CEO = Creatively Endowed with stock Options

Recently Mark Cuban, the owner of Dallas Mavericks, was in the news for suggesting that CEOs be paid in cash. Apparently, Mr. Cuban did not read my articles written back on April 27 and on June 14, 2004 on this subject, published on prudentbear.com. The articles are reproduced here for interested readers.

Management ought to treat Financial Statements with Respect
April 27, 2004

Dr. Gurram Gopal is Assistant Professor of Business Administration Elmhurst College, Elmhurst, IL There has been a lot of discussion lately regarding the expensing of stock options by corporations and with the first quarter's earnings season under way, this issue takes on added importance. Executives like Craig Barrett of Intel Corporation, Ms. Carleton Fiorina of Hewlett Packard and John Chambers of Cisco Systems have argued against the expensing of stock options granted to managers and employees, as there is no "accurate" method for valuing the options. On the flip side financial analysts and some mutual fund managers have argued for expensing, citing the need for "more transparent" corporate reporting. In line with this view the Financial Accounting Standards Board has recently announced a proposal to require publicly traded companies to record as a compensation expense all forms of share-based payments to employees, including employee stock options. The value of this stock compensation would "generally be measured at fair value at the grant date." Ostensibly the determination of "fair value" is left to the companies. Both these arguments ignore the fundamental purposes of financial statements of public corporations. Financial Statements of corporations are intended to serve several purposes. In part they are supposed to disclose the "assets" and the "liabilities" of the company, using "real" and verifiable data wherever possible. They are also expected to inform the investors as to how their money has been used by management and the benefits delivered to them, the owners of the company. To this latter point, the financial statements are a "report card" on management's performance. Investors already have "one strike" against them- the "report card" on management is "prepared" by management. It is simply unconscionable to pollute this report card further by giving management the ability to "value" options or other non-cash compensation that they either provide for themselves, or that they receive from the board (often with "assistance" from management). Financial Statements should be considered "sacred" and treated with respect- clearly not something that has been done in the era of the off-balance sheet financings and other shenanigans. All "money" coming in and going out should be in the form of cash. Would Intel accept stock options printed by Hewlett Packard management as payment in lieu of cash when Hewlett Packard buys its processors? I don't think so. Will Intel management pay a supplier like Applied Materials in Intel stock options when it purchases Applied Materials' equipment? Quite unlikely. The accounting of revenues in "cash" is a key ingredient in financial statements. Similar attention needs to be paid to all expense items. All compensation provided to employees, management, and the board should be accounted for in the form of cash. No company management should be in the business of printing and issuing its own stock options. If indeed management (and employees) need extra motivation in addition to a fair market cash compensation, this has to be done while keeping the financial statements sacrosanct. Here is a suggestion- if the board decides to provide stock options (or other products) to a manager these should come out of the "total cash compensation" for that person. The board can take a part of the "cash" compensation and buy stock options in the open market on Wall Street and give them to the manager. Quite a few bankers would be more than willing to create and sell stock options to a company for cash- they currently price and sell call options that are available to investors on a daily basis. Since the company is paying cash for the options it is providing to managers and employees, there is no question as to the "valuation" of the options. The valuation problem and the associated risk are now shifted to Wall Street, which specializes in this area and does this on a daily basis. This is the "only" way to ensure that investors get a "true" picture of the compensation paid to management, which is the key part of performance evaluation. A simpler mechanism is for the board to take part of a manager's cash compensation, purchase the company's stock in the open market, and provide that stock to the manager, with the requirement that the stock be held for a pre-determined duration before the manager can sell the shares. The key element here is that whether the board rewards a manager in the form of options or stock, these have to be "purchased" in the open market, not printed by the company. There is an underlying philosophical question as to why management needs to be "incented," in addition to getting paid handsomely, to do a "job." It is not at all clear whether stock options are effective in motivating management and employees in an ethical manner (WorldCom and Enron come to mind). In order to determine if the "incremental" value provided to the shareholders is a sufficient "return" on the "incremental" cost of stock options we need to know the "exact cost" of the stock options. What happened to the good old (ethical) value of doing a job well because you are getting paid for it, in cash?

Financial Engineering 101

June 14, 2004

Ten laws of 21st century financial science: A core course in Financial Engineering Dr. Gurram Gopal is Assistant Professor of Business Administration Elmhurst College, Elmhurst, IL As visitors of this site are well-aware there are many developments in the financial and political arenas that give cause for concern. Included are the war on Iraq ( “International Perspective” by Marshall Auerback), the notion of increased wealth due to higher asset prices (A Grotesque Misnomer, by Dr. Kurt Richebächer) and the easy credit fostered by the Fed (Money and The Flip-side of Speculator De-leveraging, by Doug Noland). Right along these lines is the quarterly "Flow of Funds" report issued by the Federal Reserve last Thursday where it reported that U.S. household wealth grew to a record-high $45.2 trillion in the first quarter of 2004, boosted by rising real estate and mutual fund values. At our college’s commencement ceremony a few days ago, as I was contemplating on these events and the responsibility of Colleges and Universities in developing the “ human geniuses” that have driven these developments my attention turned to the discipline du jour- “Financial Engineering.” Back in the dark ages (the seventies) when I was in college, engineering referred to the application of scientific principles, especially those related to the properties of matter, to create physical products useful to the human race. How grossly ignorant have I been all these years! We have come up with “software engineering” to bestow scientific grandeur to the practice of writing software (hacking). Nowadays leading educational institutions like Columbia, MIT, Northwestern, etc. all offer programs leading to degrees in “Financial Engineering.” I have started preparing my course material for FE 101, Ten laws of twenty-first century financial science (revised 2004). Law #1. Laws of supply and demand do not work when a financial institution borrows money (e.g. when Al G. is your Pal.) Application: You would expect that as you borrow more, the marginal rate would rise. WRONG! See the growth in the borrowings related to the “carry” trade and the interest rate policies of Al’s Banks. Law #2. The American taxpayers, a.k.a. the Government, are there to bail you out if you make a mistake, so no amount of risk is unacceptable. Of course making large political contributions does help in some sticky situations. Applications: Government’s $15 billion airline bailout bill, signed by President Bush on September 22, Orange County’s Bankruptcy in 1994, President Bush’s S&L bailout plan in 1989. Law #3. Be patriotic and support the American taxpayers by bundling all your credit offerings and reselling them to the government or to the GSEs. This provides you with idiot-proof free insurance. Application: See the mortgage lenders, mortgage-backed securities (MBS) and government-sponsored enterprises (GSEs) like the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Law #4. Rates on secured debt should be higher than those on unsecured debt. Application: Interest Rates on home equity lines should be higher than credit card rates. I received a pre-approved home equity loan from my bank at a 4.25% rate (three years), and simultaneously a pre-approved credit card application with 0% APR on purchases and balance transfers for one year. Apply a recursive process to the credit cards (i.e. move balances to a new credit card when the one-year time expires on the old one) to see that you may not have to pay any interest on those purchases. Law #5. No one has ever gone broke by underestimating the intellect of the public. It is your duty to create products that take advantage of this fact. Application: New “financial engineering products” in the home buying industry- 0% cash down mortgages, current account mortgages, cash back mortgages, etc. Law #6. Balance sheet assets of the company are meant for the personal benefit of you and your fellow managers, and the Balance sheet liabilities are for the shareholders to pay. Applications: Use of corporate jets for personal travel, luxury apartments purchased or leased by corporations for personal use by its senior executives, GE granting extraordinary benefits for life to former CEO Jack Welch. United Airlines deserves special mention for hiring a new CEO Glenn Tilton in September 2002 with a $3 million signing bonus, a pay of $950,000 a year, creating a trust valued at $4.5 million to replace the retirement plan at Chevron Texaco that he forfeited, and three months later he takes UAL into bankruptcy. Law #7. The Current Assets account of your employer is there to pay any fines those pesky regulatory and other governmental agencies might impose for your violations. Applications: Citigroup’s Settlement on WorldCom Class Action Litigation for $1.64 Billion After-Tax. The $1.4 billion settlement between the biggest U.S. brokerages and securities regulators regarding the issuance of misleading stock recommendations and handing out new shares to curry favor with corporate clients. The broad agreement does not include the punishment of any Wall Street analysts or executives who supervised them. Bank of America and Fleet Boston ‘s $675 million settlement of allegations of improper mutual-fund trading. Law #8. Debt remains senior to Equity, but Management Claims are senior to Debt. Application: Kmart Chairman James B. Adamson’s salary of $1.5 million and a sign-on bonus of $2.5 million in 2002 along with perks like weekly flights to Florida on corporate aircraft; a car and driver in Michigan, New York and Florida; hotel lodging in Metro Detroit and financial counseling. At the same time holders of pre-bankruptcy debt received 40 cents, in cash, for each dollar of the debt they held. Common stock holders can frame their worthless stock certificates in a nifty new frame designed by Martha available at any Kmart store. Law #9. Option valuation models like Black-Scholes do not work for options and other derivatives issued by your firm to its management and employees. They are useful, however, in determining the value of derivatives when they are not part of your company’s compensation packages. Application: John Chambers of Cisco has in excess of 39 million unexercised options, but companies like Cisco and Intel claim that there are no reliable methods for valuing these options. Law #10. When the public trusts you with their money, they want YOU to get risk-free rewards while THEY are saddled with all the risk. Application: Highly paid, poor performing CEOs, mutual fund managers, etc. Once you have mastered these ten laws, you can then take FE 201: TAPS (Taking Advantage of People’s Stupidity) and FE 202: SITS (Sock it To Shareholders).