The Options Blood Bath

Reform is more attractive than revenge.

IN THE WAKE of the Enron Corp. scandal, we argued vigorously for new rules on corporate governance, but we never took pleasure in the demise of Enron's audit firm, Arthur Andersen LLP, which reduced competition in the over-concentrated accounting business and hurt employees who had done nothing wrong. In the current executive options scandal, likewise, defenestrating senior executives shouldn't be the priority. What matters is that the rules should prevent future abuses.

The latest scandal involves the practice of granting executive options on a day chosen retrospectively for the cheapness of a company's shares. This has the effect of enriching executives at the expense of shareholders: If a company's share price is $100, but a grant of 100,000 options is backdated to a day when the share price was $90, then the executive has been given $1 million. There's nothing wrong with such grants if they are disclosed properly. But frequently they haven't been. So far, more than 160 companies have been embroiled in the backdating scandal. More than 50 senior managers have been ousted, including, most recently, Bruce E. Karatz, chief executive of KB Home, a home-construction company, who will forfeit ill-gotten gains of about $13 million.

This loss of senior talent may be justified if the transgressions are serious. William W. McGuire, the ejected boss of UnitedHealth Group Inc., may have led his insurance firm to spectacular growth, but his greed in amassing $1.1 billion in stock options plus a pension of $5.1 million a year is matched only by the revelation that the board member who chaired the compensation committee had conflicts of interest. Even so, there are reasons to feel queasy about the broader options blood bath. The offenses mostly date from the years between Congress's 1994 obstruction of an accounting rule that would have caused the cost of executive options to be accounted for properly and the 2002 Sarbanes-Oxley law, which signaled that Congress had turned serious on accounting honesty. So however regrettable it might be, the fact is that Congress sent a signal of tolerance to which executives responded.

Moreover, there has been little consistency among companies as to what merits an executive's ejection. The board of Apple Computer Inc. appears to have gone lightly on Steve Jobs, chief executive and high-tech icon. If that is acceptable, it's hard to feel certain that other chief executives, some of them with statures approaching that of Mr. Jobs, truly deserved to go.

If the ousting of executives provokes mixed feelings, what of reforms that might prevent abuses? Backdating was partly a way of granting executives "in-the-money" options -- ones that grant the right to buy a share for less than its current value -- without having to report them as an expense. But the accounting rule that Congress obstructed 12 years ago was finally pushed through in the wake of the Enron scandal, so now all executive stock options must be treated as an expense, whether they are in-the-money or not. So one incentive for backdating has already been abolished.

But it's still fair to ask whether the use of executive options should be reined in, if not by regulation then at least by company directors. Because options are opaque, they invite abuses. Why not give managers a stake in their company by granting them restricted stock instead?