CEOs as Central Bankers

321Gold | Market Ruminations ^ | 2003-Feb-07 | Tim Picks

[sourcery]

In a recent speech at Harvard, Charlie Munger said that to set up a foolish accounting system is really something sinful.

I would agree. A foolish, loose accounting system tempts otherwise good people to cheat. If an accounting system rewards poor behavior, that behavior will spread. If you don't cheat, you end up looking like a slacker. When it comes to companies, the biggest cheaters will end up gobbling up the honest companies that appear to be 'underperforming.'

The human mind has an incredible ability to rationalize poor behavior, so the cheater will easily convince himself that he has done nothing wrong. No one with a conscience wants to think of himself as a thief, so the human mind enters into denial, rationalization, and self-delusion.

As you will see below, I am certainly not trying to let the cheaters off the hook. But what I am saying is that the accounting system must be changed, otherwise nearly everyone--yes, even saints like you and me--would be tempted to cheat if we could make hundreds of millions of dollars, especially if we thought we could get away with it and everybody else was doing it anyway.

No Longer A Hot Topic The subject of stock options has kind of disappeared off the radar screen, and that is a shame. Because not only is it a sinful accounting system that tempts good people to cheat, but stock options (if not expensed) are also embezzlement, in my opinion. We are not simply dealing with an accounting question; we are dealing with criminality as well. In fact, that should be the first concern.

In this multi-part article, I will attempt to show the following: 1) unexpensed options are embezzlement, 2) expensing options is not "double-counting," 3) arguments against expensing options are ridiculous and insulting, 4) if CEOs really believe their own arguments about not expensing options then they need to resign immediately for the benefit of shareholders, 5) if they refuse to resign, their Board of Directors must immediately move to fire them or else the Board members are opening themselves up to being sued personally, 6) stock options are a form of private sector inflation in which CEOs are acting as central bankers, and finally, 7) all of this is very analogous and pertinent to what is happening in the economy right now.

Those statements are not meant as hyperbole and lots of huffing and puffing. I will attempt to prove each one.

Options or Warrants? Firstly, employee options are misnamed. These should be called 'employee warrants,' and in some countries they are called exactly that.

Options and warrants are similar in that they allow the holder the right to buy the underlying security at a fixed price for a given period of time. But options are written (sold) on shares that are already issued and outstanding, meaning that when they are exercised the shares simply change hands from one owner to another. Warrants, however, are securities that are issued by the company itself and when they are exercised the company issues new, additional shares in exchange for the agreed upon strike price. Options, when exercised, don't result in dilution, warrants do.

Therefore, "employee stock options" are really "employee stock warrants," because the company has issued them, and when they are exercised, the company issues new, additional shares, and there is dilution to the existing shareholders. This distinction will become important below. To call them options is deceptive and implies there is no potential dilution. Whether this was done on purpose or not I don't claim to know. Hereafter, I will refer to them as employee warrants.

Fiduciary Obligations Now let's get to the issue of why unexpensed employee warrants are embezzlement. And keep in mind here that I'm talking about real-world morality--principles--not the sort of legalese that we have witnessed where managements adhere to the letter of the law while trampling all over the spirit of the law, and rape shareholders in the process. If I am a cashier at a store and I take money out of the till, I have embezzled.

The management and Board of Directors of a company have a fiduciary obligation to act in the best interest of the shareholders. They can't give themselves a company asset for free when it has a real-world market value. If they do, they have stolen. They have a legal obligation to sell any corporate assets or securities for the best possible price, and bring that cash onto the balance sheet. They can't, for example, deed themselves the company headquarters for free, and claim that was in the best interest of shareholders -- regardless of how many disclosures they may have made, how many SEC filings they may have made, etc.

If they deed the company headquarters to themselves for free, they better have documented that they made a legitimate, prolonged attempt to sell the property. Offer it with no minimum bid. Offer to sell it for any price, something. If there are no takers, only then would it be reasonable for them to deed it to themselves for free because they would have proved it was not worth anything. The same thing would apply for an option on the property.

Similarly, did any executives attempt to sell their company's warrants to investors, or did they just give themselves the warrants and claim they weren't worth anything?

Executives hide behind the argument that their employee warrants are not "freely tradable" and are therefore not worth anything. Nonsense. Right now give me a 10-year option on your house at today's market price and I'll agree that I can't sell it or trade it, I can only exercise it. Have I gained anything of value and have you lost anything of value? Of course. To suggest otherwise is insulting. And besides, the "freely tradable" argument focuses on what happens to the executive, when the legal obligation is to focus on what happens to the shareholder.

The Reality Of The Transaction The way to show what is really happening in these employee warrant transactions is to show the transaction management had a legal obligation to do, but did not.

And that would be for the company to do a public offering of 10-year at-the-money warrants. Sell them to investors; that determines their current market value. Bring that cash into the corporate treasury . . . . . and then hand all that cash to the executives and expense it as compensation. (Wouldn't the shareholders love that! The company sells securities and insiders get the money!) Because that is exactly what is happening here. The result to the shareholder is the same: his company has issued new warrants and yet the company has no cash to show for it.

Or, alternatively, if the executives want to end up with the warrants (as they do under the current system) instead of the cash, then they have to buy them at the offering price, just like everybody else. The obvious difference from the current system being that if the executives bought them, then the company would receive that cash (just like in any offering) and it would go onto the balance sheet. There would also be nothing to expense.

Or, another alternative would be to do what Coke did. As I recall, they went to a number of different investment banks and said how much would you pay us for these warrants? They used an average of the prices offered by the banks, and then gave the employee warrants to the executives and deducted that amount as compensation.

So, you have three possible scenarios for the real-world accounting treatment of what happens:

1. The company SELLS warrants (at their market value) to investors, then hands the cash to the executives, which would clearly be an expense -- you can't give an employee cash and claim that's not an expense.

2. The company SELLS warrants (at their market value) to the executives, and the executives give cash to the company in exchange for the warrants. Nothing for the company to expense here, because it's simply someone (the executive) purchasing a warrant. The cash goes onto the balance sheet of the company.

3. The company GRANTS warrants directly to executives, and expenses the market value that would have been received had the warrants been sold. You cannot give an executive something that has a market value and claim that's not an expense, or a loss, or something. It has to appear, in some form, on the Income Statement. (Nor can you morally, as a fiduciary, give something to yourself for free when you know very well it could have been sold for cash.)

It is the time-value of employee warrants that needs to be expensed, because the time value is being given to the executives for free. This, in my opinion, is the key point.

By Expensing, Are We "Double-Counting?" No. Dilution is an entirely separate matter. And this is the whole point of how bad of a deal employee warrants really are for the shareholders -- employee warrants are both a current expense and potential future dilution. It's a terrible deal.

Let's go back to the first example of a company that sells warrants to investors and then that cash is given to executives and expensed. Well, anytime those warrants are in the money, those investors have every right to exercise them and collect their newly-issued shares from the company. It's an entirely separate issue from the expensing; there will clearly be dilution also, once the warrants are in-the-money.

But under the current system with employee warrants, the income statement does not show that executives are getting the time value of the options for free. The executives get today's price fixed for 10 years, for free.

Warrants are not stock. New stock will not be issued until and unless the warrants are exercised. With warrants, the dilution is neither immediate, nor certain. Theoretically, you could sell warrants to investors in the open market, and then the stock price goes down and continues to go down, and the warrants expire worthless. There would never be any actual dilution. (There would have been the potential for dilution, but it never occurred.)

And yet the company would have received money when they sold the warrants. It is this money that needs to be accounted for. Why did the company receive money? Because the warrants have a time value. Just like an option, warrants are made up of both intrinsic value and time value. At the time of grant, employee warrants have no intrinsic value, but they have lots of time value.

If you can lock in the current price of an appreciating asset for 10 years, that has real value, in cash, today. The executives are receiving this time value for free when it has real, cash market value. (Would you give someone a free option to buy your home at today's market price for the next 10 years? No, you would insist on being compensated.) I realize I'm being repetitive, but this is the key point.

Companies On Steroids An analogy to help distinguish between expensing and dilution is that of an athlete on steroids. He boosts his present performance by taking steroids. There is no doubt about this. An entirely separate matter is whether or not he will see negative consequences down the road. He may or may not -- as not all steroid users suffer long-term negative effects. But regardless, the two are independent events. We know the first will occur, the second may or may not.

Similarly, a company that does not expense for the time-value of the employee warrants is artificially boosting its current reported income by under-reporting its expenses. There is no doubt about this. It is occurring. Whether or not the company will also experience dilution down the road is unknown -- it may, or it may not.

Cash Is Missing So, in sum, if a company ends up with warrants outstanding and has the cash on its balance sheet to show for it, then just a regular, good-old-fashioned issuance of securities has occurred, regardless of who buys them. No expenses on the Income Statement, and no actual dilution until the warrants are in-the-money.

If, however, a company ends up with warrants outstanding and has no cash to show for it, then one of two things has occurred: an expense. . . . . or theft.

And oddly enough, many CEOs are arguing in favor of theft, and they're doing so with a straight face.

That's disgusting.

In part two, I'll deal more with the ridiculous arguments against expensing employee warrants.

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Tim Picks Email: Tim Picks February 7, 2003

All data and information within these pages is thought to be taken from reliable sources but there is no guarantee as such. All opinions expressed on this site are opinions and should not be regarded as investment advice.

Tim Picks is editor of the Market Ruminations newsletter which is available exclusively by email. To subscribe, just send a blank mailto:timpicks-subscribe@topica.com If you are in the United States, an upcoming issue will include a FREE REPORT that will show how you are likely owed some money. No kidding.

©2003 Tim Picks

[razorback-bert]

Gee, some sense on employee options.