Given how much the Valley has at stake, we should at least be circumspect about accounting “compromises” emanating from the left coast. Cisco, in particular, has been a self-interested advocate. In the 1990s, John Chambers, the company’s CEO, lobbied vociferously against expensing. And no one at Cisco stood to lose more from it. During the last four years of the boom (1996 to 1999), Chambers received option grants of, successively, 1.6 million shares, 1.8 million, 1.4 million, and 2.5 million. No one can say for sure whether the potential lucre that such options represented was a factor in Cisco’s decision to try to grow so rapidly – too rapidly, as it turned out. All we know is that the options existed, that Cisco’s managers stood to make millions on each increment of stock price appreciation, that during the late 1990s Cisco placed huge equipment orders, and that in 2001 it was forced to write off $2.25 billion worth of that equipment. Its stock collapsed, too – from $80 in 2000 to $8 in 2002.
However, it is also possible to see Cisco as an options success story. Even its post-bubble low of $8 a share was 100 times the going-public price of 1990. By any fair reckoning, the net result of the boom and bust of the tech industry was also strongly positive.
Chambers has not lost his ardor for options. In both 2002 and 2003, he received an enormous new grant of four million shares. Then, in 2004, when it became clear that expensing was coming, Cisco, along with Qualcomm and Genentech, proposed a valuation formula that seemed absurdly lax. As FASB noted, “the proposed method can be easily designed to produce a value of zero.”
This is when Cisco turned to Morgan Stanley to design an option look-alike to sell to investors. What has Morgan wrought?
The instrument is a “warrant” that would be sold to investors. Suppose that in June 2006 Cisco granted a new batch of employee options. It would also sell to investors warrants that had the same terms as the options – including that they be nontradable.
In theory, the holders of the warrants would get the same return as the employees. So whatever investors bid for the warrants would determine the value of the options.
Cisco intends to sell the warrants in an auction, but the auction would probably be open only to a dozen or so institutional bidders, which Cisco (or perhaps Morgan Stanley) would preselect. This has raised concerns. Since when did limiting the number of potential bidders lead to the most accurate price?
What’s more, the fact that the warrants could not be traded will presumably greatly limit the demand for them. “You are talking about a very idiosyncratic contract,” notes Myron Scholes, one of Black-Scholes’s Nobel laureate creators. “The Cisco management team must know a lot more about HR [human resources] at Cisco than the outside investors. Due to that, [investors] would probably insist on a large discount.” (Knowing, for instance, whether an executive who had been granted a lot of options was planning to leave the company before being able to exercise those options would matter; if her options expired worthless, so too would a proportionate amount of warrants.) Scholes says the new instrument would likely produce an artificially low value. This would fulfill the apparent aim of Cisco’s executives, since the lower the assessed cost of the stock options it grants, the smaller the effect on its reported earnings.
That the SEC has similar concerns became evident in June, when Chester Spatt, the agency’s chief economist, worried aloud in a speech at Carnegie Mellon University that “barriers to transferability” might unduly depress the estimated values of stock options. Corporations have disputed this, noting that employee options cannot be traded either. The SEC has yet to decide, and the hope of high-tech executives is that the incoming SEC chairman will be faithful to his constituency.
Investors should hope, more neutrally, that the SEC sticks to the decision to require expensing and then quickly embraces some market instrument that attaches to options a reasonable cost. That will result in some expense on Cisco’s books, one that a free market has validated, and in some penalty against its earnings the next time it decides to award its CEO four million options. Ultimately, the existence of a financial deterrent is more important than its precise amount. And the option issue needs to be put to rest.
Roger Lowenstein contributes to the New York Times and other publications. His most recent book is Origins of the Crash.