Should Stock Options be Scrapped ?

There is this excellent movie released last year ‘Enron: The smartest Guys in the Room’. It is not a commercial kind of movie but more like a documentary one. It traces the rise and fall of Enron, which at one time was 7th largest corporation of US. By now I am sure everyone knows what fraud was being done at Enron? The profit, which the rogue team of Ken Lay, Jeffery Skilling, Andrew Fastow and few others made, was due to stock options. They made millions of dollars by exercising their stock option. A stock option is the stock given by company at a fixed price (may be even free) which most of the time is less than market price. They sell their stocks when the market value is considerably high.

Stock options are part of compensation package of the most of the top level executives of any corporation. They run into millions of dollars. We also have example of the both the founders of Google taking an annual pay of 1 dollar since 2004. They will manage the rest through their stock options. The amount of money they can make this way is directly connected to the share’s market value. The underlying assumption of this was to reward them for appreciation of shares worth which in turn is beneficial for all the stock holders of the organization.

If we see this in the context of Enron then these stock options seems to be the biggest motivation for those ‘smart guys’ to artificially inflate the company’s profit and pump up the stock’s market worth. Would they have done this had they not have any stock option? Hard to tell, but I think they would not have done it this way. So, should a company give stock option to its top level executives, and if not, then what instead? Before we think of it, let’s look at another incident which happened last week in India.

Last Thursday (2nd Feb), a top Indian IT company announced it has bagged a deal worth 300mn US $ from a beleaguered US automotive giant. The deal was spread for 5 years, so an inflow of 60mn US $ each year. The media was quick to catch this news. This was the second ever largest deal bagged by any Indian IT company. The stock immediately appreciated, not much, but still 1.14%. This company does not have much of its stock in circulation as the promoter group has close to 82% of the stake.

Next day it opened at much higher price but ultimately settled at lesser value due to weak market overall. On Saturday the same company clarified that the deal was not for 300mn but for only 27mn US $! The figure of 300mn was its estimate of future business they wish to bag from the automotive company. This comes to less than 6mn $ per year. The stock predictably declined on Monday. It is now for the regulatory bodies to find out if anyone profited from this pumping of the stocks. There has been no news till now of anyone even thinking of investigating this. But we saw one more method of artificially pumping the shares. If someone had stock option then it was a good opportunity to exercise it.

All this leads me to think this, Should companies continue to give stock option to its top executives? Of course due to tough regulatory norms and surveillance this kind of fraud is becoming more difficult but still chances always remain. Should the companies explore other ways of rewarding its top executives while acting in good faith of its shareholders? A good option could be to give percentage of revenue or profits realized. This will also, secure the interests of the share holders, as increase in revenue and profits will ultimately increase the market worth of the stock. This would have worked well even with Enron.