The flipside of that coin is knowing what not to buy. Another feature of Berkshire Hathaway is that, unlike hedge funds, Warren Buffett and Charlie Munger eschew leverage, avoiding companies burdened with debt. If you are not leveraged, and your businesses generate enough cash to meet your expenses, you do not have to worry about what anyone else thinks of your financial situation.You never have to sell assets into a distressed market to raise money, and if the stock market closes for years, you do not need to worry, since your assets keep growing and generating value. Warren and Charlie know they could have had higher historical returns had they used leverage, but in a distressed market, one can obliterate a great track record by destroying shareholder capital.
When calculating compounded returns, the game is over and your track record is irrelevant if you multiply by zero. We both knew the market was overleveraged, rating agencies misrated debt, and investment banking models were incorrect, but neither Warren nor I was aware that day that our interests would become more closely aligned as the largest financial debacle in the history of the capital markets began to unfold.
Both Warren and I knew the financial markets were overleveraged and credit derivatives contributed to the excessive leverage. Things were still relatively calm as I boarded the plane home in August 2005, but financial warning lights flashed bright red. Archimedes, the ancient Greek inventor and scientist, had said that if you gave him enough leverage, he could move the world. The global markets had combined high leverage with bad lending practices, and the financial world would soon feel the negative force.
Chapter 3
The Prairie Princes versus the Princes of Darkness
Bravo! Your Golden Fleece Award is a gem.
—Warren Buffett
to Janet Tavakoli, October 2, 2006
Both Warren Buffett and I advocate treating employee stock options as a cost of doing business.Warren operates in a competitive marketplace, and he has no problem compensating employees well. This cost of doing business should be calculated correctly and it should be expensed. Stock options are not an issue when Berkshire Hathaway finds a well-run family-owned business to purchase; if Berkshire Hathaway buys shares of stock in the marketplace, however, stock options are difficult to avoid. For example, Berkshire Hathaway has owned shares of Coca-Cola since 1988 (8.6 percent of Coca-Cola shares as of the end of 2007)1, but Coca-Cola did not start expensing employee stock options until 2002.2
In his 1985 letter to Berkshire Hathaway shareholders, Buffett challenged the CEOs of corporate America. He offered to pay a substantial cash sum to any executive granted a restricted stock option in exchange for the right to any future gain the executive might realize. Stock options are a real cost of doing business.You say you cannot value them? Great! I’ll pay cash for them. Now try to explain to your shareholders how this cash didn’t just come out of their pocket and move into yours. Warren’s challenge, which he continually reissues, remains unanswered.
Many corporate executives resist expensing the value of employee stock options, complaining there is ambiguity in how one values them. But accounting practices are rife with ambiguities. As long as the rules are understood, accounting helps paint a picture of corporate value with a semblance of consistency. For example, corporations depreciate expensive factory equipment according to accounting rules. While depreciation does not precisely capture the exact cost and timing of equipment replacements, it highlights the fact that there is a significant cost to stay in business. The rules of depreciation create some ambiguities; but one cannot use this as an excuse to ignore a real cost of doing business.Treating all employee stock options as an expense clarifies whether the hit to reported earnings is justified by the projected increase in shareholder wealth needed to compensate shareholders for the cost. No wonder some CEOs did not want to expense them.
The intent of stock options is benign, but the execution is flawed. In a rational world, options have a realistic strike price reflecting the true business value after building in carrying costs and retained earnings. If employees increase the value of the company beyond that, they can exercise the options, buy the stock at a reduced price to the future higher price due to employee value creation, and participate in the gain. It is theoretically possible to come up with a fair and rational strike price, but it is rarely attempted.
Stock options, which are call options, are a moral hazard inviting unnecessary risk taking because corporate officers get leveraged rewards for any success—and suffer no consequences if they fail. Officers of corporations can leverage up corporate balance sheets, make poor acquisitions to pump up revenues, and be rewarded for stock price pumping mischief. Out-of-control—albeit legal—management behavior has no penalty, and often brings rich rewards.
When Merrill Lynch parted ways with CEO Stan O’Neal in October of 2007, he received no bonus or severance, but he kept $161.5 million in accumulated compensation and retirement benefits, more than an entire neighborhood of lower middle class Americans will make in a lifetime.Yet, he left Merrill after it took an $8.4 billion writedown in the third quarter of 2007.3 Shortly thereafter, he took a seat on the board of Alcoa.
Derivatives like stock options can be used to leverage a bet.They can also be used to cover a scoundrel’s tracks. The Wall Street Journal exposed a scandal of broad-reaching implications. By August 2006, over 100 corporations—with more to follow—were under investigation for backdating stock options after Assistant Professor Eric Lie of the University of Iowa identified anomalies in the strike prices of employee stock options. The research suggested the prices were intentionally manipulated to give greater value to the recipients. The corporate officers involved are not founders of these corporations; they are merely stewards. These officers consciously betrayed the trust of stockholders, misstated financial reports, and diverted millions of dollars of shareholder wealth for their personal gain.
If the corporation marks stock options to market, it may record large fluctuations in value, even if very little money has changed hands. Employee stock options are usually restricted, meaning that employees must wait for a period of time until the options are “vested.” Once vested, if the options have value and are exercised, the company receives a tax deduction. For example, suppose an employee were given options to buy 100,000 shares of the company; the shares vest in three years; and the options have a strike price of $10. In three years, the options will be worth nothing if the share price is below $10, but if the price of the company stock rises to $15, the employee pockets a gain of $500,000, and the company deducts this amount.
Most stock options give the employee a window of time in which to exercise the option after it vests, so even if the option cannot be exercised for cash when it first vests, it may become valuable before the window of time is up, also known as the expiration date. Figuring out exactly what the value of the option is today, before the option vests and before the expiration date requires assumptions. One has to estimate the probability of a future gain and the timing of a future gain, and it makes sense to come up with a standard way of estimating today’s value. Every unexpired option is worth something.The options have a positive value today, since they give the employee the right to a potential gain tomorrow.
After divorcing his wife of many years and devoted mother to his children, one of my acquaintances crowed that he had “screwed her out of millions.” As part of the divorce settlement, he kept his entire passel of unexercised stock options. He persuaded his wife’s lawyer that these options were virtually worthless and negotiated away other much less valuable assets instead. Shortly afterwards, he monetized the options and figured his after-tax take was around $3 million. Did I mention he is an acquaintance, not a friend?
In 2004, the Financial Accounting Standards Board (FASB) finally drafted a proposal requiring companies, whose stocks are listed on U.S. exchanges, to show the value of employee stock options as an expense. Neither Warren Buffett nor I anticipated the possibility that corporate executives might manipu
late the value of the options awarded them by “backdating.” We were concerned about arguably more benign distortions of reported value.
In April 2004, I told the Financial Times it is still possible to manipulate the value of the options and therefore manipulate the amount of the expense.4 Wh+ichever option pricing model a corporation uses, the biggest fudge factor in determining value is the volatility assumption. Volatility is related to the price of the stock. For a call option, lower volatility means a lower option price, which means a lower corporate expense. One proposal had surfaced suggesting that one could assume zero volatility. Have you ever heard of a stock price that never moved?
Then, in July 2004, Warren penned an editorial for the Washington Post. I dubbed it “Warren’s Kill Bill article.” The U.S. House of Representatives proposed a bill that would allow corporations to expense only those stock options awarded to the chief executive and the other four highest-paid officers. Other employee stock options would not be expensed. Obviously, this would have created a huge accounting distortion. Warren advocates expensing all stock options. Warren admonished Congress. “Legislators,” he warned, “should remember that it is better to be approximately right than precisely wrong.”5
In December 2004, the FASB adopted a new standard (SFAS 123R) requiring that employee stock options be valued on the date they were awarded and expensed over the vesting period of the options. Somehow, the FASB still could not bring itself to require mark-to-market accounting.
Almost a year later, in November 2005, the Wall Street Journal opined that data patterns suggested some stock options were backdated to set the lowest possible stock price in the relevant time period. The call options were much more valuable than if they had been awarded without this hindsight benefit. Eric Lie, a “mere” assistant professor at the University of Iowa, identified the pattern. Dozens of corporations and billions of dollars of shareholder wealth was involved.67
The problem with financial products that make cheating easy is that cheats tend to flock to them. The deck is already stacked in favor of stock option holders and against other shareholders. But now the truly greedy pulled cards out of their sleeves. It is not necessarily illegal if everything is fully disclosed, but in every instance, it is sleazy. Moreover, if disclosures are misleading, it can be deemed securities fraud. A March 2006 Wall Street Journal article identified about a dozen companies with suspicious patterns that had become the target of an SEC probe.8
Backdating ensures the most advantageous value possible to employees receiving stock options, no matter how one calculates the value. For example, suppose the rational strike price of a stock option based on business value is $10 at the time a stock option is awarded. But if, three months prior to the options being awarded, the stock had traded at its lowest price for the past year, say at a price of only $3, a backdating executive could set the strike price of the option at only $3 and give himself a much better chance of realizing a future gain.The option is therefore much more valuable.
Backdating is deft theft. Shareholder value is diluted more than any reasonable man expects. Unless the cost of the stock option is expensed, shareholders have a very hard time realizing that executives just took a larger piece of the investment pie than the shareholder might otherwise have been willing to cut for them. Expensing stock options deters cheats.When stock options are immediately expensed, the cost becomes transparent. Had corporate America listened to Warren Buffett, expensing would probably have killed backdating before it started.
Warren’s wisdom is often at odds with “famous names” and the nonsense taught by economists in graduate business schools. In August 2006, venture capitalist Kip Hagopian published a commentary in California Management Review, the scholarly journal of the University of California-Berkley Haas School of Business. He stated that expensing employee stock options was improper accounting and argued stock prices reflect employee stock options liabilities, implying that shareholders know how to efficiently value these stock options.9 He got 29 “famous names” to undersign his article. These included Milton Friedman (who would pass away in November) and Harry Markowitz, both former University of Chicago professors and winners of the Nobel Prize in Economics; George P. Schultz and Paul O’Neill, both former U.S. Treasury secretaries; and Arthur Laffer. Holman W. Jenkins Jr., a member of the Wall Street Journal editorial board, also supported this notion in a separate commentary.10 Even if it were true that shareholders are well equipped to independently value stock options—and it is not—the proper place to account for costs is in the accounting statement. Shareholders shouldn’t have to make a separate correction for material information that has been omitted from financial statements. The “famous names” should have lobbied for more transparency, or better yet, the abolishment of stock options as a compensation scheme. Instead, these Princes of Darkness advocated opacity.
By September 2006, more than 120 U.S. corporations were under investigation by U.S. regulators for backdating employee stock options, followed by many more. By September 2007, companies including Affiliate Computer Services, Apple Inc., Broadcom, United Health, and more had been subjects of the SEC probe, lost senior executives, and reported serious accounting issues related to backdating. In total, 85 U.S. companies made earnings restatements or took charges against earnings due to backdating.
Berkshire Hathaway was not one of them.
If you asked the executives to sell the companies they manage at the same dip in the market price that they had assigned to the strike of their stock options, they would protest that depressed market prices do not reflect the true business value and it would be a breach of their duty to the shareholders. In fact, one wonders why some of the executives weren’t buying back company stock at some of the price dips. This would have increased shareholder value. Instead, some executives used their lowest stock price to dilute shareholder equity in order to enrich themselves. Backdating executives and their sycophants twisted financial logic with flexibility that rivals the gymnastics of Cirque du Soleil. There should be some sort of reward for executives that used backdating to increase the probability of their realizing upside without taking additional risk.They demonstrated calculating “creativity.”
U.S. lawmakers blamed themselves in the ensuing scandal.They cited a tax law passed by Congress in 1993 exempting employee stock options from the $1 million tax deduction limit for senior executives. Executives have an incentive to award themselves stock options, and backdating may have been an unintended consequence of the law. Honest executives use stock options as they were intended, by both setting rational strike prices and securing the tax deduction, thus benefiting stockholders. Backdating, a perverted twist on employee stock options, is a separate problem. Shareholders and U.S. lawmakers alike were ambushed. Backdating directly benefits the option holders; greedy executives would probably have backdated with or without the tax deduction.
The late William Proxmire, while serving in the U.S. Senate, created the Golden Fleece Award for congressmen who waste taxpayer money. The Wisconsin Democrat named it after the mythological Golden Fleece swiped by the creatively deceptive Jason. Following Proxmire’s example, I wrote a commentary in October 2006 bestowing the Golden Fleece Award for Optional Integrity on corporate executives who backdated their own stock options and failed to specifically disclose this material information to their board of directors and shareholders.1112 I nominated Harry Markowitz, the surviving Nobel Prize winner who supports not expensing stock options, to bestow the award.Warren called the idea a “gem.”13
Had I not met Warren Buffett, I do not know if I would have ever published such an article pushing against famous names in finance. Meeting him encouraged me to put my own views forward and not to concern myself with what everyone else was doing, however many titles or awards they may have accumulated.
Warren wrote a memo the previous week to Berkshire Hathaway managers partly because of the option-backdating scandal that already embroiled more than 100 companies, and partly in
reaction to Hewlett-Packard’s headline-making pretexting scandal. Warren sent me a copy of his memo the day after I sent him my commentary.
Former Hewlett Packard chairwoman Patricia Dunn stepped down and, along with four others, faced criminal charges after allegedly using pretexting—a nice way of saying investigators pretended to be someone else to dupe phone companies—to obtain the phone records of staff, board members, and journalists. It seems that in trying to track down a boardroom leak, they became bigger rats.14
At the time Warren wrote this memo to the “All Stars”15 (his managers), Berkshire Hathaway employed over 200,000 people. It is impossible to totally eliminate bad behavior in a conglomerate that size. Nevertheless, Buffett asked his top managers to increase their efforts especially when there was even a hint of a problem. He especially admonished his managers not to excuse potential problems because other corporations were doing something problematic:
The five most dangerous words in business may be “Everybody else is doing it.”. . . [L]et’s start with what is legal, but always go on to what we would feel comfortable about being printed on the front page of our local paper . . . Your attitude . . . expressed by behavior as well as words, will be the most important factor in how the culture of your business develops.16
On October 8, 2006, I sent Warren an e-mail about a segment I had watched the previous evening on television:
I found it ironic that Patricia Dunn of HP defended her actions during her 60 Minutes interview by claiming everyone was doing it while you lead your memo by debunking that excuse. I especially liked: And culture, more than rule books, determines how an organization behaves.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 5
