CEO vs CEO: in the fight over expensing stock options, it's the tech industry against the world. .

On a brisk Wednesday morning in mid-March, six men and one woman assemble in a nondescript room in a suburban office park in Norwalk, Conn., 40 miles from New York City. The gathering in the small, maroon-carpeted amphitheater has the informal, collegial feel of an academic seminar. The air isn't brimming with excitement, but then, what could be more boring than a meeting of the Financial Accounting Standards Board, the independent body that sets the accounting rules for U.S. companies? After some low-key discussion, six out of seven commissioners vote in favor of putting an item on their agenda--to expense or not to expense stock options --in hopes of getting it decided and in effect in 2004. "It's clear to me from the daily love notes I get from investors that this is something we need to deal with," says the FASB chairman, Robert Herz, stroking his mustache with a pen and betraying little sense of urgency.

Don't be fooled by the sleepy atmosphere or the backwater location. In fact, the issue before FASB is shaping up as one of the most intense, divisive battles in Corporate America. It is pitting CEO against CEO, Silicon Valley against Wall Street, and investors against corporate management. At stake is billions of dollars in income and compensation--at least on paper-for CEOs and their employees. And given that options make up the lion's share of CEO compensation packages, it's a particularly sensitive issue for them.

Yet, among themselves, CEOs do not see eye-to-eye. On one side are at least 80 CEOs from the Standard & Poor's 600 who have announced that their companies will expense stock options, from Coca-Cola's Douglas Daft to General Electric's Jeffrey Immelt. Included in that camp are the CEOs of all the major financial services firms, including Citigroup's Sandy Weill and American International Group's Hank Greenberg. Lending additional heft are luminaries such as Alan Greenspan, Paul Volcker and Warren Buffett. "I tend to be over on the Warren Buffett side," says Boeing CEO Phil Condit, who counts himself as part of this camp. "Which is, it looks like compensation, it smells like compensation, and therefore you really ought to treat it like compensation."

This crowd argues that expensing options is the only way to make income statements accurately reflect the underlying economic reality of their businesses. After all the accounting shenanigans of recent years, they argue, investors deserve honest numbers. "The world is demanding that companies do the right thing," says Jeff Lane, chief executive of Neuberger Berman, the New York-based investment advisory firm. "We are in the asset management business. We are a fiduciary. We are supposed to hit the ball down the middle of the fairway."

Technology companies vehemently reject the implication that their numbers are less honest simply because the value of their options is footnoted rather than expensed. T.J. Rodgers, CEO of Cypress Semiconductor, accuses companies that have embraced options expensing of pandering to public opinion. "These are politically correct moves," says Rodgers. "If you don't have many options outstanding, if your earnings would drop from 33 to 32 cents per share, in the era of Enron you can run out and say, 'I'm the corporate good guy. I'm going to expense options.'"

As for Buffett, Rodgers says: "He's a hypocrite. He claims that they're bad, but he has no options. It's a zero-dollar transaction to declare that he will expense options."

Rodgers is joined by a coalition of 200 tech company CEOs, called TechNet, which includes industry heavy-hitters such as Cisco's John Chambers and Intel's Andy Grove. They believe that requiring the expensing of options is a knee-jerk response to the abuses of a few greedy CEOs and that it will effectively throw the baby out with the bath water. Expensing options will damage their competitiveness, they argue, and even if they wanted to expense options, no valuation tool exists to place an accurate price tag on them. "Most experts believe the Black-Scholes pricing model does not provide an accurate, reliable or consistent measurement of the fair value of stock options," says Chambers. "Clearly, using this method for expensing options would bring more confusion to financial reporting, not less."

Apples to a vegetable

Those in favor of expensing options disagree. But both sides agree that the current valuation tools are far from perfect. In 1996, the FASB issued FASB 123, which recommended that companies expense options, but allowed them to merely disclose the value of their options in a footnote to their annual reports. (The standards board originally wanted to require options expensing, but backed down after the tech lobby flexed its political muscle.) It also recommended that they use the fair value method, but allowed the intrinsic value method as well. That left investors to grapple with two approved valuation methods, which was like comparing "apples to a vegetable," says Eloise Hale, director of investor relations at Bank of America. "Frankly, there's not a lot of uniformity."

The fair value method uses an options pricing model, usually Black-Scholes, to value the options at the date they are granted. So if one million five-year stock options were granted on Jan. 1, 2003 when the stock was $10, those options are valued on Jan. 1, 2003 and charged as an expense in increments over the vesting period.

The problem is, what if over five years, the stock drifts down to $3 and employees never exercise their options? The company has already taken a hit to reported earnings in 2003--even if employees never collect a dime from their options. Due to this phenomenon of "forfeiture," the fair value method tends to significantly overestimate the value of the options.

The alternative intrinsic value method, on the other hand, often puts the cost at zero, which is also incorrect. That's because intrinsic value is defined as the difference between the market price of the underlying stock when the options are granted and the exercise price at grant date, which are almost always the same, because most companies issue options at or above market prices. "By expensing options, you may expense options that may not cost the company anything," says Neuberger Berman's Lane. "On the other hand, options are not worth zero. If they were worth zero, no one would give them out or want them. It's a choice between two bad arguments."

Despite those misgivings, the movement to expense options has gained considerable momentum since the bursting of the dot-coin bubble in 2000 exposed unprecedented corporate accounting fraud. FASB's failure to require companies to expense options in 1995 has been blamed for enabling CEOs to quietly grant massive stock options to themselves and their cronies, drive up the stock price, cash out and leave the shareholders holding the bag after the stock crashes. "The perception was that some executives may have been making decisions that would cause the stock price to move in relatively small amounts, and that would give them a payoff in their options," says Diane L. Doubleday, senior compensation consultant at Mercer Human Resource Consulting.

For better or worse, the public equates stock options with excessive CEO pay. That's thanks in part to CEOs such as Enron's Kenneth Lay, who made $123 million from exercising stock options in 2000, before Enron shareholders got wiped out. Larry Ellison made $706 million from stock options in 2001. Had he and other Oracle employees gotten cash instead of options that year, Oracle's operating income would have declined by $933 million, according to Bear Stearns & Co.

It is this apparent "overhang" that has shareholder advocates up in arms. In 2001, the S&P 500 companies had $80 billion in pretax stock-option compensation expense; only two of those companies included the expense in their reported income, according to a study by Patricia McConnell, senior accounting analyst at Bear Stearns. Siebel Systems, in 2002, reported a loss of $35 million. But if Siebel had taken into account all of its outstanding options grants--at least according to the footnote in its 10-K--it would have lost $1 billion.

Rather than waiting for the FASB to move, companies with a finger in the wind are deciding on own to expense options. By late March, the total was 207, with every week bringing another handful of new companies. This group includes more than 80 of the 500 companies in the S&P 500. Most of these companies, such as CocaCola and GM, got religion in 2002 and 2003.

Boeing has had it for years. Way back in 1998, the aerospace giant began expensing options. At the time, Phil Condit was frustrated with regular stock options because they did an imperfect job of rewarding long-term performance. If the market went up 9 percent, for example, and Boeing stock went up only 5 percent, Boeing executives could still do very well. "A classic stock option rewards mediocre performance," says Condit.

That led the CEO to focus on performance-based, long-term compensation--specifically, performance vesting stock. The way these phantom shares work is if the company's stock doesn't outperform the S&P 500, the shares don't vest. But when Boeing shares do better than the S&P 500 Index, the stock vests immediately. "I get to write a letter to every person who holds these performance vesting shares and say, as of today, a certain number vested and the next set vest at a given share price," explains Condit.

How does Boeing account for these performance shares? It uses the fair value method with the Black-Scholes model and takes a hit to income, complying voluntarily with FAS 123, the rule that made expensing options optional. "It was a big decision. So there was a lot of board discussion," says Condit. "We felt strongly about performance vesting, so it was worth doing."

Boeing's total outstanding options in 2001 were only 3 percent of its total shares outstanding, much less than many Silicon Valley companies. Even so, in 2001, Boeing took a charge of $227 million against earnings as a result of the new options grants that it made that year.

Of course, the company won't know until the options or performance shares vest--assuming they do--whether Boeing executives will receive $227 million or anything close to it when they cash in their options. And if they never vest, says Condit, "you still have that charge."

Nonetheless, Condit doesn't find fault with the current valuation method. "I don't get wound around the axle on the Black-Scholes," he says. "It's not perfect, but it's the best measure we've got today."

To Condit, granting performance options is the same as buying back Boeing stock on the market. "The share dilution does represent a cost, no different than when I buy back shares," he says. "Therefore, the accounting correctly recognizes the expense."

Condit points out that in 1999 and 2000, a lot of performance grants vested. "I had a period when I sent out a lot of letters," he says. But in 2002, with the market downturn and the airline industry in deep distress, none vested. This year could be more of the same. But Condit says he has succeeded in tying people's expectations to Boeing's performance.

Ready to duke it out

Only one industry as a whole has come out in favor of expensing options: financial services. Half of the 207 companies that have announced they will expense options are financial firms.

Why are financial services firms pro-expensing, in stark contrast to the tech industry? "I guess they don't have any concern about the reliability of the option pricing model," says Bear Stearns's McConnell. "We've got a derivatives desk where they use these models all the time to price things." McConnell is referring to Wall Street's reliance on the Black-Scholes model to price options and derivatives on their trading desks. "And the way compensation is generally negotiated in this business, it's hard to argue that options aren't compensation," she notes.

The largest financial services company, Citigroup, and its CEO, Weill, are long-time believers in broad-based options: At year-end 2001, Citigroup had the most options outstanding of any company that has started expensing options (see table, pg. 39). Bank One is another believer, perhaps because its CEO, Jamie Dimon, worked with Weill for many years. "We did it for the simple fact that we think it's accurate and fair and reasonable," Dimon said in announcing his decision. "We just want to get this thing behind us and move on as a company. We're just recognizing reality."

Investors are clearly on the side of these CEOs. A number of investor organizations support expensing, from the Investment Company Institute to S&P. "I continue to be infuriated with the tech industry and their blatantly self-serving position on stock options," says Kenneth F. Broad, a CFA and portfolio manager at Transamerica Premier Growth Opportunities Fund. "Options have contributed mightily to the current crisis of confidence we have in the stock market."

The technology companies, on the other hand, believe expensing options threatens the entrepreneurial ownership that has fueled innovation in Silicon Valley. "Instead of having a few fat cats flying $36 million corporate jets, we have managers who manage by walking around and we have employees who have a chance to make enough money to change their lives," says Rodgers. "And now I take all of that and screw it up for some pinhead accounting theory."

It is the present accounting theory that has allowed technology companies to award their employees the most options of any sector. In 2001, they granted 3.1 billion, or 42 percent of the more than seven billion options granted by the S&P 500. Tech companies had high ratios of options to total stock outstanding as well: In 2002, Cypress Semiconductor's option grants were 34 percent of its total shares outstanding; Cisco's were 17 percent.

The high-tech crowd argues it has a good reason for having so many options: Its members distribute them more democratically than the rest of Corporate America. "All Cisco employees get stock options," says Chambers. "I strongly believe that when employees are shareholders, everyone feels responsible for and shares in the success of the company."

The fair value method and the Black-Scholes pricing model would wreak havoc on Cisco's income statement. In its 2002 fiscal year, which ended July 27, 2002, Cisco's income would have declined by 80 percent if it had expensed the options it granted for vesting in 2003, according to its SEC filings. That's because stock options granted to employees last year were valued at $1.52 billion. Cisco's ported income of $1.89 billion would have shriveled to $373 million if it had factored in the value of its options.

One example Cisco gives to show the flaws in the BlackScholes model is that for the fiscal year that ended July 2001, its options were valued at $3.3 billion. Today, using the same model, those options would be valued at $131 million because of the drop in Cisco's stock. If the company had expensed the options and they were never exercised, it could not then go back and restate prior years' earnings.

The right course of action, according to Cisco and the other tech companies, is simply better disclosure. Companies should provide investors with plenty of detail in the footnotes on which options have expired and which are still worth something, and leave it to investors to figure things out. Under this approach, some companies would expense and others would disclose. "Expensing options would be more confusing to the balance sheet," says Chambers. "If [they are] expensed, many financial analysts have said they would simply remove the impact of this 'expense' by pulling it out of a company's financial reports when evaluating a company's true financials."

To protect the accounting status quo, the tech CEOs are offering up reforms of their own. One is to limit the number of options received by top management to less than 5 percent of all that are awarded. "We're concerned about abuses at that level--people who've got the ability to control the corporation and line their own pockets while leaving the shareholder holding the bag," says Rick White, who heads TechNet and is a former Congressman from Washington state. "That's not acceptable. We need to adopt rules to deal specifically with that."

Cisco's Chambers has his own three-point reform agenda: "Shareholders must approve all stock option plans. Stock options should be distributed across the organization -- not just at the executive level. And executives should hold vested options for a set period of time, especially the CEO and CEO."

The horse is on its way out

For now, CEOs such as Chambers have the freedom to choose their own ways to remedy the problem. But if, as some observers believe, the FASB acts this year and requires companies to expense options in 2004 using the fair value method, that luxury will be gone. The line of argument fast gaining strength is that the United States can't tolerate a situation in which one set of companies adheres to certain accounting rules but another set doesn't--which is why the tech lobby is racing to keep the expensing horse in the barn. "The horse isn't out of the barn, but it's moving toward the door," admits TechNet's White.

If it gets out, opponents aren't likely to sit by quietly-particularly those who've already been vocal in admonishing the accounting standards board. "Those guys are idiots at the FASB," says Cypress Semiconductor's Rodgers. "We've got some people in Connecticut who want to screw up the miracle of Silicon Valley for some sort of accounting purity."

If the FASB does require options expensing, it would almost certainly put a damper on the use of options. Susan Strausberg, CEO of EdgarOnline, a Norwalk, Conn., company that posts SEC filings online, says it could cause problems for her 80-person company. "In difficult times, would I add phantom expenses to my balance sheet in order to give more options to my people? No," she says. "We'd have to go back and see if we could give cash bonuses, which isn't necessarily good at a given time."

So while a debate rages about the Sarbanes-Oxley Act and the new requirements imposed by stock exchanges, the fight over options could actually emerge as more important in some respects. CEOs are much more united in their posture toward the new governance rules being imposed. But the deep divisions among them on expensing options makes it more likely that FASB will find the political strength to follow through and require it. For better or worse, that promises to force change in a key aspect of how CEOs reward themselves and the people who work for them.

The 25 Companies That Expense The Most

                                      Millions of
                       Announcement     options
                         of date     outstanding,
Name                   of adoption   year end 2001

Citigroup                8.07.02         364.4
J.P. Morgan Chase        8.12.02         359.8
General Electric         7.31.02         354.5
AT&T                    10.22.02         317.5
SBC Communications       3.14.03         229
Cendant                  8.28.02         218.0
Nortel Networks          1.24.03         215.5
Merrill Lynch            8.13.02         194.5
Bank of America          8.12.02         184.6
Ford Motor               9.12.02         172.1
Morgan Stanley           8.13.02         151.4
American Express         8.12.02         146.1
Coca-Cola                7.14.02         141.0
BellSouth                2.28.03         106
FleetBoston Financial    8.14.02         105.5
Procter & Gamble         8.05.02         104.2
Bank One                 7.16.02          90.5
Goldman Sachs            8.12.02          84.4
USA Interactive          7.24.02          84.4
DuPont                  11.05.02          73.2
Home Depot               8.23.02          69.4
Dow Chemical             8.26.02          67.5
General Motors           8.06.02          67.0
Amazon                   7.23.02          66.0
AIG                      8.11.02          54.3

Source: Bear Steams