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Stock Option Grants
Mark,

A few weeks ago there were numerous news reports about how some companies had allowed management to somehow benefit
from incorrectly declaring stock options. (I admit I may not be phrasing this properly because I wasn't certain from
the reports exactly what the officials were doing.)

Now, I see in today's news that the Cheesecake Factory is auditing its books with respect to options declarations.
This is one of the companies in our club's portfolio.

Can you explain in layman's terms what was happening and how it affects stock holders?

Thanks.

Phyllis

Hello Phyllis,

The problem with most of the companies who are being investigated for 'improper stock option grants' involves 'back-dating of those option grants. In a nutshell, companies give stock options to certain key employees. Those options allow the employees to buy a significant number of shares at a specific stock price (strike price). That price is usually the stock price on the date on which the options are granted. The idea is that the key employees will work hard to make the company more profitable and then they can benefit from the resulting higher stock price.

The problem is that some of these companies granted options on one date, but listed the option grant as occurring on a date in the past - a date on which the stock was priced much lower. That would allow those people who received stock options to buy shares at a much lower price. That is illegal and immoral. That's why it's such a potential problem.

When a company gives stock options to its employees, there is an expense involved. After all - if the employees ever exercise their rights to buy stock at the strike price, the company must deliver those shares to the people who exercise. If the company does not already own the shares, it must go to the marketplace and buy the shares at the current price and then sell those shares to the employee at a discount. That results in a loss - and that is bad for the stockholders. Even if the company owns the shares, if it delivers those shares to the employees who exercise options, they lose money. They owned shares worth one price, but they had to sell that stock at a lower price to the employees. Also bad for shareholders.

In recent times, companies can no longer simply give out options. They must expense them. The value of the options is determined my a formula (Black Scholes) and the cost of those options should be listed as an ordinary business expense. Today's problem occurs when companies either do not list the option grants as an expense - or because they did something wrong with backdating. All in all, those once popular option grants are not a good thing for shareholders. But, I have no clue how significant the expense is or if the stock price will suffer.

Mark