By Robert James Cimasi

Published January 2008

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A 2005 Medical Economics financial survey revealed that 88 percent of physicians invest in stocks and stock mutual funds, yet just over half of the survey respondents reported using professional financial advisors. In relying on their own advice to seek out value in their investments, physicians have become increasingly interested in the growing intensity of the scrutiny with which the FBI and Federal prosecutors are pursuing executive stock option backdating investigations. Investigating the manner in which a company has issued and currently issues executive stock options and understanding how that may impact the value of owning that company’s stock is a dollars and (good) sense diagnosis physician investors should make.

Executive stock options are comprised of a contract under which the employer grants the executive the right to purchase a specified amount of shares of the company’s stock at a designated price (exercise price or strike price) for a designated period of time required between the grant of the option and when it may be exercised (option vesting period, typically one to five years). Ostensibly, stock options are offered as an incentive-based executive benefit to encourage an increase in performance of the company’s stock and to act as a remedy for runaway executive pay in those instances where results were not delivered. Ideally, options would only pay off if the price of company stock went up – serving as a mechanism to align an executive’s interests with those of shareholders. Another benefit of a company granting options was to delay the timing of the expense of cash compensation payment to executives, since (until recently) accounting rules didn’t require companies to treat the issuance of options as an expense hit against reported earnings.

The history of using stock options indicates that these "variable, at risk" returns have taken a larger role in compensating executives since they first appeared in the 1920s. In the1950s, Congress reversed several court rulings in giving these options a substantial tax advantages over the payment of compensation as ordinary income and, by the middle of decade, they accounted for nearly a third of executive compensation of large industrial companies. While they lost some level of popularity during weak stock market of 1970s , the 1990s saw a renewal, as the Federal government boosted their use as compensation, e.g.: (a) in 1993, in an effort to limit executive pay, companies couldn’t deduct more than $1 million annual compensation for top execs [Section 162(m) of Internal Rev. Code]; (b) in 1994, Congress helped defeat a proposal by the Securities and Exchange Commission (SEC) and accounting regulators that would have required companies to treat the grant of a stock option as an expense and deduct it from earnings; and (c) Congress let stand existing laws which allowed a tax deduction whenever stock options were exercised by which the employer could deduct $1 from its income (for tax purposes) for every $1 of option gains by employees. This combination of financial reporting and tax incentives encouraged a shift in compensation from a relatively transparent form of cash compensation toward an option form that lacked transparency altogether – a condition which created a potential for abuse and an increasing source of investor concern.

The difference between the strike price and the company stock’s current market price indicates the option’s intrinsic value to the executive who holds it. When the exercise price: (a) equals the current share price, the option is referred to as "at the money"; (b) is less than the current share price, it’s call would be "in the money"; and, (c) is greater than the current share price it’s call would be "out of the money." The perceived negatives and investor concerns associated with offering executive stock options arise from the manipulation of these options which may decrease the value of an investor’s shares. Executives who benefit from manipulating stock options both steal value by the dilution of the other shareholders’ interests, as well as by impacting the stock’s market price, which may fall following public disclosure of the scandal.

There are several types of executive stock options, including an Incentive Stock Option (ISO), by which the recipient would generally not generate any tax consequences when it is granted or exercised, but the resulting gain would be taxed at either the prevailing long-term capital gains rate or the ordinary income tax rate when the underlying stock is sold. This tax advantage is perceived as the major benefit of an ISO relative to the Non-Qualified Stock Option (NQSO) by which the difference between underlying share price and exercise price becomes part of employees gross income and is subject to tax upon the exercise of the option.

Understanding how to arrive at the fair value of stock options requires recognizing that options have financial/economic value to their holders through consideration of: (a) the intrinsic value of the underlying shares of the enterprise; (b) the time horizon of the option’s time to expiration; (c) the volatility of the underlying security (d) market interest rates; and (e) the probability of the payout of dividends of the security. Certified valuation professionals utilize several appraisal methods in appraising the value of stock options including the Black-Scholes Option Pricing Model, widely used to estimate the value of common stock. Option pricing methods for estimating the fair value of noncontrolling ownership interests in the common stock of the company typically: (a) treat both preferred stock and common stock as call options on the company’s enterprise value; (b) exercise prices are based on the liquidation preference of the preferred stock; and (c) common stock is assumed to have an exercise price equal to the remaining value immediately after the preferred stock is liquidated.

The several ways by which executive stock options have been manipulated include: (a) backdating, by which stock options are granted retrospectively to a look back time when the company’s stock price was low that results in the option having no risk, i.e., it is essentially granted in the money with guaranteed intrinsic value (over 200 publicly traded companies have been identified as likely to have backdated stock options); (b) repricing, by which the option’s exercise price is retroactively lowered – if the company’s share price failed to rise above the option’s exercise price, companies simply lowered that price (a University of Texas study indicated that approximately 11 percent of companies repriced options at least once between 1992 and 1997); and (c) reloading, whereby instead of the options disappearing when exercised the grantee automatically gets replacement options upon exercise of the initial options (typically replacement options number fewer than the options exercised) which carry the same date, but a different exercise price (the current market price) than the original option. Reloading plans were supposed to provide incentives for executives to both own and continue holding stock in their company, in that exercising those options generally had to be paid for with existing shares (not cash), the value of which shares equals the cost of exercising the option. By 1999, nearly 20 percent of large companies offered reloading plans.

There are several significant ways in which the manipulation of executive stock options can affect the market value of a company and an investor’s interest in it. Note that the granting of in the money options is not, in and of itself, illegal; the problems arise from not disclosing that information to other shareholders and not accounting for backdated option grants as in the money options. The consequences to the investor from this practice is that: (a) compensation expense for the company is underreported, (b) net income was over-reported, and (c) concealment from the shareholders constitutes financial fraud according to the SEC and US Department of Justice, which subjects the company to scandal and regulatory/litigation expense.

To protect their interest, shareholders now commonly require that executive stock option plans specify that the exercise price must not be lower than the fair market value of the stock on the option grant date. Further steps have been taken to address this issue with increased accounting and regulatory scrutiny, including: (a) the Financial Accounting Standards Board (FASB) Statement No. 123, which requires that the granting company’s financial statements include certain disclosures about stock based employee compensation arrangements (regardless of the method used to account for them), and that stock options granted be stated as expenses utilizing option pricing methodologies designed to determine their underlying economic/fair value; (b) the Sarbanes-Oxley Act of 2002 (a/k/a the Public Company Accounting Reform and Investor Protection Act of 2002 - or - SarBox), which strengthened auditing standards and improved disclosure of financial reporting, including provisions curtailing the practice of backdating options and the requirements for reporting of executive stock option grants (Form 4 filing) for public companies, which now have to be filed with SEC within two business days of the transaction instead of within ten days of the month following the transaction; and (c) the Internal Revenue Code section 409A which imposes severe tax penalties on noncompliant deferred compensation arrangements, including stock options granted with an exercise price below the fair market value of the company’s stock as of the grant date.

Efforts toward increased shareholder control, transparency and disclosure are targeted toward curtailing the manipulation in the granting of executive stock option grants and may eventually restore investor confidence in their use as a form of compensation. However, a 2004 study of 250 large companies (by Fredrick W. Cook and Co.) indicated that firms are currently reducing their use of stock options as an executive reward, with only 88 percent of those surveyed using executive stock options – down from 94 percent in 2004. Physician investors should be aware of the potential for abuse and the impact of executive stock options on the value of their investment in a company, investigate the company’s past practice and current policies regarding these grants, and make their investments in an informed manner.

Robert James Cimasi, MHA, ASA, CBA, AVA, CM&AA, CMP, President of Health Capital Consultants, is a nationally known author, teacher and speaker on valuation and health care industry topics.