Weather | Sports | Forums | Comics | Classifieds | Calendar | Movies
Simple greed generated by generous executive stock options was at the heart of the Enron scandal. Such options tempt the holder to put personal profitability first, at the expense of the company's health.
By FREDERICK R. STROBEL
© St. Petersburg Times, published January 27, 2002
The $80-billion collapse of Enron Corp. already is producing congressional inquiry, criminal investigation, lawsuits and regulatory questions dealing with everything from offshore accounts to energy markets to political campaign contributions. All these lines of investigation and inquiry must move forward, but we also should not overlook the obvious. At the heart of the Enron scandal was a simple motive, personal greed, and a common corporate payoff, the executive stock option.
These two elements can wreck any company, and the unwitting stockholders who support it.
Stock options have become the engine that is driving the acceleration in corporate executive compensation in America. Not wanting to run the risk of public and stockholder criticism over soaring executive pay, corporate boards of directors sometimes use stock options as a way to hide the money they pay to their executives. They grant executives generous options to purchase stock in their companies at generally below-market prices and then resell immediately in the open market for a handsome profit. Further, the executive often gets to pay taxes on the gain at the lower capital gains rate.
The granting of such options is defended as a way to attract top-quality executives and to give them an incentive to build the profitability of a company. However, evidence is mounting that, when the options are too generous, the executive begins working for himself and not for the company or the vast majority of its stockholders.
Here is how the option game works. A corporation's board of directors, to whom the president reports, grants the president the right to purchase, let's say, 100,000 shares of company stock at $5 per share over the next two years. Perhaps the stock is currently selling at that price or even below $5. Assume that the price of the stock on May 1 is $12. The executive exercises his options and buys 100,000 shares at $5 per share and then turns around and sells these 100,000 shares for $1.2-million. His profit is $700,000.
One justification for the stock options is that they encourage the manager to ensure the company's efficiency and profit, a condition that tends to send stock prices up. Sometimes, this incentive can work as intended, and I have personally observed corporate executives who did improve company performance through a solid business improvement model to satisfy this justification.
But there is another way to send a company's stock price up long enough for the executive to exercise his options and make a bundle, and it has little to do with improving the company's long-term health. This other method includes: the acquisition of subsidiaries and the misstatement of their prospective profits to the parent company; questionable accounting practices that overstate profits; misinformation on company health to the Wall Street analysts who follow the stock; and a public relations campaign to get everyone possible to buy the stock, including your employees. Does this sound familiar? This is exactly what happened in the Enron case, with an extra political ingredient -- buying off politicians so they would not stop this kind of economic thievery by the executives.
Consider the following facts. Louis Pai, the former Enron Energy chairman, netted $33.6-million by exercising his stock options, buying and selling 911,000 shares last year. In a like manner, chairman Kenneth Lay earned $16.1-million from sales of 491,000 shares, former CEO Jeff Skilling earned $15.5-million, and Ken Rice, the former head of Enron Broadband, earned $14.7-million -- all from stock sales in the year 2001. Lay was selling 3,000 to 4,000 shares per day. Rice was selling about 1,000 shares per day and then, on July 13, he sold 385,000 shares and left the company in August. Skilling regularly sold 10,000 shares per week.
With this kind of daily personal profit maximization going on, it is hard to imagine that these managers could be running the company in the best interests of the rest of the stockholders, the company employees and its customers.
In fact, Enron executives encouraged their employees to hang on to Enron stock in their 401(k) retirement plans. Only weeks before the company imploded, according to Reuters, Lay wrote employees to advise them that: "My personal belief is that Enron stock is an incredible bargain at current prices and we will look back a couple of years from now and see the great opportunity that we currently have." If employees had known the real truth about the company's increasingly cloudy future and had reacted by selling their stocks, the prices might have dropped -- endangering the profits that executives might have received from exercising their options.
Further, the granting of options is often a factor in a chief executive's willingness to allow his company to be sold out through merger or acquisition. In such a takeover, the chief executives of the company being taken over do quite well, but the acquiring company usually is forced to absorb those high stock costs by laying off employees. Less than three years ago, Richard Korpan, former chairman of Florida Progress, engineered the 1999 sale of his company to Carolina Power & Light, and then received a $17.4-million personal severance package and an $828,845 annual pension.
Of course, sometimes the takeovers don't work at all, and the whole company goes bust, as was the case with Enron and its acquisitions.
Since the government grants extraordinary legal privilege and protections to corporations, one would think that financial misdealings and executive self-dealing would prompt swift and harsh government oversight. However, many of our lawmakers charged with passing the necessary regulations to protect the small stockholder and the company employees have themselves been bought off. To keep the politicians and regulators at bay during a period of deception and excess, Enron gave $710,000 in campaign contributions to Republicans in 2000 and 2001 and $634,000 to the Democrats. Lay personally gave $325,200 to the Republicans in 1999 and 2000; Skilling gave $50,000 in like manner. It is little surprise that those in Congress who received the contributions showed no interest in passing laws to regulate the manner in which corporations compensate their executives.
In recent years, we have left it more and more to the private sector to regulate itself. The Enron case proved to be a spectacular failure in this regard. Arthur Andersen & Co., the firm's auditor, is under suspicion for not properly performing its duties of certifying the veracity of Enron's financial statements.
Standard economic theory assumes that a typical firm operates in such a way as to maximize profits. However, several decades ago, Harvard University economist John Kenneth Galbraith pointed out the increasing possibility that the corporate executive might be inclined to work for his or her own personal profitability first and the company second. The granting of such overly generous stock options has proved professor Galbraith's words prophetic.
So what action can be taken?
Reforming and limiting executive stock options by federal law is a logical place to start. Campaign finance reform, which has been debated but never passed into law, is another necessary way to address the problem. But the ultimate solution may just come from voters and stockholders themselves. Voters have the ability to get rid of politicians who accept large political donations from such executives who have earned their money through use of such options gimmicks. Stockholders can send a message to companies that abuse executive stock options and put all investors at risk.
An economist colleague of mine commented, long before the Enron collapse, that the granting of stock options had the effect of rendering corporate governance out of control. On reflection, that was a nice way to put things. Rather, our lax standards for such corporate governance is putting our way of managing the world's largest economy out of control. What happened at Enron was frighteningly predictable.