Financial Times Editorial - Too many bad Apples

Financial Times Editorial - Too many bad Apples
Published: October 7 2006 03:00 | Last updated: October 7 2006 03:00
Copyright The Financial Times Limited 2006



It is a very nice bet if you can get it: win, and you keep your prize; lose, and the house lets you roll the dice again. Steve Jobs, chief executive of Apple Computer, admitted this week that he knew some grants of stock options to employees were backdated to inflate their value, a practice that gave staff free wagers of this kind at the expense of shareholders. With dozens of American companies engulfed in similar scandals, corporations should call time on employee stock options.

Options give staff the right to buy company shares for a fixed price at some date in the future. That exercise or strike price is usually the market price when the options are issued, but if it is subsequently backdated to a time when the shares were cheaper, then employees make a bigger profit. More than 90 per cent of US companies use stock options because of evidence that managers perform better if they own a large financial stake.

Apple need not worry about Mr Jobs: worth several billion dollars, it is unlikely that stock options get him out of bed in the morning. Nor is he likely to be much damaged by the current controversy - his value to Apple is too great and he did not personally benefit from the backdating. However, if he had been a hired gun rather than the visionary founder, his position might have been stickier.

Certainly, those culpable for backdating should be punished. But what the affair really shows is how options mismanage managers. They are good at rewarding executives when the share price goes up. Indeed, they can be fantastically lucrative: the chief executive of Capital One, the US financial group, made almost $250m (£134m) exercising options last year. But they do not work if the share price goes down sharply. Once the share price falls too far below the exercise price of the options, the executive will probably doubt it can recover, and therefore have no incentive to try and make it. A company in that position has two choices: either issue more options or reprice the existing ones. Not only has the latter practice led many US companies into action bordering on fraud, but it sends managers entirely the wrong signal: even if the company performs badly, they stand to cash in.

Even without repricing, options are not the best way of motivating executives. Because they get rich if the share price goes up, but lose nothing concrete if it goes down, they have an incentive to take risks. There are plenty of ways they can do so: by borrowing heavily and gearing up the company, by making a large acquisition, or by betting the company on investment projects of very questionable value.

Better, then, for companies to grant executives the right to shares at a future date - preferably dependent on the company's performance over the period. The value of shares does not fall off a cliff like out-of-the-money options, and grants of stock should make executives more closely focus on long-term performance.

This will be even more the case if executives are not able to cash in their shares until a couple of years after they have left the company. That allows time for the errors made by the previous administration to become manifest in the share price.

Executive remuneration is subject to fads, and there are already signs that options are losing their appeal, partly in response to accounting changes. But companies need to be careful what replaces them.