 2001, the average value of option grants to CEOs of
S&P 500 companies soared nearly tenfold, according to data
compiled by Kevin J. Murphy of the University of Southern
California. The result was that options, which in 1992 made up
less than a quarter of the average CEO's pay, by 2001 provided
more than half of pay packages -- packages that were much
larger. Companies have started doling out fewer options in the
past few years, but grants remain far more generous than a
In 1985, Miami financier Victor Posner pulled down $12.7
million, putting him atop lists of best-paid CEOs that year.
Last year, 393 executives earned more than that, thanks largely
to gains from exercising options, according to Standard & Poor's
ExecuComp, which tracks executive pay at about 1,800 public
companies. The top 2005 earner was Barry Diller of IAC/InterActiveCorp.,
with $295 million, nearly all from options.
Defenders of options, who remain numerous, say options shouldn't
be judged by a few giant packages. Many companies have given
out options judiciously, say defenders, some of whom attribute
rising executive pay to tight competition for top managers.
Others say stock options have helped to foster innovation, by
giving young but cash-poor companies a currency with which to
Some supporters of options even give them partial credit for the
long bull market that began in 1982, figuring that options help
focus top executives on the key issue for shareholders: the
stock price. Frederic W. Cook, a New York compensation
consultant, calls the stock option "the most perfect equity
derivative that's ever been invented: It's simple, elegant,
easily understood, and it gives you a little piece of the
Stock options usually give recipients a 10-year window to buy
the company's stock at the price when the options are granted.
If someone gets options when the stock trades at $50 and it goes
to $75, the holder can cash out at the $50 "exercise price" --
also called a "strike price" -- and nail a $25 profit on each
option. Options usually don't "vest," or become exercisable,
for at least a year after they're granted.
Stock options appeared at least as early as the 1920s, says
Carola Frydman, an assistant professor of finance at
Massachusetts Institute of Technology who has studied the
history of executive pay. The modern era began in 1950, when
Congress, reversing a court ruling, gave options substantial tax
advantages over ordinary income. By the middle of that decade,
they accounted for nearly a third of CEO compensation at large
"In the 1950s, they called it the period of stock-option
opulence," says Ms. Frydman. "They didn't know what was
After losing popularity during the weak stock market of the
1970s, options surged back into favor in the late 1980s. One
reason was public fury over mammoth executive paydays for bosses
with just average performance. In an influential 1990 Harvard
Business Review article, Mr. Murphy and Michael C. Jensen said
the problem was executives were paid like "bureaucrats" instead
of entrepreneurs. They called for giving "big rewards for
superior performance and big penalties for poor performance."
"We were suggesting people shift from salaries to stock options
to put more pay at risk," Mr. Murphy says today . But "that's
not what companies ended up doing. They layered on massive
amounts of options on top of the rest."
The bandwagon got two big boosts from an unlikely source:
First, it passed a law, pushed by President Clinton, seeking to
rein in executive pay by limiting the tax break for it. The
1993 law said companies couldn't deduct yearly compensation of
more than $1 million for any one of their top five officers.
But it exempted certain kinds of pay linked to performance,
which included stock options. Companies rushed to restructure
pay plans to grant more options. In 1994, the first year the
law was in effect, the value of option grants to CEOs at S&P 500
firms leapt by 45% on average, according to Mr. Murphy, and
nearly doubled again over the next two years.
The 1993 law "deserves pride of place in the Museum of
Unintended Consequences," said Christopher Cox, chairman of the
Securities and Exchange Commission, this fall.
Then in 1994, Congress helped beat back a proposed rule
requiring companies to treat a stock-option grant as an expense
and deduct it from profits. The plan, backed by the SEC and
accounting rule makers, sparked intense corporate opposition.
Congress stepped in to fight it, and after a long battle, the
accounting rule makers caved. They issued a watered-down rule
saying all that companies had to do was disclose in a footnote
what options would have done to their profits, had the proposal
Meanwhile, Congress left alone an older law that gave companies
a tax deduction whenever stock options were exercised. Under
that rule, which applied to the most common type of option given
to executives, the employer can deduct a dollar from its income
for tax purposes for every dollar of option gains pocketed by
With rules like these, "what wasn't there to like about a stock
option?" says Paula Todd, a compensation expert at consulting
firm Towers Perrin. "You could grant them in unlimited amounts,
with no expense, and claim a tax deduction. [Companies] would
pay their dry cleaners if they could with stock options."
Better Than Average
Soon, other forces spurred companies to give executives ever
more stock options. One was the "Lake Wobegon effect," named
for the mythical Minnesota town in radio host Garrison Keillor's
world where all the children are above average. Many boards
believed their chiefs should be paid at least as much as the
average in their industry, and often more. That attitude had
the effect of pushing this average up, year after year.
Another force largely escaped notice because it seemed benign.
This was a tendency by companies to grant top executives the
same number of options each year, or more, even if the stock
price had risen. During a bull market, doing so kept raising
the value of pay packages.
Consider an executive who is granted a million options when the
stock is at $20. If it's 50% higher a year later, the executive
can reap a $10 profit per option, or $10 million.
But now the stock is at $30. If the executive again gets a
million options, and the stock again rises 50%, the executive's
profit is $15 million, not $10 million. In order to give this
executive an option grant of merely the same value in year two
as in year one, the year-two grant would have to contain far
Directors had a hard time telling a CEO they were cutting the
number of options because the stock had risen. Ms. Todd says
the CEO's reaction would be, "I worked to get the stock price
up, and my next grant is smaller and has a higher strike
Exxon awarded CEO Lee Raymond a similar number of options yearly
from 1993 through 1999 -- 800,000 to 900,000, adjusted for later
stock splits. Over that period, the stock rose sharply. The
rise meant the value of the 1999 grant was $8.5 million, or six
times that of the 1993 grant, by ExecuComp's tally. The
calculation used a standard formula for valuing options known as
"Black-Scholes," which sets a value for a grant at the time it's
given by estimating how much gain it will someday bring the
An Exxon Mobil Corp. spokesman said the grants were made by a
panel of outside directors and based partly on the size of
grants to top executives elsewhere. After 2001, Exxon replaced
options grants with restricted stock, a different form of
compensation that the board said was "more effective in aligning
executives' interests with those of shareholders." Mr. Raymond
retired a year ago.
At times, the value of options companies doled out has been
equal to a large share of their profits. Retailer Abercrombie &
Fitch Co. gave CEO Michael Jeffries 4.66 million options in
1999, a grant ExecuComp valued at $120 million. The firm's 1999
net income was $150 million.
Abercrombie didn't actually have to shell out $120 million when
it gave the options to Mr. Jeffries, of course. But it incurred
an obligation to issue 4.66 million shares someday at the 1999
price. And this obligation didn't have to be reflected as an
expense on the company's income statement.
A spokesman for Abercrombie said the grant had a "delayed
vesting" feature "intended to incentivize Mike Jeffries to
remain with the company ... and to continue to generate
exceptional financial results." Under him, the stock has risen
more than 750% since it began trading in 1996. Mr. Jeffries is
eligible to exercise the big 1999 grant now, and if he did so
would reap about a $120 million profit.
The options-issuing frenzy reached a peak in 1999 and 2000.
Dot-com companies, some with little other way to pay employees,
handed out options like confetti. Thousands of people made
fortunes on stratospheric rises in the stocks of tech firms,
some of which didn't exist a couple of years later. Meanwhile,
some "old economy" companies, trying not to lose top people to
Silicon Valley, cranked up their own options generators.
In mid-2002, Alan Greenspan testified to Congress about what was
then a tech and telecom bust, and about a wave of corporate
scandals at firms like Enron, WorldCom and Tyco International.
The Federal Reserve's then-chairman spoke of an "infectious
greed" that seemed to grip some in business, for which he partly
blamed "poorly structured" stock options. Giant grants
"perversely created incentives to artificially inflate reported
earnings in order to keep stock prices high and rising," he
said. "The incentives they created overcame the good judgment
of too many corporate managers."
Moving the Goal Post
When stock prices failed to rise, some companies changed the
rules. If the share price fell well below stock options'
exercise price, they simply lowered that price. Companies
defended the move by saying options far "under water" or "out of
the money" no longer served as incentives to executives to
Critics of repricing say it subverts the fundamental options
purpose of aligning managers' and shareholders' interests.
Since shareholders can't get a refund on a stock they bought
that has fallen, the critics say, why should executives be able
to do something similar?
Repricings "basically ensure that the manager gets paid no
matter what. It takes a lot of risk out of the whole thing,"
says David Yermack, a New York University professor who studies
About 11% of companies repriced options at least once between
1992 and 1997, according to research by Chandra Subramaniam, an
associate professor of accounting at the University of Texas at
Arlington. Borland Software Corp. did it eight times in the
decade ended in 1998. System Software Associates Inc. repriced
the same options five times in 1996 and 1997 as its stock kept
plunging, Mr. Subramaniam says. In a paper published in 2004,
he and his co-authors calculated that repricings padded
executives' pay by an average of nearly $500,000 each.
In 1998, a change in accounting rules crimped repricing
somewhat. Companies now had to take a hefty charge against
earnings if they put new exercise prices on existing options.
But there was a loophole. If they canceled the old options,
waited six months and issued new ones at a lower price, there
was no penalty.
As tech stocks collapsed in the early 2000s, directors rushed to
shore up options stranded out of the money. At computer-chip
maker PMC-Sierra Inc., the company stock peaked at $245 a share
in March 2000, then plunged below $10. Many shareholders fell
The boss had a softer landing. Between September 2002 and March
2003, the company repriced 1.6 million of CEO Robert Bailey's
options, slashing the exercise price on some all the way to
$5.95 from $52.375. Mr. Bailey has cashed out about a third of
the repriced options, for profits of $4.86 million, more than
eight times what he'd have made if they hadn't been repriced.
PMC-Sierra confirmed the figures but had no other comment.
Lock and Reload
In the late '80s and early '90s, companies found another way to
goose stock-option grants: "Reload" them.
Normally, options disappear when exercised. But with a reload
plan, a person who exercises options automatically gets
replacements. Typically the replacements number fewer than the
options exercised. They carry the same expiration date but a
different exercise price -- the current market price.
Reload plans are supposed to encourage executives to hold stock
in their company, says Mr. Cook, the pay consultant, who
invented them. To get a reload, executives exercising options
generally must do so not with cash, but with stock. That is,
they must hand in existing shares whose value equals the cost of
exercising the options. Since executives can't do that unless
they own shares, they have an incentive to be shareholders of
the company and to hold onto new shares obtained when they
Critics decried reloads as abusive, a kind of option replication
machine that enriched top managers -- while diluting other
stockholders' ownership as the number of shares outstanding
The first reload plan appeared in the late 1980s. By 1999,
according to Mr. Cook's firm, nearly a fifth of large companies
were offering them.
The king of reloads was Sanford Weill, who retired in April as
chairman of Citigroup Inc. with an options fortune largely
based on a single grant reloaded many times. In 1992,
shareholders of his company, then called Primerica Corp., were
asked to approve a reload plan. Deep into the legalese, on page
17, was a clause that would prove extremely lucrative for Mr.
Weill: The reload plan applied to previously issued options,
including a giant grant Mr. Weill got in 1986.
The plan initially also had an unusual element. Any options
issued as a result of reloads wouldn't expire on the options'
old expiration date, but could carry a new 10-year term.
Not long after the plan was adopted, Mr. Weill exercised nearly
all of his original 1986 options, for a gain of more than $60
million. He then received replacements for most of them,
restarting the clock with 10 more years to run. Year after year
Mr. Weill exercised some of the replacements, each time getting
more new options -- some of which he then exercised, once again
getting more replacement options, and so forth.
From 1992 through the end of last year, Mr. Weill racked up
total option profits of $964 million, roughly $870 million of
which came from the original 1986 options and their generations
of reloaded progeny. Shareholders did extremely well, too. As
of yesterday, the stock of Citigroup and its predecessors was
more than 30 times the price in the 1986 public offering of Mr.
Weill's original company.
A Citigroup spokesman, Michael Hanretta, said Mr. Weill's
options were so valuable because the company "created superior
shareholder value." Mr. Hanretta also noted that employees
couldn't activate the reload feature unless the stock had risen
20% from the time an option was granted, and at various times
Mr. Weill was required by company policy to hold onto all or
most of his shares.
Reloads have died out in recent years, after new accounting
rules made them too costly to issue. A separate 2000 rule also
made it financially prohibitive to add a reload feature
retroactively -- eight years after Mr. Weill got that benefit.
Other rule changes have also helped slow the options express.
Besides a 2002 requirement for prompt disclosure of grants, a
new accounting rule means companies must record an expense when
they make an options grant, and reduce profits accordingly.
Many companies have cut back on options, and some have stopped
awarding them at all, often replacing them with grants of
Over the years, few corporate executives have availed themselves
more thoroughly of what options have to offer than Nabors's Mr.
Still chief executive at the age of 77, Mr. Isenberg lives in
the Breakers resort complex in Palm Beach, Fla., and commutes to
Nabors's U.S. headquarters in Houston. A generous donor, he has
helped found a school in New York for children with learning
disabilities and given millions to the University of
Massachusetts at Amherst, which has named its business school
Mr. Isenberg worked at Exxon for 13 years and then headed a
small steel company, settling into early retirement after that
firm was sold in 1982. He was persuaded to rejoin the business
world by his friend Martin Whitman, a prominent New York
investor, whose fund had taken control of a troubled
oil-services company called Anglo Energy. Mr. Isenberg invested
some of his own money and in 1987 took the helm of what was soon
renamed Nabors Industries.
Early on, Mr. Isenberg personally lent the company $5 million
when it wanted to make an acquisition but lacked funds, Nabors
says. It was the first in a series of deals that "made the
company," said the Nabors spokesman, Denny Smith.
From a regional player, Nabors grew into one of the world's
largest contract oil and gas drillers, with yearly revenue of
$3.6 billion. Its stock has risen at a lush 21.7% compound
annual rate since early 1987, although it has underperformed the
Dow Jones Oil Equipment and Services Index in the past five
An employment contract Mr. Isenberg got when Nabors emerged from
bankruptcy entitled him to an annual bonus equaling a percentage
of the company's cash flow above a threshold. Nearly two
decades later, Nabors is long out of bankruptcy but has
continued to renew this unusual percentage-of-cash-flow deal,
albeit with less-generous formulas.
Rather than accept all his bonuses, Mr. Isenberg in many years
declined part of them in favor of stock options. By Nabors's
reckoning, his option grants were worth tens of millions of
dollars in some years. Mr. Smith, the spokesman, said this
acceptance of options instead of cash meant Mr. Isenberg was
placing a big chunk of already-earned pay "at risk, in alignment
with shareholder interests." Mr. Isenberg still received
substantial cash bonuses, of as much as $3 million in a year,
and sometimes was given additional options.
For a time, Nabors operated under an options "reload" plan. It
was a generous one: Instead of replacing only a portion of
options that were exercised, it replaced them one-for-one. Mr.
Isenberg could cash in options and take profits yet still have
just as many options as before, though with higher exercise
In another atypical feature, the replacement options sometimes
had new terms of 10 years, making them even more valuable.
Nabors says it stopped reloads before 2000. But in that year it
gave Mr. Isenberg a "special award" of 2.4 million options, in
lieu of a reload on 4.7 million options that he exercised for a
$122 million gain. (Share figures in this article aren't
adjusted for a recent two-for-one stock split.)
In 1998, amid an industry slump, Nabors's stock sank sharply.
Some of Mr. Isenberg's options were "under water." The board
repriced them. In exchange for giving up a fourth of his old
options, he got new ones carrying a more favorable exercise
"The repricing was designed to restore incentive value to the
option packages," said Nabors's Mr. Smith. He said repricing
was widely available to employees. As it happened, Mr. Isenberg
made less money by accepting the repricing deal and giving up
some of his options than if he had held on, Mr. Smith said.
Following a single grant from its genesis shows how the various
maneuvers can pile up profit.
Mr. Isenberg received a grant of 1.8 million options dated in
Sept. 23, 1991. He exercised them in 1996 and 1997, pocketing
about $24 million in profits.
Normally, that would have been the end of these options. But
Nabors reloaded Mr. Isenberg, replacing his exercised options
with a similar number -- which had 10 more years to run.
Then in 1998, amid the stock downturn, Nabors repriced the
Mr. Isenberg cashed in most of them in 2000 and gave the rest to
a family member in 2002. His total profit from a single grant
-- reloaded, extended and repriced: about $54 million, not
including the gift.
The CEO's overall stock-option gains, both realized and not yet
cashed in, came to $685 million at the end of last year, says
S&P ExecuComp -- putting him 8th on its list of big winners from
1992 to 2005.
Mr. Isenberg also has benefited from some good timing of his
option grants. The Sept. 23, 1991, award was dated on the day
Nabors's stock touched its lowest closing price of that month,
But it isn't clear when the price was actually set. Company
documents suggest the grant price may actually have been
determined many months earlier, on another day when the stock
closed at $5. Moreover, the grant was contingent on a new
Isenberg employment contract -- which other documents indicate
wasn't signed until well after Sept. 23, when the stock was
For a grant of a million options dated Dec. 4, 1995, another
monthly low, Nabors produced no minutes of a
compensation-committee meeting. Instead, a memo seven weeks
later said there had been a discussion on Dec. 4 of Mr. Isenberg
trading in part of his bonus for options. The memo said the
idea first would be run by a consultant, suggesting the grant
wasn't made final until weeks after the stated Dec. 4 award
In all, of 11 new option grants to Mr. Isenberg between 1991 and
2002, two were dated at quarterly lows in the Nabors stock price
and five more at monthly lows. The odds against such a
fortunate pattern occurring by chance are long.
Nabors's Mr. Smith, in a written reply to questions, rejected
any notion that any backdating might have been involved. Nabors
let the Journal review dozens of pages of documents at its
Houston offices that Nabors says support the conclusion that the
low-price grants were actually made on the fortunate dates. For
four of the seven grants dated at monthly or quarterly lows,
Nabors showed compensation-committee minutes saying that
meetings were held on those dates and options granted. For
another monthly-low grant, it showed committee minutes saying a
meeting was held the day after a grant, with the grant made
"effective" the previous day.
In mid-2002, a federal law required executives to report option
grants within two days after they're made, instead of having
weeks or months to do so, a change that sharply cut the
potential for backdating. Since mid-2002, none of Mr.
Isenberg's four option grants came at monthly stock lows.
Mr. Smith noted that before June 2002, Nabors was registered in
Delaware, and directors could meet on short notice. Nabors then
became a Bermuda-registered company. Mr. Smith said that since
then it has had most board meetings outside the U.S., with
options awarded at meetings "scheduled long in advance."
Mr. Isenberg has received compensation "beyond expectations,"
Mr. Smith said, because of Nabors's prosperity. The spokesman
said Nabors is discussing a restructuring of Mr. Isenberg's
future pay arrangement. Meanwhile, he has voluntarily cut the
bonus he's entitled to in half.
Write to Mark
email@example.com and Charles Forelle at