ShareThisBy KATHLEEN PENDER
Monday, October 30, 2006
Companies say they dole out stock options to attract, retain and motivate employees.
Yet, in another example of dubious options practices, 887 companies threw out the retention factor by accelerating vesting requirements during the past two years, according to Jack Ciesielski, publisher of the Analyst's Accounting Observer newsletter.
That means that instead of having to stick around for as many as four or five years to cash in their options, employees could exercise them as soon as they were in the money, meaning the stock's market price was above the strike price.
Most companies accelerated vesting to circumvent a new accounting rule that requires option grants to be recorded as expenses on income statements. That includes previously issued options that have not yet vested.
Unlike option backdating, which might be illegal in certain circumstances, this practice _ known as accelerated vesting _ had the blessing of accounting and securities regulators. But that doesn't make it any less "despicable," says Ciesielski.
"I don't know what happened in the backdating cases," he says. "I do know what happened here. Boards basically gave away shares."
Ciesielski notes that 19 companies that accelerated vesting are also being investigated for possible options backdating. "If they had something to hide about backdating, maybe they were accelerating to cover their tracks," he speculates.
An option gives employees the right to buy stock at a certain price, called the strike price, over a certain number of years, usually 10. If the market price rises above the strike price, employees can exercise their options to buy stock at the strike price. They can turn around and sell the same shares at the market price and pocket the difference.
To encourage employees to stick around, companies usually make option grants vest over a number of years. If a 1,000-option grant vests over five years, the employee could exercise 200 options per year. Acceleration gives the options away without requiring employees to stay with the company.
Under the old accounting rules, companies generally did not have to record any compensation expense on their income statements when they granted stock options. As a result, most option grants had no impact on earnings (although they did reduce fully diluted earnings per share because they increased the number of fully diluted shares outstanding).
Under a rule that took effect for fiscal years starting after June 15, 2005, companies must take a charge on their income statements when they grant options. This does reduce earnings.
The expense is based on the estimated value of the options on the grant date and can be written off over time, typically the vesting period.
The charge applies not only to new option grants going forward, but also to options that were granted before the change took effect but have not vested.
Suppose a company granted 1,000 options two years before the change took effect and the options vest over five years. The company still has 600 options to write off over the next three years.
To avoid taking those charges, companies could accelerate vesting, making the remaining options immediately exercisable. As long as the options had already vested before the accounting change took effect, a company generally would not have to show the compensation expense in its income statement.
(One exception: If the accelerated options were in the money, the company had to take a very small charge, says Chris Senyek, a Bear Stearns analyst.)
If a company accelerated options, it had to disclose the fact in a public filing but could give precious few details about the compensation expense it was avoiding. As a result, some companies disclosed the before-tax expense, some the after-tax expense and some no expense at all.
By scouring SEC filings between mid-2004 and mid-July 2006, Ciesielski's team found 887 companies reporting at least 1,009 accelerations. That means some companies were serial accelerators. Six companies accelerated three times and one company, Ciber, accelerated four times.
"The total amount of after-tax compensation dodged is estimated to be $4.7 billion _ a low figure, because 272 firms disclosed nothing about the value of the accelerated options," the report says.
Assuming those non-disclosers are in line with other firms, Ciesielski estimates the total cost avoided could be $6 billion.
A similar report published in January by Bear Stearns found 749 companies accelerating options, wiping out "over $6 billion of employee stock option expense" from future income statements.
Both studies reported that about one-third of accelerators were tech companies, which is not surprising considering the tech sector is a large issuer of options.
Ciesielski found 47 "insta-vesters" that issued grants just before the deadline with no or virtually no vesting period.
Many companies said they were accelerating options to avoid the new options expense and to improve employee morale.
Many noted that they only accelerated options that were out of the money, meaning they had no immediate value to the employee because the stock's market price was below the strike price, in some cases far below.
However, Ciesielski found 33 companies that accelerated options that were already in the money, meaning the market price was above the strike price.
He also found 51 instances where companies accelerated out-of-the-money options that later became in-the-money.
He says 51 "may not sound like many," but that's only because most companies did not provide enough information to know when accelerated options would come into the money.
Although many corporate governance experts have blasted accelerated vesting, investors have largely ignored it.
"Some investors might have been foolishly willing to give accelerating firms a bye for the sake of easier earnings comparisons _ and investors like their earnings, no?" Ciesielski wrote. But, he adds, "like it or not, accounting ... is an important part of corporate governance. Investors need to take note of which firms' directors have been all too willing to erase the value of unearned option compensation from the history books."
(E-mail Kathleen Pender at kpender(at)sfchronicle.com.)
