Option Grants to Employees

I've long believed that many stocks in  the stock market are basically a mechanism of transferring wealth from investors to senior management. The way this is done is via stock options at prices lower than the market price. So employees and/or executives excercise their stock at low prices and then sell it to investors at market prices. Does this sound crazy? Not convinced? Just read the latest news out of Mercury Interactive. I don't think this is an isolated case, though of course not all stocks/companies are doing this.

Here's a quick summary of the situation over at Mercury Interactive:

The company also said a special committee of the board found the executives benefited personally from the improper grants. So far, the committee has determined 49 instances dating from 1995 in which the stated date of a stock-option grant differs from the date the option was granted. In virtually every case, the price on the actual date was higher than the price on the stated grant date, the company said.

Basically, by manipulating stock option pricing grants, Mercury executives allowed employees and managers to profit risk-free from stock options grants. Here is how the WSJ.com explains it:

The practice, which applied to "the overwhelming majority" of grants issued between January 1996 and April 2002, the report said, likely allowed executives and employees to make more money on their options because it set a lower "strike price" at which the options could be exercised.

That's because in almost every case of misdating, the price of Mercury shares on the reported option-grant date was lower than the share price on the actual day the options were issued, the SEC report said.

By manipulating the grant dates, Mercury "was able to provide employees with the lowest possible exercise price," says Robert Willens, an accounting and tax analyst with Lehman Brothers in New York. "The lower the exercise price, the better off you are as an employee, so you'd want to cherry pick the dates on which the prices would be set," he says.

How can this help you become a better investor? The investment lesson here is stay away from company's who routinely give options at significant discounts to the prevailing market price of the stock. Always look at the latest proxy statement to get a sense of past option grants.

Also, an interesting method for determining a good price for buying a particular stock, is to look at option prices. Try to buy stocks near or even below recent option grant prices. At least you are then playing with the house.