Recently, I answered five questions posed to me in this USA Today article:
Q: Are business people and employees still angry about the financial debacle and rising pay to executives — especially on Wall Street?
A: The outrage is at the highest levels I’ve ever seen. There are too many non-performing CEOs whose pay does not conform to reality. Twenty years ago, CEO pay was 250 times higher than rank-and-file pay. Today, it’s 600 times, even as the country slides into a recession. Executives shouldn’t recklessly gamble with everyone’s money, then be allowed to paddle away. That’s flat-out wrong. In the words of Tony Soprano, you get paid when we get paid, you get out when we get out.
Q: Given the $700 billion financial system bailout plan, will executive pay level off or keep growing?
A: Pay won’t necessarily continue rising. People realize that trees can’t keep growing into the sky. I think pay will more closely match performance, and there will be an appropriate balance to executives’ pay and the interest of shareholders. I will say as long as there are guaranteed golden parachutes that allow executives to bail out of a crashing company while shareholders and employees go down, there will be no reform in executive pay.
Q: Is the bailout plan’s limits on executive pay for companies that receive money a wise or dumb move?
A: Congress can’t regulate this stuff. It’s too complex. The imposition of unspecified pay limits really is a mistake.
Q: Who bears responsibility for too-high executive pay?
A: It’s easy to point fingers and vilify CEOs. For every bad CEO, there are 99 good ones. Microsoft, Berkshire Hathaway, General Electric, Procter & Gamble — all are companies that clearly practice pay for performance. We need to look around ourselves to find the responsible parties, and it’s a combination: business people, boards of directors, Congress, institutional investors, mutual funds, the media — and let’s not forget executive pay consultants.
Q: What’s the easy solution to a complex problem?
A: If we had very clearly defined regulations based on the design of pay plans — rather than on caps and limits on pay — we might go somewhere. Just a few years ago, it was all the rage for companies to peg executives’ pay to earnings per share. Then, all you had to do was to issue and buy back your company stock, and all of a sudden, you were skewing earnings. If a company performs well, you get paid. If it doesn’t perform, you don’t get paid. Hopefully, the financial crisis will teach new lessons to everybody.
– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
With all the gyrations in the market lately, I couldn’t help but wonder what this might mean for stock options. Yes, stock options have already experienced a bit of a decline in popularity in recent years thanks to FAS 123(R), but will the flight from options increase? (To read a better version of this blog, see this document with four charts added.)
Not being able to let this go, I ran some quick calculations of volatility for the Dow 30 stocks. The results confirmed that volatility had increased dramatically in 2008 (through October 17th) compared to 2007, 38.99% vs. 21.80% (based on a daily volatility calculation using adjusted closing stock prices), an increase of approximately 80%.
To see how this dramatic increase in volatility might impact stock options, I then looked at volatility for the same group of companies over two three-year periods (i) 1/1/2006 to 10/17/2008, and (ii) 1/1/2006 to 12/31/2007. Not surprisingly, the rise in volatility that showed in the year-over-year comparison also echoed in the three-year volatilities, 24.11% vs. 19.84%, an increase of approximately 22%.
So, how might this impact the future use of stock options? Options are going to become more expensive to use and, if the market is in a prolonged bear market (such as that between 1966 and 1982), there may not even be much upside potential. Additionally, the new bailout-related mandates, including admonitions against incentives that encourage “excessive risk,” are also likely to have an adverse impact on the use of stock options.
However, the stock prices themselves will be depressed compared to prior periods, so wouldn’t the impact of increased volatility be offset by the decrease in the stock price? To test that I took the closing median stock price of the Dow 30 companies for each of the 3 year periods, $33.33 for 1/1/2006 to 10/17/2008 and $46.99 for 1/1/2005 to 12/31/2007, and then used the medians of the most recent FAS 123(R) assumptions disclosed by the Dow 30: risk free interest rate of 4.80%, dividend yield of 2.33% and an expected life of 6.0 years, and ran a Black-Scholes model of a “median” stock option for the Dow 30 in each three-year period.
The results confirm that the relative cost of a stock option will increase as a result of the increase in volatility for 2008. The Black-Scholes values were $8.45 (25.36% of face value/median stock price) for the 1/1/2006 to 10/17/2008 period and $10.45 (22.23% of face value/median stock price) for the 2005-2007 period, representing a 14% increase in the percent of face value/median stock price. So, even though the stock price has dropped as has the Black-Scholes value, the FAS 123(R) cost for stock options will represent a larger percent of the stock price.
Is this the death of stock options? Probably not. But, their increased cost, possible limited upside and the new mandate to avoid excessive risk in compensation programs (at least for those companies participating in the financial bailout) will cause a good number of companies to reconsider their use of stock options, and, most likely, many of them will veer further away from stock options and towards full value awards like restricted stock units and performance shares/units. In these challenging times it will be harder to justify leveraged incentives that can result in greater upside potential than is the case for shareholders whose equity participation has come the old fashioned way – by buying full value shares.
A short while ago, Corp Fin Director John White announced he will be leaving the SEC at the end of the year after working at the SEC for nearly three years. I understand that John will return to the law firm for which he spent over 30 years, Cravath Swaine & Moore. Like his predecessor, John has overseen an enormous amount of regulatory change on his watch – and we thank John for all he has done for the corporate community (and for us by speaking out about responsible executive compensation disclosures).
Last Friday, the WSJ ran this front page, top article – entitled “Banks Owe Billions to Executives” – reporting that the big financial institutions getting capital infusions from the Treasury Department owed their senior executives more than $40 billion for past years’ pay and pensions as of the end of 2007.
The article notes that “Few firms report the size of these debts to their executives. (Goldman is an exception.) In most cases, the Journal calculated them by extrapolating from figures that the firms do have to disclose.”
What the WSJ would be surprised to hear is that many companies don’t even report the size of these debts to their own compensation committees and boards – because they don’t conduct a wealth accumulation analysis! In our “Wealth Accumulation Analysis” Practice Area, we have a number of sample tables to help you get started, including this new “Wealth Accumulation/Full Walk Away Amounts Chart” courtesy of Watson Wyatt and Deloitte Consulting.
In his “Icahn Report” Blog, Carl Icahn recently threw down the gauntlet and blamed compensation consultants for excessive CEO pay. Here is an excerpt from his blog:
A major reason executive pay packages are ballooning is because of the incestuous relationships between boards and CEOs who conspire to give lucrative pay-and-perk packages to each other. But it is also due to the egregious use of “compensation consultants” that soak up multi-million dollar fees to provide strategic counsel to boards and in addition advise ever higher pay packages to top managers they presume to oversee – whether they perform well or not.
We’re ready to see some responses from those toiling in the fields. I know Carl has missed the mark, how about you?
Recently, Equilar released its latest trend reports regarding stock ownership policies. Below is a summary of the full reports (which can be purchased from Equilar here):
1. Executive Stock Ownership Policies
– The prevalence of Fortune 250 companies with publicly disclosed executive stock ownership policies, including ownership guidelines and/or holding requirements, increased from 80.9% in 2006 to 82.6% in 2007.
– Ownership guidelines remain the most prevalent form of ownership policy, appearing at 78.0% of Fortune 250 companies in 2007. In 2006, 75.5% of companies disclosed guidelines.
– For Fortune 250 companies with ownership guidelines, most choose to define ownership targets as a multiple of base salary. In 2007, 79.8% set their targets in this fashion.
2. Director Stock Ownership Policies
– The prevalence of Fortune 250 companies with publicly disclosed non-employee director stock ownership policies, including ownership guidelines and/or holding requirements, increased from 77.6% in 2006 to 78.9% in 2007.
– Often, ownership guidelines and holding requirements can be used in tandem to promote equity ownership. Among the Fortune 250, the prevalence of companies with both types of policies for non-employee directors increased from 12.8% in 2006 to 16.2% in 2007.