Shareholders Unite to Expense Options


By Louis Lavelle With little fanfare in recent weeks, shareholders in favor of including options as an expense on corporate income statements have won majority votes at two dozen companies, and significant minority votes at many more. Even at tech outfits, including Intel (INTC), Veritas Software (VRTS), and Apple Computer (AAPL) -- which remain steadfastly opposed to expensing -- shareholder revolts over expensing options have succeeded or almost succeeded. Even at Intel, and despite a company campaign to convince shareholders to reject the proposal, supporters of expensing came very close to prevailing.

What gives? To hear tech executives tell it, shareholders have been swept up in a tidal wave of governance reform. Blaming managers for their diminishing portfolios and seeing wrongdoing all around, they're willing to vote indiscriminately against anything that has the management seal of approval. There may be something to that appraisal. Across Corporate America, shareholders are withholding their votes for director nominees and voting en masse for resolutions on everything from independent directors to CEO pay.

HOGS AT THE TROUGH. Companies best not write off the shareholder revolution on expensing as just irrational behavior, however. For one thing, shareholder resolutions, particularly on the subject of expensing, don't make this much headway without a great deal of help from cautious institutional investors.

At Intel, for example, many investors view expensing as a way to control the company's profligate use of options. In just two years, Intel has distributed more than 400 million options, representing a staggering 6% of the company. "I think any company that gives out that many options is in need of reining in," says Dwight Blazin, an analyst at Davis Selected Advisors who voted his own Intel shares in favor of the expensing resolution. "It's like a bunch of hungry hogs coming up to the trough just before the trough is closed."

Even if these resolutions don't carry the day, the votes could have influence well beyond the boardroom. As the debate over expensing unfolds in coming months, the Financial Accounting Standards Board and Congress will be watching the battles closely for signs that popular support for expensing -- especially among tech investors -- has reached the high-water mark.

PR BLITZ. Supporters of expensing say that the groundswell of investor support could give them the last bit of momentum they need for enacting the accounting reforms. Says Patrick McGurn, vice-president at Institutional Shareholder Services, which recommended that institutional investor clients support the expensing proposals: "Every time there's another majority vote, it's a step in the direction of mandating expensing."

To date, only four tech companies have had a majority vote of shareholders in favor of expensing: Veritas Software (57%), Mercury Interactive (MERQ

, 52%), Apple Computer (52%) and NCR Corp. (NCR

, 51%). But the proposals have garnered substantial yes votes at six others, including IBM (IBM), Hewlett-Packard (HPQ), and Intel.

At Intel, the company launched an all-out public relations offensive in the weeks leading up to the annual meeting that included more than 60 pages of public filings urging investors to vote down the proposal, as well as a personal lobbying campaign by Chairman Andrew Grove. While 47.5% of the votes cast favored the expensing proposal, they accounted for only 30% of the shares outstanding. Exceedingly few shareholder resolutions garner 30% their first time on the ballot. And the fact that the measure attracted such robust support in the face of intense, company-led opposition is even more amazing.

VANISHING PIE. Jeffrey Sonnenfeld, associate dean at the Yale School of Management, says institutional investors upset over the dilution caused by massive executive stock-option grants are using the votes to send management a message. "It's a large shout that the giddiness is gone," Sonnenfeld says. "The pie isn't growing exponentially any more. Every slice someone crams in their mouth affects everybody else at the table."

Opponents of expensing warn that the remedy might be rife with problems. Intel CEO Craig Barrett, among others in the tech community, has argued that, since options require no cash outlay, they're not an expense.

What's more, opponents say current methods for valuing options are inaccurate. And if expensing were to become law, there would be no way to properly credit companies for options that are never exercised, either because the option owners left the company or the options expired at less than their agreed price. This is no small matter. Had Intel been expensing options since 1995, it would have reduced earnings by $3 billion -- and done so for options that are underwater.

DEAF EARS. For Silicon Valley, where perennially cash-poor tech startups rely on broad-based options programs to reduce compensation expenses and give incentives to their workforces, the issue is particularly important. Take away "free" options, the theory goes, and the entrepreneurial, risk-taking mindset that created the innovative technologies and business models of the 1990s will disappear. "As an engine of economic growth, one of the things [an options program] does is allow you to motivate employees and retain them," says Bill Calder, an Intel spokesman. "It's very much about innovation and continuing to grow the economy. Take that away and you risk some potential backlash."

So why did such arguments not resonate with many institutional investors? For one thing, most are well aware of how many options the companies in their portfolios issue every year -- the information is already disclosed in footnotes -- and they factor that in to their decisions on whether to buy or sell.

In addition, the inaccuracy of current methods for valuing options pales in comparison with the fundamental inaccuracy perpetrated by all nonexpensing companies. By keeping options off the financial statement, such outfits are saying that options have no value at all. Yet they clearly do -- for both the employees who receive them and the company that awards them. "We know the value of those options is not zero," says Blazin. "We know that zero is not an accurate number."

UNPRECEDENTED SUPPORT. The shareholder revolt against expensing is also part of a broader uprising focused on executive pay. In 2003 so far, more than 300 resolutions targeting outrageous executive pay have been placed on company proxies by shareholder activists, including Big Labor -- three times the number that appeared in all of 2002, according to the Investor Responsibility Research Center.

Fully a third of the pay proposals call for expensing, which is one of the few measures getting uniformly high "yes" votes at companies where it has been put on the ballot. Of the more than 40 proposals on expensing that already have been put to a vote, "yes" ballots have averaged more than 48% -- a degree of across-the-board shareholder support almost unheard of in recent history. Corporate America is not deaf to the calls for accounting reform. Indeed, some 275 companies have voluntarily agreed to expense stock options, including outfits that represent a third of the Standard & Poor's 500 index's market capitalization.

Tech investors' votes for expensing puts executives in a difficult position, especially before Congress and regulators. Tech executives wanted to enter the expensing fray with the near unanimous backing of their shareholders. Now, it looks like they will have to go it alone. Lavelle covers the expensing issue for BusinessWeek in New York


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