Stealth CEO Compensation and Stock Options

Via Dean Baker comes Eric Dash of the New York Times writing about one aspect of the compensation package for Denny’s CEO:

For leading the turnaround of the Denny’s restaurant chain, Nelson J. Marchioli was all but given an extra $500,000 last year, slightly more than his reported bonus for 2005. For leading the turnaround of the Denny’s restaurant chain, Nelson J. Marchioli was all but given an extra $500,000 last year, slightly more than his reported bonus for 2005. But Denny’s shareholders would be hard pressed to discover that added part of their chief executive’s pay. Instead of writing Mr. Marchioli a check, Denny’s board handed him about 333,000 stock options that came with a built-in paper gain. The amount was not mentioned in Denny’s compensation committee report. It was not counted in the company’s summary compensation chart. Only by carefully studying a table, deep in the proxy statement from the year before, would an ordinary investor realize that Denny’s awarded those options last December with a “buy” price of $2.42 when Denny’s shares were selling for $3.91, a 38 percent discount.

The $1.49 per option “discount” represents only the intrinsic value with the value of this compensation likely to be around $1 million. Nicholas G. Apostolou and D. Larry Crumbley had a nice explanation of the accounting for employee stock options:

Instead of replacing APB 25’s intrinsic value based method of accounting for stock-based employee compensation plans, SFAS 123 allows a choice between the intrinsic value method and the fair value method. The intrinsic value method, however, triggers footnote disclosure of the effect on earnings, whereas the fair value method does not. Since the great majority of publicly traded companies continue to use the intrinsic value method, the grant of options does not dilute reported earnings. Thus, stock options continue to be “stealth compensation,” deductible for tax purposes without diluting financial earnings. Warren Buffet, CEO of Berkshire-Hathaway, criticized the current rules for accounting for options in his company’s 1998 annual report: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?” The authors surveyed the 1998 annual reports of 30 companies that used the fair value method rather than the intrinsic value method. In certain situations, the difference in earnings is so great that financial statement users’ decision making could be affected.
For years, stock options have been “stealth compensation”: expenses that are not charged against financial statement income but are deductible for tax purposes. Nevertheless, stock options dilute earnings, meaning that they are not free to shareholders. In 1995, FASB adopted SFAS 123, which established financial accounting and reporting standards for stock-based employee compensation plans.

In order to provide some estimate of the value of these options, let’s turn to Denny’s latest 10-K where we see they use the Black-Scholes option pricing model the following weighted average assumptions: (a) expected volatility = 90%; (b) expected life = 6 years; (c) interest rate = 4%; and (d) dividend yield. The Economic Research Institute provides us with a Black-Scholes calculator, which returns a value equal to $3.194 per option under these assumptions. Our attempt to model the value of the options received by Mr. Marchioli suggests that they were worth around $1 million – not $500,000.

In the late 1990’s, Apostolou and Crumbley as well as others were less worried that investors would not realize that executives were receiving options as part of their compensation packages and more worried that the true value of these options were larger than the APB 25 accounting would suggest, which is why Warren Buffet and others were arguing that we should make SFAS 123 valuations mandatory.