Employee stock options allow company executives to buy shares of their company at a specified price during a specified time period. They are given to executives as a form of noncash compensation. The option or “strike price” is normally equal to the market price of the stock on the day that the option is granted to the employee. The stock option is intended to motivate the executive to increase the stock price of the firm. If the stock rises, the investor is pleased. If the stock rises, the executive exercises the option, buys the stock from the company at the strike price, and then immediately sells those shares on the stock exchange at the current (higher) market price to obtain a capital gain. This is considered to be a win-win situation. Both the investor and the employee gain from the increase in the market price of the company’s stock.

However, sometimes the stock price falls, and the current price is less than the strike price. Such stock options are referred to as “underwater” or “out of the money.”

In such cases, companies will sometimes reprice the stock options to a price that is less than the current market price or cancel the underwater options and issue new options that are priced at the new current market price. Both repricing and backdating of stock options have effectively been curtailed as a result of SOX disclosure requirements. As a result, two new strategies are available. One is to “spring-load”

the options by issuing them to employees just before good news is announced to investors. The other is to “bullet-dodge”

by delaying the granting of stock options until after bad news has been released.

An analysis of the ethics of repricing, backdating, spring-loading, and bulletdodging is contained in the article “Ethics of Options Repricing and Backdating: Banishing Greed from Corporate Governance and Management.” In their article, which was published in the October 2007 issue of The CPA Journal, Raiborn, Massoud, Morris, and Pier present four ethical arguments.

The theory of justice says that equals should be treated equally and unequals treated unequally in proportion to their inequalities. All investors are equal, and executive investors should be treated no differently from all other investors in the company.

As such, preferential treatment through the backdating of stock options is inappropriate and unethical. Spring-loading and bulletdodging are grounded on management’s inside knowledge of good and bad news that will have an impact on the company’s stock price. Their inside knowledge discriminates against all the other shareholders who do not know the good or bad news.

Utilitarianism or consequentialism argues that the ethically correct decision must be of benefit to most shareholders in the long term. Backdating stock options benefits the executive at the expense of the other shareholders. It is not in the best interest of the majority of the shareholders of the company. Spring-loading and bullet-dodging are only in the shortterm interests of a minority of the shareholders

(i.e., executive shareholders) and not in the best long-term interests of all the other (majority) shareholders.

From a deontological perspective, backdating and repricing are akin to lies because the intention is to manipulate and deceive the other shareholders. Deontology does not accept that the end justifies the means. Furthermore, it does not allow exceptions to a rule. Spring-loading and backdating treat one category of shareholders

(management) differently than the other category of shareholders (all the current and future shareholders). As such, it is unlikely that everyone in society would accept as a universal rule that management should be given preferential treatment.

It is difficult to say that manipulating stock options, through any of these four tactics, is the sign of a virtuous person. Virtue ethics does not accept discrimination and prudential treatment of insiders as the mark of an ethical businessperson.

The conclusion of the article by Raiborn et al. is that the repricing of stock options may be legal but it is certainly unethical.

Their concluding paragraph reads, Stock options were designed as a way to provide pay for performance, not to reward poor performance by backward-looking repricing or backdating.

Such activities undermine the incentive justification for use of stock option plans. Executives deserve compensation packages that provide both short-run benefits and a long-run motivation to increase organizational value for all stakeholders. Compensation methods that cause the tone at the top to be perceived as a cacophony of greed should be banished from the orchestra.

Questions:-

1. Do you think that stock options actually motivate employees to work for the long-term good of the company?
2. Do you think that stock options inadvertently encourage managers to engage in questionable accounting activities, such as earnings management, to artificially increase the company’s net income and thereby the value of the executives stock options?
3. Do you agree or disagree with the four ethical arguments summarized above and contained in more detail in the article by Raiborn et al.? Explain why.
4. Should a board of directors approve repricing or backdating stock options for outstanding executives whose current stock options are underwater due to uncontrollable economic factors and who will be lured away unless some incentives to stay are created? What other incentives might work?