Climbing toward a common goal. (Stock Options).

A proposal for getting back to the original purpose of stock options: incenting management to work for shareholders-whatever accounting rules prevail.

Corporate scandals and significant stock market declines have created serious questions about whether stock options really align management's interests with those of shareholders. And, regardless of how few the actual cases of real abuse, stock options have been swept into the corporate scandal arena and condemned as one of the culprits.

Abuses--some perceived, some real--include: CEOs reaping hundreds of millions of dollars of stock market profit in a single year; diluting share value by issuing massive option grants; and management manipulating earnings to prop up the stock price and cash in their options.

In the current environment, the potential for improving stock options' use has been sidetracked by an unsettling debate over whether their value should be measured and expensed. While many argue that expensing is not the answer, many companies have started expensing options.

However, according to the Deloitte & Touche Human Capital database, after an initial flurry when many decided to expense stock options (105 companies as of Sept. 30, 2002), the number of companies doing so has slowed considerably (148 companies as of March 31, 2003).

Yet, this does not seem to be an issue that can be solved by accounting rules. Something more fundamental than accounting is broken, and this apparent rush to "fix the accounting" has created a debate that does not get to the real issues.

What is needed is a focus on how to change stock options to achieve their original objective: aligning management with long-term shareholders.

Stock options should be an incentive for management to create real value over time, and not for just a year or two. Management should become a long-term shareholder of the "buy and hold" variety Additionally, the life of the option and vesting period should be longer; executives should be required to hold most of the shares gained through the exercise of stock options for very long periods of time.

Stock Options Abuses

Stock options were better before consultants and tax lawyers conjured up ways to minimize or eliminate the payment of the exercise price. When first introduced, managers had to invest their own money to exercise options and had to retain shares for at least a minimal period to receive long-term capital gain tax treatment. But arrangements were conceived to allow the exercise of options with no personal investment by management through the use of "in-the-money" options to pay for shares and other techniques.

At some companies, options were granted disproportionately to top executives, apparently providing incentives to only a few. New York Times columnist Gretchen Morgenson cited a study conducted by two professors of human resource management at Rutgers University Joseph R. Blasi and Douglas L. Kruse, who examined stock option grants and shareholder returns from 1992 to 2001 at the 1,500 largest American companies. They found that companies dispensing significantly larger-than-average option grants to their top five executives produced decidedly lower total returns to shareholders over the period than those dispensing far fewer options.

Stock options are not the only culprit for management's short-term focus. A bigger cause is the craze over meeting analysts' expectations and the harsh punishment of stocks when quarterly earnings fall short of expectations. But, undoubtedly the potential for vast personal wealth must have also contributed to the short-term focus, as the temptation was there to report large, quick profits, cash out stock options and move on to the next option grant or even the next company.

Paul Volcker, former chairman of the Board of Governors of the Federal Reserve System, said, "Stock options reward the good, the bad and the ugly in a booming market, and reward nobody in a bear market... [Options] are so subject to abuse that there ought to be an extreme bias in public companies against their use." While boards of directors may not have the ability to change the short-term focus of the market, they can use stock and stock options to tie management more closely to the long-term interests of the shareholders. And while it may be appropriate for some shareholders to try for quick profits, management should have an incentive to maximize shareholder value over a longer period, making them partners with the long-term shareholders.

To Expense ... or Not Expense

Some issues in the expensing debate include: Is the grant or exercise of a stock option an expense? What is the value? Should a change in that value over time be captured in the financial statements? How should the income tax consequences to the company be recorded and when? While some companies have decided to expense stock options, others have decided that options are not expenses but are capital transactions.

Giving or selling stock to managers at less than fair value is a dilution of the ownership percentage of other stockholders. Options may be granted at fair value, but the option privilege itself has value. Traditional accounting rules have focused on the dilution issue. The dilution, if significant, is reflected in earnings per share (EPS) calculations. The number of grants outstanding has always been disclosed so that shareholders can take the potentially dilutive effect into account in their own subjective determination of stock value.

Some stock incentive plans result not only in recording expense when granted but in recording additional expense as the stock value increases and vesting accelerates and in recording income when stock value decreases. This leads to charges and income amounts that have little relation to the performance of the business.

Those who favor expensing stock options argue that there is a cost to options and that this cost should be disclosed not only in the footnotes but also in the income statement. The International Accounting Standards Board (IASB) currently has a proposal that would require companies to record an expense for stock options, and the Financial Accounting Standards Board (FASB) has now decided that stock options will be expensed when granted.

How those stock options should be valued is apparently the sole open issue. The debate will continue. There will be a decision. Stock options will be expensed, and how to expense will be determined later this year. As a result, accounting may be improved--but a change in accounting will not solve the real issue.

Needed: Fundamental Restructuring Stock options need a fundamental restructuring, not an accounting facelift. Management incentives should align with long-term shareholders, and the compensation committees of boards must ensure that this occurs. Here's a recommendation:

* At a minimum, increase the time that options are outstanding to 10 years.

* Increase vesting periods with no vesting for the first three years, then 25 percent vesting per year in years 4 through 7.

* Require managers to pay cash for all option shares and to hold such shares for four or more years after exercise.

* Eliminate arrangements that reduce the employee's cash outlay, like using appreciation from past options as a trade-in for new options.

* Make certain that any performance criteria for awarding stock options to executives are real. Giving Sammy Sosa a great bonus if he hits 20 home runs this year is a performance-based arrangement, but not a very good one. Performance criteria need to be midterm (3 years) and they need to be substantive--not a rising stock market raising all option awards.

* Index stock option exercise prices to the stock price movement of a peer group or the S&P 500.

* Require executives to hold until retirement a substantial percentage of all stock received through the exercise of stock options. For example, Bank One has recently required its top 14 executives to hold 75 percent of all stock received, including outright stock grants and shares they buy when exercising options.

Questions Raised This proposal is bound to raise some questions and the need for discussion: What about high-tech companies? What about those companies that need to develop a product and get it to market quickly? How do they attract talent when they cannot afford to pay cash compensation? What about portfolio diversification for senior executives?

Maybe in these cases, instead of holding a "substantial percentage of the all stock received," it's a "significant" percentage. Is the vesting period too long? Perhaps. However, if the vesting period is shortened, the required holding period should be increased. The goal is long-term investment--7-14 years meets that criteria; 1-3 years does not.

There are likely other improvements to this proposal, as there are many issues to be resolved and debated. The solution is not in the accounting but in the substance of the arrangements. With this proposal, let the real debate begin.

Tom Fianagan and Nick Bubnovich are Partners and Mike Underwood is a Director with Deloitte & Touche. They can be reached at [e-mail], nbubnovich(c)deloitte.corn, and munder [e-mail].