Options Frenzy: What Went Wrong?
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Executives' Ownership Stake
Put Extreme Focus on Stock;
Creating a `House of Cards'
THE NATIONAL CENTER for Employee Ownership is in Oakland, Calif. A
Dec. 17 Marketplace article incorrectly reported it is in Kansas City,
Mo. In addition, the center estimates that 80% or more of the value of
all stock options is awarded to managers. The center's director was
quoted in the article as saying that amount is awarded to "senior
executives."
(WSJ Dec. 31, 2002)
WORRIED HE was missing a once-in-a-lifetime boom, Roy Satterthwaite
decided to grab a piece of the action.
It was the late 1990s, and the stock options of the dot-com world were
an almost irresistible magnet. Giving in to the pull, Mr. Satterthwaite
left a $150,000-a-year job at International Business Machines Corp.,
eventually landing at Commerce One Inc. as a vice president and general
manager. In early 2000, just seven months after starting at the
e-commerce software company, he cashed in his first stock options -- and
became a millionaire. Buying a vacation house at Lake Tahoe, he was able
to pay the whole amount with one check. The lure of option riches inspired Mr. Satterthwaite and his
colleagues to put in 100-hour weeks -- presumably a plus for the
company. But it also skewed their priorities, he says. Feeling they were
in a desperate race with start-up rivals, he says, he and colleagues
both inside and outside Commerce One increasingly focused their efforts
on making sales and cutting deals that would increase revenue. That was
the number investors seized on -- the one that boosted the stock price.
The problem was that the company's nascent infrastructure often wasn't
up to the task of supporting all those sales, he says.
"It was all a mad rush for the next customer sale, versus focusing on
making previous customer transactions successful," recalls Mr.
Satterthwaite, who today is an executive in residence at CommerceNet, a
not-for-profit technology incubator in Palo Alto, Calif. "You were
really only required to look good at a certain point in time, and as you
rose with the rising tide of the market, you could cash out."
Throughout Silicon Valley, Mr. Satterthwaite says, options "motivated
us to a selfish, short-term view" by promoting rapid sales growth at the
expense of the detail-oriented work of building an infrastructure. "They
did not create what I believe the shareholders want, which is long-term
value. In many ways, they were a house of cards."
Amid a slide in revenue and continuing, albeit reduced, net losses,
the company's shares in 4 p.m. trading on the Nasdaq Stock Market stood
at $3.36, down 14 cents and far off their 52-week high of $43.70, set on
Jan. 4.
Commerce One declined to comment.
Stock options were once championed by consultants, professors,
investors and politicians as the ideal golden carrot -- an incentive for
executives and valued employees to improve corporate performance by
aligning their fortunes with those of shareholders.
And that has happened -- occasionally.
At the same time, many current corporate ills, from frequent
job-hopping to outright fraud, can be traced at least in part to the
proliferation of options in the 1980s and early '90s, according to
regulators, investigators and even some of the beneficiaries themselves.
What went wrong?
For one thing, the option-as-carrot premise assumes that self-interest
dictates prudence. Not so -- in fact, often just the opposite. "When
everything you've worked for and built is at stake, when your entire
ability to go through the rest of your life is at stake, there's a
tendency to take extra risk," says Steven M.H. Wallman, a Securities and
Exchange Commission member from 1994 to 1997.
Federal Reserve Chairman Alan Greenspan this year blamed "poorly
structured" options as a major contributor to the "infectious greed"
that gripped business in the 1990s. "The incentives they created
overcame the good judgment of too many corporate managers," he testified
before the Senate Banking Committee.
Edward F. Walsh, a compensation consultant who helped to design option
plans for Campbell Soup Co. and PepsiCo Inc., recalls how options first
gained currency when business was struggling in the early 1980s. The
theory "was that it would be good if you walked in the same shoes as the
shareholder," says Mr. Walsh, who served as Campbell's human-resources
head in the mid-1980s.
Mr. Walsh believes ownership stakes underlay necessary downsizing,
mergers and other corporate restructurings that took hold during the
1980s. But the churn extended too far into the 1990s, he says. "It went
way too far," he says. "The whole game came around to, `How fast can I
get my money out? How am I going to get mine?' "
At the same time, options rarely received scrutiny from corporate
directors -- or anyone else. "The money to be made through the
appreciation of stock value was for the most part unchecked," says Jacob
Frankel, a partner at Smith Gambrell & Russell LLP in Washington, who
was at the SEC from 1988 to 1997 as a senior counsel in enforcement. He
adds: "The absence of checks and balances, which would have been the
responsibility of boards and other gatekeepers permitted various forms
of looting."
Federal tax and accounting policies, which kept options tax- and
expense-free, tended to feed the frenzy. Investors' focus on company
stock prices only increased, for instance, after the SEC began requiring
companies to include stock-performance charts in their annual proxy
filings.
In Silicon Valley, where options were a popular form of compensation
for start-up technology companies, employees at first had modest
expectations for their options.
"The general concept of a stock option was, `If things go well, I'll
be able to buy a house with my stock options,' because you couldn't buy
a house with your salary," remembers Ken Pelowski, who received his
first option grant when Intel Corp. hired him out of business school in
1987. "No one really thought about the grand-slam home runs," says Mr.
Pelowski, now a 43-year-old managing director at Redpoint Ventures, a
venture-capital firm in Menlo Park, Calif.
By the early 1990s, that had changed. More tech companies were going
public, stock markets were rising and the economy was booming. With
every report of a newly minted "Microsoft millionaire," and every
increase in CEO compensation, stock ownership was trumpeted as the
embodiment of classic American ideals of independence and
entrepreneurship -- and a way for everyone to get rich.
Even so, the benefits were mostly limited to the upper ranks. "It's
probably the case that 80% and probably higher, of the value of all
options goes to senior executives," says Corey Rosen, executive director
of the nonprofit National Center for Employee Ownership in Kansas City,
Mo.
As start-ups in search of talent littered the landscape with options,
some people amassed unimaginable fortunes by job-hopping. Honorio
Padron, a onetime NASA engineer and son of Cuban immigrants, became a
millionaire thanks to option packages received while moving through
executive postings at PepsiCo's restaurant unit, retailer CompUSA Inc.
and energy provider Exelon Corp.
"It was fantastic, a quantum leap," says 50-year-old Mr. Padron, who
is now chairman and chief executive officer of Padron Group LLC in
Chicago, his own investment group. "My standard of living got totally
transformed -- bigger house, wife didn't work, kids going to the best
private schools in the country."
Lawyers that served growth companies grabbed pieces of hot companies
they represented before their public offerings. Some firms awarded
partnership stakes to young lawyers far earlier than was traditional,
just to keep them from bolting. "It was a heady time," says Keith C.
Wetmore, chairman of law firm Morrison & Foerster LLP. "There were
greater opportunities in firms for equity participation and seemingly
unending equity upside in the landscape of lawyer compensation. You felt
like you were part of not only a transformation of the economy, but the
law."
But as options became the currency du jour for executives, the
fixation on an employer's near-term stock price grew apace, to the
dismay of more cautious souls. In the late 1990s, as national sales
director for McAfee Associates Inc., a Santa Clara, Calif., software
company, that widely distributed options, Mark Friedberg grew
disconcerted by associates' obsession with the share price. McAffee
executives "were getting wildly wealthy, and became extremely aggressive
with bookkeeping and accounting and managing sales channels," says Mr.
Friedberg. He adds: "Inventories would come in and go out to make sales
better. When you'd go to a sales meeting and the first thing the vice
president does is put up a chart and says, `The stock is at 10, it will
be a 100 next year if we do this,' you'd think, `Maybe we should do this
the other way around. We should focus on engineering products, and if we
have happy customers, maybe the stock will hit 100.' "
Sylvia Garcia-Lechelt, senior vice president, human resources at
Network Associates Inc., which was created in 1997 when McAfee merged
with Network General Co., says stock options are "foundational" to the
company, widely distributed as "a way to get people engaged. There's no
promise -- in fact, most people don't get wealthy just from options. Its
just a little piece of the compensation picture."
Mr. Friedberg himself wasn't immune from the fixation on options. "It
skewed my thinking and let me trade salary for a higher upside," he
says. He left McAffee in early 2000 to take another job and today is
consulting.
Mr. Friedberg's thoughts weren't widely shared at the time, to the
subsequent regret of people like software executive Katrina Roche, who
twice took generous options in lieu of large salaries.
Ms. Roche was hired for the first of those jobs, at Baan Co., Europe's
second-largest software company, in 1998. Her new boss figured her
options eventually would be worth at least $7.7 million. But the day she
started work, the company announced it would miss earnings -- and the
share price began a downward spiral. "There was no hope I was going to
see money from those options," she says.
After several years at Baan, she joined i2 Technologies Inc. in Dallas
as chief marketing officer, again receiving a large option grant. But
the stock started downward soon after she joined, and Ms. Roche, a
single mother of an infant son, realized that her salary alone would be
insufficient to provide for her child, who today is 19 months old. She
recently left i2 but hasn't forsaken options altogether. She is now
president and chief operating officer of Nonstop Solutions, a closely
held company with no current plans to go public, where she received
options to buy a certain share in the company over time.
In a handful of cases, overreliance on expected option wealth led
desperate executives to commit fraud, say law-enforcement officials and
regulators. "The rapid growth of an executive-compensation shift to
enormous stock options, stock grants, perks and nontraditional benefits
such as off-balance sheet activities distorted the core roles of
executives, their responsibility and accountability," says Brent Braun,
a special agent for the Federal Bureau of Investigation in Los Angeles
who has investigated white-collar fraud.
Such cases were almost inevitable, suggests Mr. Wallman, the former
SEC commissioner. "We sowed the seeds and got what we sowed," he says.
But have lessons been learned? It's hard to tell. Today, even with the
stock market in tumult and the benefit of hindsight, much of the options
debate is focusing on technical questions, such as whether to expense
them or to require executives to hold them for a certain duration.
Plenty of companies, especially in the high-tech arena, continue to
favor the status quo. Expensing options "is really a red herring in the
whole debate," says Piper Cole, vice president of global public policy
for Sun Microsystems Inc. "People who violated the law should be
punished, but I can't see any benefit in mandating a change. It's not
going to make people less greedy. To do away with options, Ms. Cole
says, "would hurt employees, because they won't get that kind of
ownership and potential upside."
Dennis DeAndre, founder and co-chairman of LoopNet Inc., an online
real-estate listing service, appreciates the value of options as
incentives but thinks they are also capable of considerable harm. "They
did create a lot of hope" at LoopNet, a closely held company, Mr.
DeAndre says. "They fostered a very strong culture in the company,
encouraged people to work endless hours. For the first time ever there
did appear to be a shortcut for reaching your financial goals."
But for most, there was no shortcut. "The worst thing that happened to
our company was the boom," Mr. DeAndre says. The subsequent market
tumble "deflated a lot of expectations that should never have been built
up to that level before," he says. "People realize now that to get
financial security is a long task that will take a lot of years, and
they were misled."
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Who Got the Most From Exercising Options?
By Matt Murray
12/17/2002
The Wall Street Journal
B1
(Copyright (c) 2002, Dow Jones & Company, Inc.)
Corrections & Amplifications
Here are 10 of the largest options exercises taken by heads of major
publicly held U.S. companies in the past five years and how their
company's stock price has fared.
In some cases, the leaders' rewards were far out of proportion to the
gains shareholders realized. In other cases, it was a closer call. On
balance, many executives were able to time these exercises to the peak
of the stock price, while shareholders who held on longer lost value.
The gain cited is pretax and on paper -- though it is typically
counted as part of an executive's overall net worth and compensation.
Some executives have since sold at least part of their shares, while
many of those who held on have seen the value of their shares decline
along with the stock market.
-- Kris Maher and Kemba J. Dunham
1. Lawrence J. Ellison, chairman and chief executive, Oracle
-- Biggest recent gain from options exercise: $706,076,907 (FY01)
-- Current stake: As of Aug. 22, he owned 1.32 billion shares, or
roughly 25% of shares outstanding.
As of May 31, he held 59.4 million exercisable options.
-- How the company has fared since his big gain: The decline in
corporate-technology spending hurt the Redwood Shores, Calif., maker
of database and application software during the past year. Since June,
the company has cut between 500 and 1,000 positions, a reduction of 1%
to 2%.
-- Company comment: `Mr. Ellison had to exercise those shares because
they were part of an options grant that was due to expire.'
2. Michael D. Eisner, chairman and chief executive, Walt Disney
-- Biggest recent gain from options exercise: $569,827,702 (FY98)
-- Current stake: As of Aug. 14, he owned roughly 14 million shares.
As of Sept. 30, 2001, he held 6.1 million exercisable options.
-- How the company has fared since his big gain: Mr. Eisner is under
pressure from directors of the Burbank, Calif., company. Its
performance has suffered due to problems with its ABC television
network, animated movies and theme parks.
-- Company comment: `Disney's market capitalization increased
sevenfold to nearly $65 billion from the day Mr. Eisner received these
options until he exercised them nearly nine years later, just 13 months
before they would have expired . . . this year Disney stock has
outperformed most of the major media companies as well as the S&P 500.'
3. Michael S. Dell, chairman and chief executive, Dell Computer
-- Biggest recent gain from options exercise: $233,283,432 (FY99)
-- Current stake:
As of April 30, he owned 300,574,296 shares and held 4.1 million
exercisable options.
-- How the company has fared since his big gain: The Austin, Texas,
computer maker remains one of its industry's bright spots. Corporate
demand dried up during 2001 at Dell and other computer manufacturers.
To spur sales, Dell cut prices and costs, helping it grab more market
share. As a result, its share price hasn't fallen as far as those of
rivals.
-- Company comment: `For us, stock options are an important part of
recruiting, rewarding and retaining employees, and we think that the
vast majority of shareholders are satisfied with our compensation
strategy and broad management of the company.'
4. Sanford I. Weill, chairman and chief executive, Citigroup
-- Biggest recent gain from options exercise: $220,162,892 (FY97)
-- Current stake: At the end of 2001, he owned 22.9 million shares
and held 9.7 million exercisable options.
-- How the company has fared since his big gain: The New York
financial-services company has been beset by several investigations
into practices of its investment-banking unit during the stock-market
bubble of the late 1990s, and has instituted some reforms.
-- Company comment: `Since 1986, when he became head of Commercial
Credit, Sandy Weill has sold shares only in 1999 and 2000. He and
other senior Citigroup executives adhere to a `blood oath' to retain
75% of all shares and options they receive while with the company. Mr.
Weill has never sold shares after exercising options.'
5. Thomas M. Siebel, chairman and chief executive, Siebel Systems
-- Biggest recent gain from options exercise: $174,613,276 (FY01)
-- Current stake: As of Feb. 28, he owned 39.2 million shares; as of
Dec. 31, 2001 he held 23.7 million exercisable options.
-- How the company has fared since his big gain: Like other
technology companies, the San Mateo, Calif., software maker, saw its
share price drop. Since July, it has eliminated roughly 1,100 jobs.
-- Company comment: `Mr. Siebel was the primary source of venture
funding for Siebel Systems and until its IPO, was the primary
shareholder. Since its IPO, Siebel Systems has generated over $3.5
billion in shareholder value and accumulated over $2 billion in cash.
Mr. Siebel remains committed to the success of the company and along
with his 6,000 employees shares the risks and rewards of being a
shareholder.'
6. Stephen M. Case, chairman of AOL Time Warner
-- Biggest recent gain from options exercise: $158,056,501 (FY97)
-- Current stake: As of Dec. 31, 2001, Mr. Case owned 11.5 million
shares of AOL Time Warner and held 18.2 million exercisable options.
-- How the company has fared since his big gain: Shares of the media
giant have slumped more than 80% since the January 2000 announcement
that America Online would acquire Time Warner. The deal was initially
valued at $156 billion; the combined company is now valued at roughly
$60 billion. Its America Online unit has been beset by slowing
subscriber growth, plummeting advertising revenue and a criminal
investigation of its accounting practices.
-- Company comment: `Steve Case is one of the largest shareholders in
the company, and his interests and the interests of our shareholders
are completely aligned. Since the merger has closed, Steve has
increased his ownership stake in the company.'
7. John T. Chambers, president and chief executive, Cisco Systems
-- Biggest recent gain from options exercise: $155,980,290 (FY00)
-- Current stake: As of July 27, Mr. Chambers owned 2.1 million
shares and held 23.8 million exercisable options.
-- How the company has fared since his big gain: Also hurt by the
tech slowdown, the San Jose, Calif., maker of computer-networking
equipment last year eliminated 8,500 jobs. A pending shareholder suit
blames senior management for the company's steep drop in market value
between August 1999 and April 2001. `The suit is without merit,' says
a company spokeswoman. In April 2001, Mr. Chambers `indefinitely' cut
his $268,131 salary to $1 a year.
-- Company comment: `John Chambers last exercised stock options in
February 2000, one full year before Cisco experienced a revenue
decline. These options were from grants received in 1995, and
constitute only a small portion of his total company holdings. Cisco's
stock has appreciated over 600% to date since Chambers was named CEO in
1995, and despite the current economic climate, the company will not
reprice employee options.'
8. Gerald M. Levin, former chief executive, AOL Time Warner
-- Biggest recent gain from options exercise: $152,590,000 (FY00)
-- Current stake: As of Dec. 31, 2001, Mr. Levin owned 2.5 million
shares and held 9.1 million exercisable options.
-- How the company has fared since his big gain: With shares of the
media titan slumping badly, Mr. Levin retired as CEO in May. When he
announced his planned retirement last December, he appointed Richard
Parsons to fill his post. Mr. Parsons has sought to restore the
company's credibility with Wall Street, partly by offering more
cautious growth projections.
-- Company comment: `With the exception of donating shares in
connection with his charitable giving in memory of his [late] son, Mr.
Levin's practice as CEO had been to hold both shares and options in the
company and only exercise options when they were close to expiring and
then holding the resulting shares.'
9. Jozef Straus, co-chairman and chief executive, JDS Uniphase
-- Biggest recent gain from options exercise: $150,295,997 (FY01)
-- Current stake: As of Aug. 16, Mr. Straus owned 3,090 shares. As of
June 30, he had 6.5 million exercisable options.
-- How the company has fared since his big gain: The maker of
fiber-optic components and telecommunications equipment, based in
Ottawa and San Jose, Calif., has been battered by the
telecommunications downturn for more than a year. Aggressive
cost-cutting measures have included plant closings and massive layoffs.
-- Company comment: `Jozef Straus's options exercise in 2000 was at a
time when business and forecasts for future business were strong, and
in fact the company continued to perform quite well in the subsequent
September and December quarters. He exercised options on only a
fraction of what was available to him, followed all company policies
and guidelines, and donated a substantial portion of the proceeds to
charity.'
10. Howard Solomon, chairman and chief executive, Forest Laboratories
-- Biggest recent gain from options exercise: $147,252,540 (FY00)
-- Current stake: As of June 21, Mr. Solomon owned 4 million shares.
As of March 31, he held 4.2 million exercisable options.
-- How the company has fared since his big gain: The New York drug
maker has exceeded analysts' expectations lately, mainly on strong
sales of its antidepressant medications. Its antidepressant drug
Celexa, launched in 1998, now accounts for roughly 70% of sales. In
September, the company won Food and Drug Administration approval for
another antidepressant medication.
-- Company comment: `These options were expiring, and they had to be
exercised. The performance of the company has been exceptional. The
stock has gained 123% since the time of that exercise.'
Sources: Securities and Exchange Commission filings; stock-option
exercise figures provided by Mercer Human Resource Consulting in New
York and by Investor Responsibility Research Center in Washington