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The Stock Option Scam

By Gordon Mott , Marvin R. Shanken | From Cuban Spy Scandal, May/Jun 02
The Stock Option Scam

Warren Buffett is a genius. Everybody knows that. The Omaha, Nebraska—based investor built Berkshire Hathaway into one of the world's most successful companies and in the process made Buffett one of the richest men in the world. In the company's most recent annual report, which is closely scrutinized in investment banking and Wall Street circles, Buffett took the blame for a $3.7 billion decline in the firm's net worth, citing losses in its insurance operations and his own miscalculations. It was the firm's first loss in net value in 37 years.

In the report, he also trained his sights on another issue: stock options. He said that, in the first place, stock options often do not subject executives to the same risk as stockholders, who will suffer if the company's stock price declines. Buffett said that reduced risk is magnified by the common corporate practice of "repricing" or simply issuing new executive stock options when the company's stock price falls.

About the same time the Berkshire report was released, General Electric, a blue-chip stock, provided a prime example of the practice. GE issued new stock options to its executives shortly after 9/11, when the market and GE's stock price fell, even though it had just started a new stock option plan in July. Now some executives have two sets of options and an opportunity to benefit twice if the stock price rises above the price of the first set of pre-9/11 options.

"Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America," Buffet said in the annual report. Using the example of a company that Berkshire acquired last year, MiTek, Buffett cited a more equitable and appropriate type of plan. Fifty-five employees of the manufacturer of construction material bought 10 percent of the company as part of Berkshire's acquisition deal. They each put up $100,000; some borrowed to get the money. "As they would not be if they had options, all of these managers are true owners," the report said. "They face the downside of decisions as well as the upside. They incur a cost of capital. And, they can't 'reprice' their stakes: What they paid is what they live with."

Living with the consequences of their decisions seems to be a lost concept among CEOs and senior executives of American corporations. They cruise along believing that no matter what they do, they will always reap profits from their stock option plans. Screw up, and the board will reprice their shares. Even without repricing, options offer a veritable gold mine to be exploited—as was the case with Enron. The temptation is overwhelming to manipulate earnings and thus the stock market's perception of the company, to drive up the stock price. Decisions are not made on the basis of good business practice, or what's good for the company, but what's good for an individual's stock options. It's one of the oldest scams in the world, only this time, the victims are not only individual stockholders but the credibility of our entire capitalist economy.

Instead, the system should reward positive business results based over a longer period, say five years. But now, each year we read about CEOs earning big bonuses and exercising huge stock options grants even though the company's earnings and stock prices are declining. That's about as un-American and anticapitalistic as you can get. It's cheating the stockholder and rewarding failure. It's time for a change. Thank you, Warren.