Why Are Millionaire Executives Given Stock Options In The First Place?
by Dan Ferris

Is there a sane, rational explanation of why no one’s asking the question in my title?

I don’t know. Let’s find out.

Let’s consider the curious case of Dr. William McGuire, CEO of UnitedHealth Group (NYSE: UNH). McGuire’s case was the big one that got the options scandal ball rolling.

According to the Wall Street Journal, McGuire was granted a total of 14.6 million options (after stock splits) in October 1999. The Journal said that, as of March, he’d exercised 5% of the total, for a profit of $39 million. It also reported that, “As of late February [McGuire] had 13.87 million unexercised options left from the October 1999 tranche. His profit on those, if he exercised them today, would be about $717 million more.”

The 1999 grant was made the very day UnitedHealth’s shares hit their lowest price of the year. McGuire received two other grants in 1997 and 2000, again at the lowest price of the year. A 2001 grant was made after a steep decline in UnitedHealth’s share price. The odds of all this happening randomly are 200 million to one, or greater.

Hence, it is concluded the options were dated deliberately at the 52-week low share price. The insidious – and I’d say inevitable – practice is labeled, “backdating.”

What I haven’t seen mentioned in the press is any discussion of McGuire’s cash compensation during the years in question. Let’s contemplate Bill McGuire’s salary from 1994 to 2001.

All told, McGuire got more than $24 million in cash compensation from 1994 to 2001. He could have easily afforded to put 10%, just $2.4 million into UnitedHealth shares via open market purchases.

From January 1, 1994 to December 31, 2001, UnitedHealth’s stock traded at split-adjusted prices between $4.20 and $17.83. Today, it’s at $47.55. If McGuire had bought at the average market price between those dates – about $11 per share – he’d have four times his money today. A $2.4 million investment would be worth nearly $10 million today. You’d think McGuire, of all people, would be able to time his purchases better than average. If so, a $2.4 million investment would be worth even more today. If he needs more than that, he should be replaced. I don’t understand why Dr. McGuire couldn’t put some of his cash compensation where his mouth is.

Yes, dear reader, you heard me right. The real scandal, as far as we’re concerned, is that options grants are made to millionaire executives at all. I could understand giving a few options away every once in a while to secretaries and other such folks. For most public companies, these people simply can’t afford the risk of buying their company’s shares in the first place. A stock option grant vesting over a few years would be an appropriate one-time reward here and there for an exceptional contribution made over a number of years. It would let the employee know he’s done well. It would give him a piece of the company that he could never afford to buy on his salary.

Not only that, but lower echelon managers and other workers have practically zero hope of taking actions that impact the value of the business. Why would you risk your capital if you’re not in a position to exercise enough control to protect it? CEOs and CFOs, however, are in that role. That’s one of their main jobs. They can hardly be expected to understand that job unless it has some sort of an impact. Putting his own capital at risk ought to improve the performance of any true business leader.

Would, for one famous example, Skilling, Lay and Fastow have done what they did if their own capital was at risk, and remained so throughout their tenure? When, “I can always sell” is no longer an option, you have to wonder if behaviors wouldn’t change a little. But they had none of their own capital at risk. They sold shares on the way down. That makes sense, too. They never had to buy them in the first place. It was all funny money: options grants.

Corporate America’s options granting, in this light, resembles the actions of the U.S. Treasury, or perhaps the Federal Reserve: counterfeiters all. The result is identical in both cases: the pre-existing paper loses some of its value. Makes you wonder. Would Hamptons real estate be as expensive today if Corporate America weren’t papered up like a cheap cathouse?

And what do you expect counterfeiters to do with their crisp, new produce? Sell it, of course. Last week, there were about ten times as many insider sellers as buyers among public companies. That’s normal. (Perhaps we’ll lengthen the time-honored list: death, taxes and insider selling.) If you give someone a free share at an artificially cheap price, he doesn’t care that it’s a piece of a business entrusted to his care. He wants his cash, and he wants it now. Who would expect any human being to behave any other way?

For now, we sit, watching the options backdating mess play out in the financial press, like a man watching a drunken 17-year-old start up his car and drive off into the distance.

In both cases, we know that, in due time, most decent people will come to wonder, “How else could this have ended?”

Good Investing,

Dan Ferris