Monday, March 23, 2009
Want a glimpse of how the government bailout works?
Taxpayer money flows in the front door and flies out the back door as bonuses. It's an outrage. But I am not going to rant about the bailouts today. You get enough of that everywhere else...
Instead, I want to share with you another form of corporate robbery that's been happening for a lot longer than the bailout boondoggle. This is a more subtle form of stealing.
I'm talking about repricing stock options. Let me explain...
In your typical Fortune 500 company, stock options constitute a big chunk of employee compensation. These options give employees the right to buy company shares at a predetermined price.
Each option has an "exercise price." If the company's stock price is above the exercise price, the employee can exercise the option and buy the stock at the lower exercise price. Then, the employee can immediately sell the shares on the open market at the higher price, profiting from the difference.
Big option grant programs are cancerous to regular shareholders. They conjure new shares out of thin air, diluting the value of existing shares. Much like inflation, option grants clip a tiny bit off value of each existing share. That value gets funneled to employees.
Say Company X gives its CFO 10,000 options with a $50 exercise price. If shares are at $100 when the options can be exercised, the CFO buys shares for $50 from the company, then immediately sells them on the open market for $100... and pockets $500,000 ($50 times 10,000).
Stock options are intended to align management's interests with those of shareholders. If management does well and the stock goes up, everyone profits. If management struggles, the options expire worthless, and managers suffer along with shareholders.
Of course, in bull markets, almost all stocks go up, and the managers of weak companies profit along with the strong ones. In bear markets, even stocks of well-run companies decline. So good management teams suffer along with the poor ones.
Despite its problems, one could argue the system is fair. But some corrupt companies are changing the rules...
Management teams are urging corporate boards to "reprice" options... In other words, to allow employees to exchange a worthless option with one that's pegged to lower stock prices.
For example, if a stock drops from $20 to $10 per share, the company may reprice employee stock options to have an exercise price of $10. As long as shares are above $10, employees are "in the money." Unfortunately, shareholders who bought at $20 are left holding the bag. They don't book a dime until the stock recovers back above $20.
In the world of repricing, management makes money during good times and bad. And shareholders foot the bill, as their stock is diluted.
Companies like Google, AMD, Apple, and Oracle engage in the criminal act of repricing options. Based on Google's fourth-quarter filing, its most recent repricing will cost shareholders more than $450 million.
So what can you do to protect yourself?
Carefully examine management compensation packages before making any investments. Companies that eschew stock options with better compensation practices (like restricted stocks) deserve a closer look.
If you are looking for examples of companies that treat shareholders right, check out the compensation packages of Berkshire Hathaway's Warren Buffett and Costco's CEO Jim Sinegal.
Silver outpaces gold in 2009... SLV up 20% this year, GLD up 9%.
Teen retailers bounce... American Eagle, Buckle, Hot Topic, Aeropostale, and Urban Outfitters near three-month highs.
Troubled insurer AIG rallied 295% in a week... but plunged 22% on Friday.