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September 12, 2006

Eying Corporate Options: Corporate bigwigs caught with hand in cookie jar

By Mark Longo

Also in this article

  • Eying Corporate Options: Corporate bigwigs caught with hand in cookie jar

Many consider the world of options to be beyond their comprehension. These investments are viewed as difficult to price. This has been a reason why the options industry hasn't had healthy growth rates among retail investors. They are often spooked by options. However, as confusing as exchange traded options appear, there is another facet ofoptions that is more daunting: corporate options.

For much of the '90s, options were seen as a panacea for the ills of the corporate world. They provided companies with an inexpensive means to incentivize CEO and employee performance. For many technology startups, they were the only form of additional compensation available. The promise of a lucrative options payday was a carrot few could resist.

This payday mentality lasted until the boom ended. As the tech bubble imploded, it suddenly occurred to analysts and regulators that options, which were handed out like candy in the tech world, had a tangible cost to the issuing firm, and ultimately, its shareholders. Unfortunately, determining that cost is another matter.

Sarbanes-Oxley

Sarbanes-Oxley emerged from the wave of corporate bankruptcies and shareholder lawsuits that followed the bust. This legislation reshaped the world of corporate compensation by demanding firms actually account for the cost of the options they issue to executives. The valuing of options may seem like a straightforward proposition.

Nevertheless, even under ideal conditions, options can be difficult to value properly. Two people, trading the same option using identical pricing models, can still arrive at wildly different values depending on how they value volatility, interest, etc. Throw in other complicating factors, such as competing pricing models, and one understands the dubious nature of options pricing. If this confusion exists in the world of liquid, exchange-traded, options, imagine the confusion in the nebulous world of corporate options.

There is an additional complicating factor in the corporate world: greed. Call options make up the bulk of many executives' compensation packages. Therefore, these executives have a significant incentive to set the strike price of their options at the lowest possible price. That allows them to make the most amount of money when the options are exercised. Calls give the owner the right to purchase the company's stock at a pre-determined price, known as the strike price. This strike price determines the intrinsic value of the option, which is the main portion of its overall value.

For example, XYZ Corporation issues call options to its employees with a strike price of $60. The stock then rallies to $100, giving those options an intrinsic value of $40 ($100-$60). This value is derived from the fact that employees can exercise the options, purchase the stock at $60 and then immediately resell it at the current market price of $100. Thus, the lucky employees net a profit of $40 per share.

Backdating

But determining the proper strike price for an option has been a problem. This problem, along with a fair amount of avarice, has been the genesis for the backdating scandal that is currently sweeping the corporate options world.