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C. Gopinath

IT is a wonderful idea to give employees stock in the company. It takes the notion of egalitarianism and capitalism to idealistic levels. Can you imagine Karl Marx standing at the factory gates exhorting the workers to break their chains while they get into limousines and drive away?

In theory, the idea is not too far-fetched. A person who owns stock in an organisation holds a share in its ownership and should, therefore, behave in a manner that is in the best interests of the organisation. She is entitled to vote at the annual general meeting, and receive dividends, which are a share of the profits. If this person is also employed by the organisation, then you have the happy state of the owners involved in running the enterprise and what can be better for the firm?

As example, the Employee Ownership Index in the UK is made up of companies with more than 10 per cent of their stock held by employees. This index has performed better than the FTSE all-share index over the last decade. Now let us get down to reality. Stock ownership and the power to vote only makes a difference if the volume of votes that it controls is significant enough to give it power to affect decisions. As a second best, the stock owning employees, even if they do not have a majority, should at least feel that they are participating in the management of the enterprise. This is possible and happens frequently in knowledge-based small organisations where the employees are truly the assets on which the organisation functions. Such as an advertising company, or a software operation. In the absence of participation and influence in setting the company's direction, ownership does not matter.

Thus, when we see high positive correlation between good organisational performance and employee ownership, it does not necessarily mean that the latter causes the former. A third variable may be involved; perhaps, what is happening is that it is an enlightened and well run company, that is even otherwise following good policies, of which one happens to be employee stock ownership. Apart from the issue of control, stock ownership can also serve as a strong motivating factor. Especially when the value of the stock keeps rising. One of the secrets of employee loyalty at Wal Mart, now the world's largest retailer in terms of sales revenues, is employee participation in profits with and without stock ownership. Depending on annual company performance, the company contributes a percentage of eligible employees' wages to his or her profit sharing account. The employee can take the balance when leaving the company, either in cash or stock. In reality, much of the money is invested in company stock.

Wal Mart also offers a stock ownership plan for the purchase of its stock, including matching 15 per cent of up to $1,800 (Rs 86,400) in annual stock purchases. Many employees who keep investing their savings into company stock have retired as millionaires. But the downside was seen recently when Enron employees who had heavily invested in their own company stock saw their savings and future pension completely wiped out due to the collapse of the company's share price.

Start-up companies see stock as a form of deferred compensation. Unable to pay their employees market salaries, they are given stock with the promise of reaping rich rewards when the company gets established and the stock price rises. During the heydays of the 1990s when technology firms were the darlings of the stock market, we saw several cases of promoters and other employees becoming exceedingly wealthy due to the astronomical valuations of their companies. The sensible ones cashed out early!

From a governance point of view, there are sound reasons for giving directors and other senior executives stock as part of compensation or bonus. The idea is to more closely align their rewards to the performance of the company. This form of compensation overcame the criticism that the top management does not really care about share price. It cleverly buried the age-old agency problem of how to get the managers to focus on their fiduciary responsibilities to the shareholders.

But this scheme has had some very unintended consequences. For one, it has deteriorated from being deferred to becoming shadowy compensation. For instance, the four top executives of AOL Time Warner, the media giant, were denied bonuses for 2001 since the company fared very badly. Rightly so, and the shareholders cheered. But wait, they were each given stock valued at $40 million (Rs 192 crore)! And even better, this is not going to affect the company's income statement! The largesse that grant of stock options in the US has become is thanks to a wink and nod from the federal government.

This is the way the scam works. A company grants its CEO the option to buy 50,000 units of stock from the company at the price ruling on the day the option is granted (called the strike price). This can be exercised within a future time frame. If the strike price is $10 (Rs 480) and it goes up to $15 (Rs 720) over two years, the CEO buys from the company, sells in the market, and pockets the difference of $250,000 (Rs 1.2 crore). The company can account for the value of the options as a cost for tax purposes but does not have to account for it in the income statement. The Federal Accounting Standards Board did try to revise the rules to the effect that it is treated as an expense in company reports and tax returns. But corporate lobbyists went into full gear and the Senate (upper house) passed a resolution in 1994 preventing the change.

By this scheme, the employee benefits, and the company feels no pain. But the other shareholders suffer. The options that have been exercised become stock and that increases the number of shares outstanding, and thereby reduces earning per share. When net income is rising rapidly, this will not be a big impact but it otherwise can. Moreover, if the company decides to buy back shares in the market in order to maintain the earnings per share, it will pay out $15 more than what it charged the employee and that affects cash flow.

The magnitude of this problem is enormous. It is estimated that stock options awarded to senior management has ballooned from $50 billion (Rs 2,40,000 crore) in 1997 to $162 billion (Rs 7,77,600 crore) in 2000. Business Week recently calculated the impact of these options for Cisco Systems. The company's outstanding options rose from 876 million to 1.06 billion over three years. Most of them have strike prices below current stock prices. 354 million can be exercised right now. If the cost of the options is treated as an expense, their loss would have increased from $1.01 billion (Rs 4,848 to $2.7 billion (Rs 12,960 crore).

As a fallout of the Enron disaster, accounting standards and corporate governance related issues are coming in for close scrutiny. Hopefully, the misuse of stock options by corporate management will come under control.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. His Internet address is cgopinat@suffolk.edu)

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